Balance Sheet Information

For many years in the US and other countries, cash was combined with cash equivalents under the heading "cash and cash equivalents" on a company's balance sheet and statement of cash flows. In an attempt to simplify accounting standards the US Financial Accounting Standards Board voted approval in early 2007 to change this heading to simply "cash." Items previously classified as cash equivalents would now be classified in the same way as other short-term investments. An implementation date has yet to be set, but in anticipation of this change, we will use the new terminology in the financial statements presented in this text. However, unless there is official implementation and guidance on this issue, "cash and cash equivalents" must be used in actual practice.

The further an asset is removed from cash, the less liquid it is. Accounts receivable are one step from cash, and inventories are two steps. Accounts receivable represent IOUs from customers, which should convert into cash within a given billing period, usually 30 to 60 days. Inventories are used in the production of a product. The product must first be sold and a receivable generated before it can go the next step and be converted into cash. Because fixed assets, long-term investment, and other long-term assets are the least liquid, they appear last.

The bottom panel of the table shows the liabilities and shareholders' equity of the company. These items are ordered according to the nearness with which thev are likely to be paid All current liabilities are payable within one year, whereas the long-term debt is payable beyond one year. Shareholders' equity will be "paid" only through regular cash dividends, common stock repurchases, and, perhaps, a final liquidation dividend. Shareholders' equity, or net worth as it is sometimes called, consists of several subcategories. Common stock (at par) and additional paid-in capital together represent the total amount of money paid into the company in exchange for shares of common stock. As we discuss in Chapter 20, a par value is usually assigned to the stock. In this case the par value is $1 per share, which means that on March 31, 20X2, there were roughly 421,000 shares of common stock outstanding. The additional paid-in capital section represents money paid in excess of par value for shares sold. For example, if the company were to sell an additional share of stock for $6, there would be a $1 increase in the common stock section and a $5 increase in the additional paid-in capital section. Retained earnings represent a company's cumulative profits after dividends since the firm's inception: thus these are earnings that have been retained (or reinvested) in the firm.

It is common to hear people say that a company pays dividends "out of retained earnings." Wrong. A company pays dividends out of "cash," while incurring a corresponding réduction in the retained earnings account. Retained earnings are not a pile of cash (or any other asset) but merely an accounting entry used to describe one source of financing for the firm's assets. We see in the table that total assets equal - or balance - total liabilities plus shareholders' equity. Indeed, that is an accounting identity. Also, it follows that assets minus liabilities equal shareholders' equity. For the most part, the liabilities of the firm are known with certainty.

Most accounting questions concerning the balance sheet have to do with the numbers attached to the assets. We must remember that the figures are accounting numbers as opposed to estimates of the economic value of the assets. The accounting value of fixed assets (land, buildings, equipment) is based on their actual (historical) costs, not on what they would cost today (the replacement value). Inventories are stated at the lower of cost or market value. The receivable figure implies that all of these receivables will be collected. This may or may not be the case. Often it is necessary to go beyond the reported figures to analyze the financial condition of the firm properly. Depending on the analysis, the shareholders' equity figure shown on the balance sheet, which is a residual amount, may or may not be a reasonable approximation of the true value of the firm to the shareholders.