Reading 22: Understanding Balance Sheet

Elements of Balance Sheet

Assets:
Resources controlled resulted from past transactions, and that are expected to provide future economic benefit.

Liabilities
Obligations resulted from past events, and are expected to require an outflow of economic resources

Equity
Owner's residual interest in the assets, after deducting liabilities

Uses and limitations

Use

Limitations

Assets, liabilities and equity should not be interpreted as market value or intrinsic value.

Balance sheet consists of a mixture of values: historical cost, amortized cost, fair value, etc.

Some assets and liabilities are difficult to quantify and/ or are not reported on the balance sheet.

Formats

Classified Balance sheet: Grouping of accounts into sub-categories ( current vs. noncurrent; financial vs. nonfinancial)

Liquidity-based Balance Sheet
Present assets and liability in order of liquidity

Classes of Assets, Liabilities and Equities

Assets

Liabilities

Equities

Current
(< 1 year)
reflect firm's operating activities/capacity

Non-current
(>1 year)
for continuing use, not resale
reflects firm's investing activities

Current
(<1 year)

Non-current
(>1 year)

Cash&Cash Equivalents

Highly liquid (typically money market instrument < 90 days)

BS values are generally identical when using either amortized cost or fair value

Account Receivable

Is reported at net realizable by estimating bad debt expense

Inventories

Are reported at the lower of cost or net realizable value (IFRS);
or the lower of cost or market value (GAAP)

Cost can be measured using standard costing or the retail method (banned in IFRS)

Different cost flow assumptions can affect inventory values

Property, plant and equipment (PP&E)
Depreciation

(IFRS) is reported using Cost Model or Revaluation Model;
(GAAP) is reported only with Cost Model

If carrying value > recoverable amount --> PP&E is impaired.

Recovery of impairment is ok under IFRS but not GAAP.

Intangible assets
Amortization

If created internally then are expensed as incurred.

Purchased intangible assets are reported as PP&E

Types

Unidentifiable assets

Items that must be expensed
(cannot be capitalized)

Example

Investment assets
(IFRS only)

Held-to-maturity securities

Trading securities

are reported at fair value

Unrealized gain/loss are reported in the income statement.

Available for sale securities

Gain/ loss are reported in equity.

Account payable

Amounts owed to supplier for G&S purchased on credit

Unearned revenue

Cash collected in advance of providing G&S

Bond payable

Reported at amortized cost

Held-for-trading liabilities & derivatives

Reported at fair value

Contributed capital
Amount paid in by common shareholder at historical cost

Preferred stock
Capital stock that has certain rights and privilege

Treasury stock
Issued common stock that has been repurchased by firm

Retained earnings
Cumulative undistributed earnings of the firm since inception

Non-controlling (minority) interest
Proportion of a subsidiary not owned by the parent

Accumulated other comprehensive income
Includes all changes to equity from sources other than net income and transaction with shareholders

Common-size balance sheet
Express each item of balance sheet as % of total assets.

Liquidity & Solvency Ratio

Liquidity Ratios

Current Ratio = $\frac{Asset_{current}}{Liability_{current}}$

Quick Ratio (a.k.a Acid test) =$\frac{Asset_{current} - Inventory}{Liability_{current}}$

Cash Ratio=$\frac{Cash + MarketableSecurities}{Liability_{current}}$

Solvency Ratios

Long-term debt to equity Ratio=$ \frac{Debt_{LongTerm}}{Equity}$

Total debt to equity Ratio=$\frac{Debt_{Total}}{Equity}$

Debt Ratio=$ \frac{Debt_{total}}{Asset_{total}}$

Financial leverage ratio= $\frac{Asset_{total}}{Equity_{total}}$

Recognition

Probable flow of future economic benefit to the entity

Can be reliably measured

Prepaid expenses:

