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How is a classified Balance Sheet prepared? (10m:51s)

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Slides 1-2 (1m:06s) Welcome to Introduction to Accounting Preparing for a User's Perspective
How is a classified Balance Sheet prepared and how do the classifications help users?

Asset and liabilities are classified in order of liquidity
In the last topic, I introduced the idea of liquidity and the classified balance sheet that relies on it. Liquidity is often referred to as "nearness to cash" or the ability of an asset to be quickly converted into cash.

Assets that are expected to be converted to cash very quickly are said to be "liquid". Some assets, such as prepaid expenses, will not necessarily be converted into cash but they will save the company from having to pay additional cash, so they are also considered to be "liquid" assets. The most liquid assets will appear on the balance sheet closest to the cash account. Assets that are expected to take longer to convert into cash should appear on the balance sheet further away from cash. If management expects that an asset will be converted into cash within one year, or within the company's operating cycle, whichever is longer, the asset should be classified as a "current" asset. If management expects that it will take longer than one year (or the operating cycle) to convert the asset into cash, it should be classified as a "non-current" asset.

Slides 3-4 (0m:58s)A company's operating cycle is the time it takes to buy product, sell it, and collect payment. The operating cycle for most retailers is less than a year. However, for other companies, like those in the lumber industry that have to buy, plant, grow, harvest, sell then collect, their operating cycle is often longer than one year. Companies that have operating cycles longer than one year will refer to the length of this longer operating cycle when making classification decisions between what is "current" and what is "non-current". Companies with an operating cycle of one year or less, will use one year when classifying between current and non-current. For the following examples, you will notice that I use one-year when making classification decisions as it is the most common.

Liabilities that are expected to be paid off within one year, or within the operating cycle, whichever is longer, will be classified as current liabilities and those taking longer than one year to pay off will be classified as long-term liabilities.

Slide 5 (0m:11s)Synonymous classification terminology
Here are some synonymous terms that you should be aware of because you will likely see all of them as you learn how to read classified balance sheets. Please pause the video and review these terms.

Slide 6 (3m:14s)Classified Balance Sheet Example
XYZ Company's classified Balance Sheet below should help you see how a classified Balance Sheet can provide significantly more useful information to users than what unclassified Balance Sheets provide. Please take a moment to review XYZ's classified balance sheet and see what you can learn about what management intends to do with its assets and liabilities in the upcoming year. For example:

What pattern do you see in how the assets and liabilities have been ordered from top-to-bottom?
Why do you think these assets and liabilities were placed in this particular order and not in some other order?
What do the noted classifications tell you about management's future intentions for each asset and liability account, the timing of such intentions, and the impact of such intentions on XYZ's future cash flows?

Based on your review, you should have noted that all of XYZ's assets and liabilities were classified from top-to-bottom in order of their liquidity with the most liquid accounts at the top and the least liquid accounts at the bottom. Note: In the US we place the most liquid items at the top of the balance sheet, but internationally, some businesses are allowed to reverse the order of liquidity by placing the least liquid assets at the top and the most liquid (i.e. cash) at the bottom. Since this accounting course focuses on teaching US GAAP rather than IFRS, we will place the most liquid items at the top and then work our way down.

According to XYZ's balance sheet, management has indicated that its most liquid asset is cash and cash equivalents and have correctly presented it at the top. Land appears to be XYZ's least liquid asset because it was placed at the bottom. Management's classification of land at the bottom of the balance sheet indicates that management plans to take at least a year before converting the land to cash AND that it expects to convert all of its other assets to cash before it converts its land.

Moving over to liabilities, you should note that management expects to pay off its accounts payable first, because they were classified at the top of all current liabilities. In addition, we can see that XYZ plans to pay off its "Other long-term liabilities" last as indicated by their placement at the bottom of all liabilities. In order to properly classify liabilities management will often refer to payment terms with suppliers, prior payment history as well as contractual payment terms for their notes, mortgages, bonds and other liabilities.

Here are some questions about XYZ's liabilities that its classified Balance Sheet might help us answer:

Do you think XYZ will actually be able to pay off its $20,000 of current liabilities when it comes due within the next year? What information and accounts would you look at to answer this? What numbers will you use to arrive at your conclusion?

Which of XYZ's $130,000 in assets do you think it will most likely be able to convert into cash so that it can pay off the $20,000 of current liabilities that will come do within the next year?

Hopefully you noticed that these current assets will be the most likely to help pay off these current liabilities.

