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The Balance Sheet StatementLearning Objectives
1.How balance sheet accounts are measured, classified and presented.
2.How balance sheet information is used.
3.Balance sheet terminology and format outside the U.S.4.How footnotes aid to the understanding of the firm’s accounting policies, contingent liabilities, subsequent events, and related-party transactions
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The Accounting Equation
Assets = Liabilities + Equity
Shareholders’ Equity:
What’s left of the company’s assets
after paying off liabilities. It also referred to as net assets.
2
Balance sheet classification:Overview
• Current assets• Property, plant and equipment• Investments• Other assets
• Current liabilities• Long-term debt• Other liabilities
• Preferred and common stock• Additional paid-in capital• Retained earnings
ASSETS LIABILITIES EQUITY= +
ContributedCapital
3
Elements of the balance sheet
• Probable future economic benefits• Obtained from past transactions or events
• Probable future sacrifices of economic benefits• Arising from present obligations• To transfer assets or provide services in the future• As a result of past transactions or events
• The residual interest in net assets.
ASSETS LIABILITIES EQUITY= +
How the money is invested Where the money came from
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Balance sheet Classification and Account Measurement - Current assets
Amortized cost or current market value
Net realizable value
Lower of cost or current market value
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Assets – classification and measurement
Resources with future economic benefit to a business entity as a result of a past transaction.
Current Assets: cash and other assets that are reasonably expected to be realized in cash or sold, or consumed during a normal operating cycle or one year, whichever is longer
Examples: Cash and cash equivalents, short-term investments (reported at the fair value), receivables (estimated amount collectible), inventory (LCM), prepaid expenses, etc.
Balance Sheet Classification and Account Measurement -PPE, Investments and Intangibles
Historical cost minus accumulated depreciation except that fair market value is used when “impaired”
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Assets (contd.)
Long-term Investments: Comprise of the following
Securities (i.e., bonds, stock, long-term notes)
Fixed assets (i.e., land, building)
Special funds (i.e., pension fund, bond sinking fund)
Nonconsolidated subsidiaries or affiliated companies
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Assets (contd.) Property, Plant, Equipment (i.e., building,
Land, Machinery and equipment, capital leases): assets used in firms’ operations and meet the following criteria:
1. Economic life > 1 year;
2. Acquired for use in operation;
3. Not for resale to customers;
4. $ is material. (materiality)
Depreciation will be applied except for land.
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Assets (contd.) Intangible Assets: assets with no
physical substance but have value based on rights or privileges that belong to the owner (i.e., goodwill, patents, franchises, trademarks,…).
Amortization for limited life intangibles (i.e., patents, franchises) and impairment test for indefinite-life intangibles (i.e., goodwill).
Balance Sheet Classification and Measurement - Liabilities
Amount due at maturity
Historical cost
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Discounted present value
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Liabilities
Legal obligations required future payments of assets or services as a result of a business entity’s past transactions or events.
A. Current Liabilities
B. Long-term Liabilities
C. Other Liabilities
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A. Current Liabilities
Obligations must be fulfilled in one year or one operating cycle, whichever is longer. (will require the use of current assets or the creation of current liability) (i.e., A/P, N/P, accrual payable, unearned revenue, income tax payable, current portion of L-T debt)
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Contingent Liabilities
Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)
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B. Long-Term Liabilities
Obligations are not due in next year or next operating cycle, whichever is longer. (i.e., bonds payable, pension liability)
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C. Other Liabilities
Long-term advances from customers, deferred income taxes.
Balance Sheet Classification and Account Measurement -Stockholders’ equity
Historical par value
Historical cost
Combination of different measurement bases
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Stockholders’ Equity
Residual claims (assets-liabilities) to the business entity from stockholders including:
a. contributed capital
b. (+ or -)Accumulated Other Comprehensive Income
c. retained earnings (or - deficit)
d. (-)treasury stock
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a. Contributed Capital
Par value of common stock
Par value of prefer stock
Paid-in capital in excess of par value of common stock or preferred stock
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b. Accumulated Other Comprehensive Income
Increase of assets without outflows of assets, increase of liabilities, increase of income or issuance of common stock (i.e.,(+) increase in market value of securities-available-for-sale (+ or -), gains or losses of foreign currency adjustments, etc.)
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c. Retained Earnings
Net income not distributed to stockholders
appropriated
unappropriated
Balance sheet information
LIABILITIES+
EQUITY
ASSETS
1. Rates of return
2. Capital structure
3. Liquidity
4. Solvency
5. Flexibility
ROA and ROCE
Debt vs. Equity
Cash conversion
Ability to pay debt
Operating and financial
Helps
assess
Balance Sheet
22
1. Rate of Return Ratios
ROA (return on assets) and ROCE (return on common equity) ratios: Evaluate operating efficiency and profitability.ROA = Net operating profit after taxes (NOPAT) /
Average assets
ROCE =(Net income – Preferred dividends) / Average
common shareholders’ equity
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2. Capital Structure
The balance sheet provides critical information for understanding an entity’s capital structure.
Capital structure refers to how much of an entity’s assets are financed from debt versus equity sources.
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3. Liquidity Ratios
Liquidity measures how readily assets can be converted to cash relative to how soon liabilities will have to be paid in cash.
Current ratio: Indicate the level of current resources available to pay current debts. Current Ratio = Current Assets / Current
Liabilities Question:
Does higher ratio always indicate better financial status?
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4. Solvency Solvency defines the ability of a company
to generate sufficient cash flows to maintain its productive capacity and still able to pay off the long-term debt.
Debt ratios provide information about the amount of long-term debt in a company’s financial structure.
Long-term debt to assets =
Long term debt/Total assets
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Solvency (contd.)
A company that can not make timely payments in the amount required becomes insolvent and may be compelled to reorganize or liquidate.
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5. Flexibility
Flexibility refers to the ability to adapt or revise to a new strategy for different circumstances.
The ability to adjust to unexpected downturn in the economic environment in which it operates or to take advantage of profitable investment opportunities when they arise.
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Analytical insights:Understanding the business
Which company is: Deere E-Trade Potomac Electric Power Wal-Mart
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Balance sheet presentation:International differences
Current Assets
Long-lived Assets
Current Liabilities
Non-current Liabilities
Stockholders’ Equity
Fixed Assets
Current Assets
Current Liabilities
Non-current Liabilities
Capital Employed
U.S. Format: U.K. Format:
+
=
+
+
+
-
-
=
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Financial statement footnotes Footnotes are an integral part of
companies’ financial reports. These “notes” help users better
understand and interpret the numbers presented in the body of the financial statements.
Three important notes:1.Summary of significant accounting
policies.2.Subsequent event disclosures.3.Related party transactions 4-3131
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Limitations of the Balance Sheet 1. Historical costs reporting for most of assets and liabilities.
2. Estimations involved in the value of some assets and liabilities (i.e., the net realizable value of accounts receivable and the cost of warranty).
3. the omission of some valuable items such as goodwill of the company.
4. Off-balance sheet liabilities.
Summary1. The balance sheet shows the assets
owned by a company at a given point in time, and how those assets are financed (debt vs. equity).
2. Be alert for differences in balance sheet measurement bases, account titles, and statement format.
3. Financial statement footnotes provide important information..
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