Financial assets

Deferred tax assets

is cash to be received before year end

Services that firm has paid for and will use before year end

Debts, equity investment of the company

Has paid more tax now, so in the future will pay less tax

Fixed assets used to operate the business

Nonphysical assets used to operate the business

reported at amortized cost

Equity account investments

Associates/ affiliates

Companies that the firm has noncontrolling influences on

Natural resources
Depletion

Recognition

Probable sacrifice of future economic benefit to the entity as a result of past transactions/ events

Amount received but not reported as revenue in the income statement (deferred/ unearned revenue)

Amounts reported as expenses but which haven't been paid

Bank borrowings

Notes payable

Provisions (estimated future liabilities)

Characteristics

Permanent

No mandatory charges against earnings

Legal subordination to creditors

to assess a firm liquidity, solvency, and ability to pay dividends

Fair values may changes after balance sheet date

Report format: Assets, liabilities, and equity in a single column

Account format: Assets on the left, Liabilities and Equity on the right

Marketable securities

Recorded at amortized cost (for holding securities) or fair value (for selling securities)

Accrued liabilities

Expenses that have been recognized in income statement, but not yet contractually due

Tax payable

amount that firm owes to tax authority

Deferred tax assets

recognized when taxes payable (tax return) > income tax expense (income statement)

difference is temporary

pay more tax now but less tax in the future

Depreciation and Depletion

Balance sheet value are

Historical cost - accumulated depreciation (GAAP & IFRS)

Fair value - accumulated depreciation (IFRS)

Historical cost: total of all initial costs to get the asset running

Unless the assets are impaired

Since IFRS allows to revalue assets

R&D

Identifiable assets

GAAP: both Research and Development costs are expensed.

Can be acquired singularly, linked to rights and privileges having finite benefit periods

Amortized over estimated useful life

Cannot be acquired singularly and has indefinite benefit period (e.g. goodwill)

Not amortized; annual impairment review

May only be recognized if they can be measured reliably

Generally exclude internally generated intangibles

Goodwill:

Purchased patents and copyrights

Purchased brand and trademarks

Direct response advertising (e.g. coldcalling)

Purchased franchise and license costs

Computer software development costs

if the software can do its purpose, from that moment any further incurring costs can be capitalized

IFRS: Research cost is expensed; Development cost is capitalized.

Internally generated brands, mastheads, publishing titles, customer lists

Start-up costs

Training costs (as we don't know this would lead to higher earnings)

Administrative and general overhead

Advertising and promotion (as we don't know this would lead to higher earnings)

Relocation and reorganization costs

Redundancy and termination costs

The excess of purchase price over the fair value of the identifiable net assets acquired in a business acquisition.

management can subjectively decide how to value goodwill

Analysis: remove impact of goodwill from ratios

Remove goodwill from assets

Remove impairment from income statement

Evaluate business acquisitions considering purchase price, net assets, earnings prospect

Financial Asset
(Current Asset)

GAAP Held-to-maturity Securities
IFRS: Securities measured at amortized cost

Debt securities that company hold to maturity, loans/ note receivable, unlisted equity securities if fair value cannot be determined

Interest income and REALIZED gains/ losses on disposal reported on income statement

GAAP Available-for-sale Securities
IFRS: Securities measured at fair value through other comprehensive income

Debt securities acquired with intent to collect interest payments but sell prior to maturity

Fair (market) value on balance sheet

Change in fair value is recorded into Other Comprehensive Income

Interest income and REALIZED gains/ losses on disposal on income statement

GAAP Trading Securities
IFRS: Securities measured at fair value through profit and loss

Debt securities that will be sold in near term, equity securities, derivatives

Fair value on balance sheet

Dividend income and UNREALIZED gains/ losses are reported on income statement and flow to equity as part of retained earnings

IFRS: at time of purchase, firm can (irrevocably) choose to

Account for an equity security as measured at fair value through other comprehensive income, or

Account for any security as measured at fair value through profit and loss

Common stock at par

Additional paid in capital

Irredeemable (if redeemable, treated as debt)

A contra account is used in a general ledger to reduce the value of a related account when the two are netted together.

UNREALIZED gains/losses are not recorded on income statement and instead are part of other comprehensive income

are measured at amortized cost