Later in this learning module you will learn how to compute and interpret the current ratio (i.e. current assets / current liabilities) which is a financial ratio that helps users assess a company's "liquidity" and its ability to pay off its current liabilities.

Slide 7 (2m:06s)Test your knowledge
Why don't we test your knowledge using a simple comparative example of two classified balance sheets, one for Company A, the other for Company B? You can assume that Company A and B are identical in every way except for how management has classified its assets and liabilities.

Based on the two balance sheets above, which company do you think will experience the most difficulty trying to obtain the necessary cash to pay off its current liabilities when they come due next year? In other words, "Which company is more liquid?"

Because a company's current assets are used to pay off its current liabilities, a "liquid" company should have more current assets than current liabilities.

Using this measure of liquidity, how liquid is Company A? Company A only has $10 of current assets, but it has $90 of current liabilities. This is not a good situation because if you compute its ratio of current assets of $10 to its current liabilities of $90 (10/90), you get .11. This indicates that for every $1 of current liability that will come due within the next year, Company A expects to only have $.11 of current assets to make such payments. This "current ratio" (i.e. current assets/current liabilities) is quite small and indicates that Company A is not very liquid. Potential suppliers should think twice before selling to Company A on account.

However, if you were to compute Company B's current ratio ($90 current assets / $10 current liabilities) you would arrive at a current ratio of 9. This indicates that for every $1 of current liability expected to come due within the next year, Company B expects to convert $9 of current assets into cash to make such payments. Company B's current ratio of 9 shows that it is very liquid and, since the companies are identical in every other way, Company B would definitely be a better credit risk. Note: it is possible to be "too liquid" if your current assets are sitting around not generating income.

Computing a company's current ratio and using it to assess a company's liquidity as compared to other companies is just one example of how users can benefit from the information provided on a classified balance sheet.

Slide 8 (0m:38s)Boeing's long-term pension liability
As noted previously, liability classifications are also very important to financial statement users because they indicate upcoming demands on the company's cash. If a significant long-term loan were reclassified from long-term to short-term because its maturity date is in the next year, such reclassification could reveal that the company will be unable to pay off the loan with its current resources and may need to refinance or find other sources of cash to pay it off. For example, Boeing has a $16.5 B liability for pensions that, luckily for Boeing, are still classified as long-term. Please pause the video and read the example below.

Slide 9 (0m:38s)How are classified balance sheets helpful to users?
Classified balance sheets help management communicate their future intentions and expected cash flows to financial statement users. For example, if a company were to classify its manufacturing plant as a current asset, that would send a message to all users that the company plans to sell or dispose of the plant within the coming year and will likely receive a significant cash inflow as a result. It also indicates that the company will either need to purchase a new plant or that it possibly is downsizing its manufacturing operations. If it is classified as a long-term asset, it sends the message that the company expects to continue to use the plant for at least one more year.

Slide 10 (0m:22s)
Classified balance sheets are very helpful to users as they strive to predict future cash inflows, through the conversion of assets, and future cash outflows, through the paying off of liabilities. This predictive ability enables users to peer into the future and recognize cash flow difficulties, as well as cash flow surpluses, well in advance so that appropriate plans can be made.

Slide 11 (0m:49s)Equity is classified by its source
Equity is not really classified in relation to liquidity, it is simply broken out based on its source, either contributed or internally generated as follows:

1) Contributed equity: When owners contribute capital and other resources to the company their ownership claims, in the form of capital stock, increase.
2) Internally generated equity: When owners choose to retain the company's net income within the company rather than having it paid out to themselves in the form of distributions or dividends their ownership claims, in the form of retained earnings, increase.

Based on a review of XYZ's Balance Sheet, we can see that its Stockholders' Equity section has been classified by funding source with both contributed equity (i.e. Capital Stock of $10,000) as well as internally generated equity (i.e. Retained Earnings of $50,000).

Slides 12-13 (0m:51s)Summary
Management uses classified balance sheets to indicate a company’s liquidity. Liquidity represents a company's ability to make timely payments on its current liabilities. In the United States, the most liquid assets are listed at the top of the assets section, and the liabilities to be paid off the soonest are listed at the top of the liabilities section. Current usually represents less than one year, but could be longer depending on the length of the operating cycle. Through proper analysis of a classified balance sheet, external users can help assess a company’s future cash flows, its liquidity and its short-term credit worthiness.

The equity accounts on a balance sheet are classified based on whether the equity was contributed directly by owners (i.e. capital stock) or was generated internally by the business and the owners elected to retain it in the business (i.e. retained earnings).