Chapter 33 - Understanding the Balance Sheet

Chapter 33- Understanding The Balance Sheet

Balance Sheet / Statement of financial Position

· Discloses what an entity owns and owes at a particular point in time

Assets

Assets Generation via

Ø Investing Activities – Purchase of Property, Plant, Equipment

Ø Operating Activities – Asset generated through business activities like cash generation, inventory or machinery etc.

Ø Financing Activities – Issue of debt to raise cash

Condition of being an Asset / Liability

Ø Future economic benefit of item flows to company

Ø Item has cost/ value, which can be measured reliably

An Asset is generated, when

Ø Cash is spent but expense is not recorded

Ø Revenue is reported but cash is not received

Liabilities

· They are obligations owned by an entity from previous transactions

· They result in outflow of economic benefits in future

Liabilities Generation via

· Financing Activities – Issuing Debt

· Operating Activities – Recognizing expense before cash is paid

Equity

Equity creation via

· Financing Activity – Issuing Capital Stock

· Operating Activity – Generating Net Income (Added to retained earnings)

Other Names -

· Stockholder’s Equity

· Shareholder’s Equity

· Owner’s Equity

· Equity

· Net Assets

Limitations of Balance Sheet

· Not all assets / liabilities are reported in Balance Sheet

· All those who are reported are not at fair value

Formats of Balance Sheet

· Account Format –

Assets	Liabilities
	Equity

· Report Format –

Assets

Liabilities

Equity

Classified Balance Sheet – (CA-CL) are grouped together; (NCA-NCL) are grouped together

Current Assets Vs Current Liabilities

Current Assets

· Def -

ü They include cash & other assets that will likely be converted into cash (or used up)

ü Within 1 year or 1 Operating cycle, whichever is GREATER

· Operating Cycle – Time taken to produce or purchase inventory, sell the product & collect the cash

· CA are presented in order of liquidity (cash being most liquid, presented 1^st)

· CA reveals operating activities of the firm

Current Liabilities

· They will be satisfied within 1 year or 1 operating cycle, whichever is GREATER

· CL meets anyone of the following criterion –

ü Settlement is expected within 1 Operating Cycle

ü Settlement is expected within 1 Year

ü There is not an unconditional right to defer settlement for more than 1 year

Working Capital

· CA-CL = WC

ü Less – Liquidity Problem

ü More – Not efficient use of funds or assets

NCA – Provide information about firm’s investing activities (forms foundation on which firm operates)

NCL – Provides information about firm’s long term financing activities

IFRS requires BS presentation in current / non-current format unless a liquidity based presentation is more relevant, as in banking industry

Financial Statement Footnotes

It should include information about measurement of firm’s asset & liabilities

· Basis for measurement

· Carrying value of inventory by category

· Amount of inventory carried at fair value – costs to sell

· Write-downs and reversals, with a discussion of the circumstances that led to them

· Inventories pledged as collateral for liabilities

· Inventories recognized as expense

Current Assets

· Cash & Cash equivalent

ü Liquid, low risk securities, maturity < 90 days

· Accounts / Trade Receivable

ü Amount to be collected from sale of good & services

ü Reported net of an allowance from bad debt

· Inventories

ü They are items are held for Sale or

ü They are used in manufacturing of goods to be sold

ü M/g firms separately report – raw material, WIP, finished goods

· Marketable securities

ü Debt / Equity securities that are traded in the market

ü Example – Treasury Securities, Mutual Funds, Certain equity securities

· Other current assets including pre-paid expenses

Inventory-Cost measurement

· Standard Costing

ü Assigning pre-determined costs to goods produced

ü Used by manufacturing firms

· Retail Method

ü Retail price (determined by market) – Gross profit = Cost of inventory

Current Liabilities

· Accounts / Trade Payable

ü They are owned to suppliers for goods & services purchased on credit

· Notes Payable

ü Obligations in the form of promissory notes owned to creditors

· Current Portion of Long Term Debt

ü Principle portion of debt due within 1 year or the firm’s operating cycle, whichever is GREATER

· Taxes Payable

ü Current taxes that have been recognized in the IS, but have not yet been paid

· Accrued liabilities / expenses

ü Wages recorded for 31^st, but paid on 1^st of subsequent month

· Unearned Revenue

ü Advance Payment received by newspaper for supply for next 12 months

Tangible Assets

· Long term assets with physical substance

· Ex - PPE

· Reported at (Historical costs – Accumulated depreciation)

ü Historical cost = Original cost of asset + All the cost necessary to get the asset ready for use

· Land is also a tangible asset, reported at historical cost. However, land is not depreciated

Intangible Asset

· They lack physical substance

· Financial securities are NOT considered as intangible assets

· Value of internally produced intangible asset is not shown on BS

· Reported at (Historical Cost – Accumulated Amortization)

