Question

Explain why the balance sheet does not portray the market value of the entity.

What do the terms "paid-in-capital" and "retained earnings" mean? A summary of the company’s significant accounting policies is a required disclosure. Why is this disclosure important to external financial statement users?
Represents the amount of capital received from stockholders. Paid-in Capital’s main source is Common Stock.

Every annual report of a public company includes an extensive discussion and analysis provided by the company’s management. Specifically, which aspects of the company must this discussion address? Isn’t management’s perspective too biased to be of use to investors and creditors?

Answer 1

Solution:

The balance sheet does not portray the market value of the entity (number of shares outstanding multiplied by price per share) for a various reasons. Most assets are not reported at fair value, but instead are measured at historical cost. Also, there are certain resources, such as trained employees, an experienced management team, and a good reputation, that are not recorded as assets at all. Therefore, the assets of a company minus its liabilities, as shown in the balance sheet, will not be representative of the company's market value.

Paid-in capital consists of amounts invested by shareholders in the corporation. Retained earnings equals net income less dividends paid to shareholders from the inception of the corporation.

The disclosure of the company's significant accounting policies is extremely important to external users in terms of their ability to compare financial information across companies. It is critical to a financial analyst involved in assessing future cash flows of two retail companies to know that one company uses FIFO and the other uses LIFO in recognizing inventory and cost of goods sold.

The discussion provides management's views on significant events, trends, and uncertainties pertaining to the company's (a) operations, (b) liquidity, and (c) capital resources. Certainly the Management Discussion and Analysis section may be slanted toward management's biased perspective and therefore can lack objectivity. However, management can offer an informed insight that might not be available elsewhere, so if the reader maintains awareness of the information's source, it can offer a unique view of the situation.