The Balance Sheet Purpose of the Balance Sheet

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Text of The Balance Sheet Purpose of the Balance Sheet

  • 1. The Balance Sheet
  • 2. Purpose of the Balance Sheet
    • Traditionally the oldest statement
    • Theoretically represents financial position, including net worth.
  • 3. Format
    • Follows the balance sheet equation
    • Three main elements- Assets, Liabilities and Equity
    • In the USA, Assets and Liabilities are classified as current or non-current, in decreasing order of presumed liquidity.
  • 4. Time Frame
    • The balance sheet reflects conditions at a point in time, usually, the fiscal year-end.
  • 5. Core Issues
      • Recognition (e.g., should I recognize this as an asset?)
      • Valuation (If so, for how much?)
      • Classification (What should I call it?)
  • 6. Definition of an asset
    • Theoretically- A resource that has the potential for providing the firm with a future economic benefit .
    • Practical- Same as above, except (a) I have to be able to quantify it, and (b) it probably has to arise via an exchange transaction .
  • 7. GAAP Recognition Criteria
    • The firm has acquired rights to its use as a result of a past transaction or exchange , and
    • The firm can measure or quantify the future benefits with a reasonable degree of precision.
  • 8. The Subjective Nature of Recognition
    • The fundamental question-
      • Do I expense it or capitalize ?
      • Often involves a subjective assessment concerning whether there will be a probable future benefit.
  • 9. Valuation of Assets
    • The options:
      • Historical cost
      • Entry Value
      • Exit value
      • Present Value
  • 10. Valuation- Why not Current Value?
    • Entry Value (replacement cost)-
      • How do you reliably estimate second-hand values?
    • Exit value (realizable value)-
      • Same problem
    • Present value (of future cash flows)-
      • How do you estimate future cash flows and associated risks?
  • 11. Balance Sheet Issues
    • The problem of mis-specification.
    • Adding apples, oranges and tomatoes. What does the sum mean?
    • The question of timing and the impact on relevancy.
    • The bottom line: The Statement of Financial Position is NOT a statement of financial position.
  • 12. The Issue of Allocation
    • Property Plant and Equipment-
      • Includes Building, Machinery, Equipment
      • Valuation: Historical Cost
      • Costs capitalized: everything necessary to get assets ready to operate
      • Recorded net of depreciation and/or depletion
  • 13. Methods of Depreciation
    • Straight Line
    • Units of Production
    • Accelerated Methods
      • Declining Balance
      • Sum of Years Digits
  • 14. Example
    • ABC purchases a vehicle for $ 20,000, with an estimated life of 5 years (200,000 miles) and an expected residual value of $ 500.
    • Depreciation-
      • Straight line- $ 3850
      • 200% declining balance- $ 8,000
      • UOP (assuming use of 50,000 miles)- $ 4,875
  • 15. Depreciation is:
    • Always an allocation process (as opposed to truly measuring something, like actual decline in exit value).
    • When accelerated methods are used,
      • More in early years
      • Lower in later years
  • 16. Non-Current Assets
    • Intangibles- Most assets you cannot touch but that provide future economic benefits to firm.
    • Include trademarks, copyrights, franchises, patents, brands, goodwill
    • Valuation: Historical Cost
    • Recorded net of amortization charges
  • 17. Intangibles are:
    • Often not systematically amortized but instead tested periodically to see if stated values have been impaired.
    • Are not capitalized if created internally. Due to conservatism, all research and development costs are expensed.
  • 18.
    • Intangible assets are the newest, and arguably most important, asset class today. From these, much wealth is being created. Unfortunately:
    • We have little idea how to measure and recognize the value of these assets.
  • 19. Summary of Key Points-Assets
    • Three issues decide how assets will be reported- recognition, valuation, and classification .
    • Recognition is mainly a question of capitalization vs expensing. The main issue is whether any future economic benefit accrues to the firm.
  • 20. Summary of Key Points-Assets
    • The Balance sheet has historically been a parking lot for historical costs that will be expensed sometime in the future.
    • Increasingly, more and more assets are being stated at current value.
    • Today , asset valuations on the balance sheet collectively reflect a mix of values and costs.
  • 21. Summary of Key Points-Assets
    • Many assets are adjusted after initial recognition. Adjustments can be:
      • Allocations - Systematic reductions that dont really measure anything. (e.g., depreciation)
      • Measurements - attempts to adjust values based on changes in exit value that have occurred. (e.g., impairment tests of goodwill)
  • 22. Liabilities
    • What are they?
      • Theoretically: probable future sacrifices of economic benefits
      • GAAP definition: probable future sacrifices of economic benefits arising from present obligations .to transfer assets or to provide services .in the future as a result of past transactions or events
  • 23. Liabilities
    • What are they?
      • Practically (Recognition criteria):
        • Probable future sacrifices of resources
        • Can be measured (quantified)
        • Generally, cant be avoided .
        • Arise through a past transaction or exchange .
  • 24. Liabilities
    • Classification:
      • Current
        • Listed in order of probable liquidation dates
        • Types: accounts payable, wages payable, dividends, payable, collections received in advance of delivering goods and services
        • Valuation- Usually at historical value.
  • 25. Liabilities
    • Classification
      • Non-current
        • Types: Deferred taxes, bonds, long-term loans
        • Valuation: Historical exchange value, with adjustments for amortization of premiums and discounts.
  • 26. Liabilities
    • The problem of what probable means-
      • Potential liabilities are known as contingent liabilities. Some future event must occur for them to happen. (e.g., a judgment by a court of law)
      • Contingent liabilities are not usually reported in the balance sheet. Instead they are disclosed in the footnotes.