The Balance Sheet Purpose of the Balance Sheet

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<ul><li> 1. The Balance Sheet </li> <li> 2. Purpose of the Balance Sheet <ul><li>Traditionally the oldest statement </li></ul><ul><li>Theoretically represents financial position, including net worth. </li></ul></li> <li> 3. Format <ul><li>Follows the balance sheet equation </li></ul><ul><li>Three main elements- Assets, Liabilities and Equity </li></ul><ul><li>In the USA, Assets and Liabilities are classified as current or non-current, in decreasing order of presumed liquidity. </li></ul></li> <li> 4. Time Frame <ul><li>The balance sheet reflects conditions at a point in time, usually, the fiscal year-end. </li></ul></li> <li> 5. Core Issues <ul><li><ul><li>Recognition (e.g., should I recognize this as an asset?) </li></ul></li></ul><ul><li><ul><li>Valuation (If so, for how much?) </li></ul></li></ul><ul><li><ul><li>Classification (What should I call it?) </li></ul></li></ul></li> <li> 6. Definition of an asset <ul><li>Theoretically- A resource that has the potential for providing the firm with a future economic benefit . </li></ul><ul><li>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 . </li></ul></li> <li> 7. GAAP Recognition Criteria <ul><li>The firm has acquired rights to its use as a result of a past transaction or exchange , and </li></ul><ul><li>The firm can measure or quantify the future benefits with a reasonable degree of precision. </li></ul></li> <li> 8. The Subjective Nature of Recognition <ul><li>The fundamental question- </li></ul><ul><li><ul><li>Do I expense it or capitalize ? </li></ul></li></ul><ul><li><ul><li>Often involves a subjective assessment concerning whether there will be a probable future benefit. </li></ul></li></ul></li> <li> 9. Valuation of Assets <ul><li>The options: </li></ul><ul><li><ul><li>Historical cost </li></ul></li></ul><ul><li><ul><li>Entry Value </li></ul></li></ul><ul><li><ul><li>Exit value </li></ul></li></ul><ul><li><ul><li>Present Value </li></ul></li></ul></li> <li> 10. Valuation- Why not Current Value? <ul><li>Entry Value (replacement cost)- </li></ul><ul><li><ul><li>How do you reliably estimate second-hand values? </li></ul></li></ul><ul><li>Exit value (realizable value)- </li></ul><ul><li><ul><li>Same problem </li></ul></li></ul><ul><li>Present value (of future cash flows)- </li></ul><ul><li><ul><li>How do you estimate future cash flows and associated risks? </li></ul></li></ul></li> <li> 11. Balance Sheet Issues <ul><li>The problem of mis-specification. </li></ul><ul><li>Adding apples, oranges and tomatoes. What does the sum mean? </li></ul><ul><li>The question of timing and the impact on relevancy. </li></ul><ul><li>The bottom line: The Statement of Financial Position is NOT a statement of financial position. </li></ul></li> <li> 12. The Issue of Allocation <ul><li>Property Plant and Equipment- </li></ul><ul><li><ul><li>Includes Building, Machinery, Equipment </li></ul></li></ul><ul><li><ul><li>Valuation: Historical Cost </li></ul></li></ul><ul><li><ul><li>Costs capitalized: everything necessary to get assets ready to operate </li></ul></li></ul><ul><li><ul><li>Recorded net of depreciation and/or depletion </li></ul></li></ul></li> <li> 13. Methods of Depreciation <ul><li>Straight Line </li></ul><ul><li>Units of Production </li></ul><ul><li>Accelerated Methods </li></ul><ul><li><ul><li>Declining Balance </li></ul></li></ul><ul><li><ul><li>Sum of Years Digits </li></ul></li></ul></li> <li> 14. Example <ul><li>ABC purchases a vehicle for $ 20,000, with an estimated life of 5 years (200,000 miles) and an expected residual value of $ 500. </li></ul><ul><li>Depreciation- </li></ul><ul><li><ul><li>Straight line- $ 3850 </li></ul></li></ul><ul><li><ul><li>200% declining balance- $ 8,000 </li></ul></li></ul><ul><li><ul><li>UOP (assuming use of 50,000 miles)- $ 4,875 </li></ul></li></ul></li> <li> 15. Depreciation is: <ul><li>Always an allocation process (as opposed to truly measuring something, like actual decline in exit value). </li></ul><ul><li>When accelerated methods are used, </li></ul><ul><li><ul><li>More in early years </li></ul></li></ul><ul><li><ul><li>Lower in later years </li></ul></li></ul></li> <li> 16. Non-Current Assets <ul><li>Intangibles- Most assets you cannot touch but that provide future economic benefits to firm. </li></ul><ul><li>Include trademarks, copyrights, franchises, patents, brands, goodwill </li></ul><ul><li>Valuation: Historical Cost </li></ul><ul><li>Recorded net of amortization charges </li></ul></li> <li> 17. Intangibles are: <ul><li>Often not systematically amortized but instead tested periodically to see if stated values have been impaired. </li></ul><ul><li>Are not capitalized if created internally. Due to conservatism, all research and development costs are expensed. </li></ul></li> <li> 18. <ul><li>Intangible assets are the newest, and arguably most important, asset class today. From these, much wealth is being created. Unfortunately: </li></ul><ul><li>We have little idea how to measure and recognize the value of these assets. </li></ul></li> <li> 19. Summary of Key Points-Assets <ul><li>Three issues decide how assets will be reported- recognition, valuation, and classification . </li></ul><ul><li>Recognition is mainly a question of capitalization vs expensing. The main issue is whether any future economic benefit accrues to the firm. </li></ul></li> <li> 20. Summary of Key Points-Assets <ul><li>The Balance sheet has historically been a parking lot for historical costs that will be expensed sometime in the future. </li></ul><ul><li>Increasingly, more and more assets are being stated at current value. </li></ul><ul><li>Today , asset valuations on the balance sheet collectively reflect a mix of values and costs. </li></ul></li> <li> 21. Summary of Key Points-Assets <ul><li>Many assets are adjusted after initial recognition. Adjustments can be: </li></ul><ul><li><ul><li>Allocations - Systematic reductions that dont really measure anything. (e.g., depreciation) </li></ul></li></ul><ul><li><ul><li>Measurements - attempts to adjust values based on changes in exit value that have occurred. (e.g., impairment tests of goodwill) </li></ul></li></ul></li> <li> 22. Liabilities <ul><li>What are they? </li></ul><ul><li><ul><li>Theoretically: probable future sacrifices of economic benefits </li></ul></li></ul><ul><li><ul><li>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 </li></ul></li></ul></li> <li> 23. Liabilities <ul><li>What are they? </li></ul><ul><li><ul><li>Practically (Recognition criteria): </li></ul></li></ul><ul><li><ul><li><ul><li>Probable future sacrifices of resources </li></ul></li></ul></li></ul><ul><li><ul><li><ul><li>Can be measured (quantified) </li></ul></li></ul></li></ul><ul><li><ul><li><ul><li>Generally, cant be avoided . </li></ul></li></ul></li></ul><ul><li><ul><li><ul><li>Arise through a past transaction or exchange . </li></ul></li></ul></li></ul></li> <li> 24. Liabilities <ul><li>Classification: </li></ul><ul><li><ul><li>Current </li></ul></li></ul><ul><li><ul><li><ul><li>Listed in order of probable liquidation dates </li></ul></li></ul></li></ul><ul><li><ul><li><ul><li>Types: accounts payable, wages payable, dividends, payable, collections received in advance of delivering goods and services </li></ul></li></ul></li></ul><ul><li><ul><li><ul><li>Valuation- Usually at historical value. </li></ul></li></ul></li></ul></li> <li> 25. Liabilities <ul><li>Classification </li></ul><ul><li><ul><li>Non-current </li></ul></li></ul><ul><li><ul><li><ul><li>Types: Deferred taxes, bonds, long-term loans </li></ul></li></ul></li></ul><ul><li><ul><li><ul><li>Valuation: Historical exchange value, with adjustments for amortization of premiums and discounts. </li></ul></li></ul></li></ul></li> <li> 26. Liabilities <ul><li>The problem of what probable means- </li></ul><ul><li><ul><li>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) </li></ul></li></ul><ul><li><ul><li>Contingent liabilities are not usually reported in the balance sheet. Instead they are disclosed in the footnotes. </li></ul></li></ul><ul><li><ul><li>The exception is when they can be quantified and are probably going to cost the firm future resources to resolve. </li></ul></li></ul></li> <li> 27. Key points-Liabilities <ul><li>Financial reporting liabilities reflect probable economic sacrifices of future resources. </li></ul><ul><li>Reported liabilities arise through exchange transactions . </li></ul><ul><li>Not all legal, or even economic, liabilities are reported in the balance sheet. </li></ul><ul><li>Liabilities are not reported at market value , but instead historical value, with adjustments. </li></ul></li> <li> 28. Shareholders Equity <ul><li>Two types: </li></ul><ul><li><ul><li>Contributed capital </li></ul></li></ul><ul><li><ul><li>Retained Earnings </li></ul></li></ul></li> <li> 29. Types of Stock <ul><li>Common </li></ul><ul><li>Preferred </li></ul><ul><li><ul><li>Preference over common shareholders with respect to dividends, if declared, and at liquidation </li></ul></li></ul><ul><li><ul><li>Usually have no voting rights. </li></ul></li></ul><ul><li><ul><li>Debatable whether preferred shares are really equity. </li></ul></li></ul></li> <li> 30. Important things to know about Equity <ul><li>Shareholders equity is a plug, i.e., the same as recorded assets less liabilities . </li></ul><ul><li>Shareholders equity does not reflect the market value of shareholders holdings. </li></ul><ul><li>Two kinds of equity- contributed capital and retained earnings . </li></ul><ul><li>Main things to know-common stock, preference stock, dividends, treasury stock transactions, stock dividends and splits, . </li></ul></li> <li> 31. Income Statement Accrual Accounting-Purpose Revenue Recognition under GAAP Expense Recognition under GAAP </li> <li> 32. The Earnings Process <ul><li>Production </li></ul><ul><li>Sales Generation (Order) </li></ul><ul><li>Delivery of product or service </li></ul><ul><li>Payment </li></ul></li> <li> 33. Possibilities for Earnings Recognition <ul><li>Point of </li></ul><ul><li><ul><li>Production, e.g., when goods are made. </li></ul></li></ul><ul><li><ul><li>When an order is received/given. </li></ul></li></ul><ul><li><ul><li>When goods and services are provided/delivered/received. </li></ul></li></ul><ul><li><ul><li>When firm receives/remits cash. </li></ul></li></ul></li> <li> 34. Cash Basis Accounting <ul><li>Is a simple reporting of cash receipts and disbursements . </li></ul><ul><li>Can be manipulated </li></ul><ul><li>Can be misleading about non-cash expenses/revenues. </li></ul><ul><li>On the other hand, involves the verifiable flow of a measurable commodity. </li></ul><ul><li>May not explicitly map to economic profitability. </li></ul></li> <li> 35. Profitability-What is it? <ul><li>Theoretically: any change in corporate wealth. </li></ul><ul><li>Practically: earned revenues less costs incurred to produce those revenues </li></ul><ul><li>The problem: Earned revenues and costs incurred are abstract ideas. Measurement of these will necessarily vary across different economic agents. </li></ul></li> <li> 36. The Problem: <ul><li>When has a firm earned revenues? </li></ul><ul><li>When has a firm incurred costs to produce those revenues? </li></ul></li> <li> 37. Accrual Accounting <ul><li>Is a set of rules/traditions (GAAP) designed to </li></ul><ul><li><ul><li>recognize revenue when earned as defined by the revenue realization principle . </li></ul></li></ul><ul><li><ul><li>Recognize expenses when they are incurred, as defined by GAAP. </li></ul></li></ul><ul><li><ul><li>NOTE: Cash inflows (outflows) associated with revenues (expenses) may occur before, during, or after accrual-based recognition occurs. </li></ul></li></ul></li> <li> 38. Revenues <ul><li>When are revenues usually recognized? </li></ul><ul><li><ul><li>Generally when sales are completed by delivery, in the legal sense, to customers. </li></ul></li></ul></li> <li> 39. Revenues <ul><li>But is this really when revenues are earned? </li></ul></li> <li> 40. Some Alternatives to Revenue Recognition at the Time of sale <ul><li>When production is complete (e.g., gold miners). </li></ul><ul><li>After sales orders are received and during production (e.g., Boeing). </li></ul><ul><li>When cash is fully received (e.g., credit collectors). </li></ul><ul><li>As cash is gradually received (e.g., real estate). </li></ul></li> <li> 41. Costs/Expenses <ul><li>The Ideal: Mapping ( Matching ) all costs incurred to revenues produced and recognized. </li></ul><ul><li>The problem: </li></ul><ul><li><ul><li>Many costs have no clear relation to revenues. </li></ul></li></ul><ul><li><ul><li>As with revenues, its not always clear if a cost has been incurred. </li></ul></li></ul><ul><li><ul><li>Sometimes, it can even be unclear if a cost even exists, or if it does, whether it detracts from revenue or actually increases it (e.g., goodwill). </li></ul></li></ul></li> <li> 42. Costs-Types <ul><li>Costs directly traceable to specific revenue transactions (e.g., costs to buy/produce inventory). </li></ul><ul><li>Costs associated with, and/or systematically allocable to time periods in which revenue is recognized (e.g., rent expense). </li></ul><ul><li>Costs for which no measurable future benefit can be discerned (e.g., R&amp;D). </li></ul></li> <li> 43. Cost-Types <ul><li>Costs in financial reports are expensed through one of two paths: </li></ul><ul><li><ul><li>Product costs : costs associated with producing or acquiring goods to be resold. </li></ul></li></ul><ul><li><ul><li>Period Costs : everything else. </li></ul></li></ul></li> <li> 44. Cost-Types <ul><li>From an analysis viewpoint, costs can also be viewed according to their relation to the production function: </li></ul><ul><li><ul><li>Fixed : Cost level doesnt change across a range of volume of goods and services produced. </li></ul></li></ul><ul><li><ul><li>Variable : Systematic variance of cost levels with production. </li></ul></li></ul></li> <li> 45. <ul><li>Income, or earnings, is equal to revenues less expenses. </li></ul><ul><li>But does earnings actually reflect the change in wealth that a firm experiences from one period to the next? </li></ul></li> <li> 46. Income- Fictitious or Real? <ul><li>Considerations: </li></ul><ul><li><ul><li>Accounting Income is determined by GAAP . Different rules = different reported profits </li></ul></li></ul><ul><li><ul><li>Dividends are paid with cash. A firm can have lots of reported income and no cash, and vice versa . </li></ul></li></ul></li> <li> 47. Goals <ul><li>The goal of financial reporting, and GAAP, are to: </li></ul><ul><li><ul><li>Report (changes in) financial position. </li></ul></li></ul><ul><li><ul><li>Report on the profitability of firms. </li></ul></li></ul><ul><li><ul><li>In the real world, these goals often conflict. </li></ul></li></ul></li> <li> 48. Income Characteristics <ul><li>Permanent versus transient </li></ul><ul><li>Controllable versus uncontrollable </li></ul><ul><li>Operational versus non-operational </li></ul></li> <li> 49. Income Statement Classification <ul><li>Income From continuing operations </li></ul><ul><li><ul><li>Single step format </li></ul></li></ul><ul><li><ul><li>Multiple step format </li></ul></li></ul><ul><li>Income from discontinuing operations </li></ul><ul><li>Extraordinary gains and losses </li></ul><ul><li>Cumulative effect of changes in accounting principles </li></ul></li> <li> 50. Single Step Format <ul><li><ul><li><ul><li><ul><li>Revenues XXX </li></ul></li></ul></li></ul></li></ul><ul><li><ul><li><ul><li><ul><li>Expenses XXX </li></ul></li></ul></li></ul></li></ul><ul><li><ul><li><ul><li><ul><li>Income before Taxes XXX </li></ul></li></ul></li></ul></li></ul><ul><li><ul><li><ul><li><ul><li>Income Tax expense XXX </li></ul></li></ul></li></ul></li></ul><ul><li><ul><li><ul><li><ul><li>Income from Continuing Operations XXX </li></ul></li></ul></li></ul></li></ul></li> <li> 51. Multiple-Step Format <ul><li>Revenues XXX </li></ul><ul><li><ul><li>Less: COGS XXX </li></ul></li></ul><ul><li><ul><li>Gross Profit XXX </li></ul></li></ul><ul><li><ul><li>Less: Operating Expenses XXX </li></ul></li></ul><ul><li><ul><li>Operating Income XXX </li></ul></li></ul><ul><li><ul><li>Add: Other Income XXX </li></ul></li></ul><ul><li><ul><li>Less: Other expenses XXX </li></ul></li></ul><ul><li><ul><li>Income Before Taxes XXX </li></ul></li></ul><ul><li><ul><li>Less Income Tax XXX </li></ul></li></ul><

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