· R&D

ü US GAAP – Expense as incurred

ü IFRS – Firm must identify the stage

§ Research Stage – Expense Cost (discovery of new scientific / technical knowledge)

§ Development Stage – Can Capitalize Cost / shown as asset (using research results to plan or design products)

Types

· Identifiable Intangible Asset

ü Patents, Trademark, Copyright

ü It is based on the rights or privileges conveyed to its owner over a finite period

ü Hence, cost of an intangible asset is amortized over its useful life

· Unidentifiable Intangible Asset

ü They can’t be purchased separately & may have an infinite life

ü They are NOT amortized, but are tested for impairment annually

ü Ex – Goodwill

Costs expensed as incurred

· Start-up & training costs

· Administrative overheads

· Advertising & promotions

· Relocation & reorganization costs

· Termination costs

Goodwill

· Purchase price (paid by buyer) – Fair value of the identifiable assets & liabilities acquired in the acquisition

· Accounting Goodwill = Derives its value from past acquisition

· Economic Goodwill = Derives its value from expected future performance of the firm

· Created in purchase acquisition only (internally created goodwill is expensed as incurred)

· Not amortized, but tested for impairment annually

· Impairment loss is recognized in IS, does not affect cash flow

· If not impaired, Goodwill can remain indefinitely on BS

· Inflate Net Income = Increase Goodwill (asset increases, hence equity / retained earnings increases) & decrease identifiable intangible asset (less depreciation, hence higher income)

· Should eliminate goodwill while calculating ratios

· Future acquisition evaluation = Price paid to acquire asset (not earning power of the asset)

Example –

Company A paid 600 during acquisition of Company B

BS of Company B at time of acquisition -

Source		Assets
Equity	470	CA	80
Liability	400	PPE	760
		Goodwill	30
Total	870	Total	870

Fair Value of PPE = 120 more than recorded Book Value. All other costs are as per BV. Calculate GW.

Answer –

· CA = 80; PPE = 880; Liability = 400

· Fair Value of Net Assets = 560 (880-400-80)

· Price Paid to acquire B = 600

· Goodwill = 600- 560 = 40

Marketable Investment Securities

· Held-to-maturity securities –

ü Debt securities acquired with the intent to be held to maturity

ü Reported at amortized cost

ü Amortized Cost = Face Value – Unamortized discount + Unamortized Premium

ü Subsequent changes in market value are ignored

· Trading Securities –

ü Debt / Equity securities acquired with the intent to profit in near term

ü Reported in BS at Fair Value

ü Unrealized gains & losses are reported in IS

· Available-for-sale securities –

ü Similar to Trading securities except unrealized gains & losses are reported in other comprehensive income as a part of stockholder’s equity

	Trading	Available-for-sale	Held-to-maturity
Reporting in BS at	Fair Value	Fair value	Amortized Cost
Reporting in IS	Unrealized Gains & Losses	-	-
	Realized Gains & Losses	Realized Gains & Losses	Realized Gains & Losses
	Interest income	Interest income	Interest income
	Dividend paid (+)	Dividend paid (+)	-
Reported in Equity	-	Unrealized Gains & Losses	-

Fair Value – Current value of the security

Others -

	Reported at
Bonds & Notes Payable	Amortized Cost
Derivatives / Non-derivative financial instruments	Fair Value
Short position in stock to earn near term profit	Fair Value

Owner’s Equity

Contributed Capital

· Total amount paid by the common & preferred stock holders

· Preferred Stock Holders

ü Preferred stock holders are paid dividends at specific rates, usually expressed as a % of par value

ü They have priority over the claims of the common stock holders in the event of liquidation

· Par Value

ü No relationship with fair value

ü Some shares issued without par value

ü Reported separately in stockholder’s equity

· Types of Common shares

ü Authorized Shares – Number of shares sold under the firm’s articles of incorporation

ü Issued Shares – Number of shares that have been actually sold to shareholders

ü Outstanding Shares – (Issued shares – Treasury Stock)

Minority Interest (explained earlier)

Retained Earnings

· Undistributed earnings (net income) of the firm since inception

· Cumulative earnings that have not been paid out to shareholders as dividends

Accumulated other comprehensive income

· They include all the changes in stockholder’s equity except

ü For transactions recognized in the income statement &

ü Transactions with shareholders (such as issuing stock, re-acquiring stock, paying dividends)

· Comprehensive income = Net Income + Other comprehensive income

US GAAP	Income Statement - Below Net Income	Separate CI	Statement of change of stock-holder’s equity
IFRS	All in Comprehensive Income Statement	Separate CI

Statement of change in Stockholder’s Equity

It summarizes transactions during a period that increase / decrease equity, including transactions with shareholders

Beginning Balance		75,492
Net Income		6,994
	Available for sale securities – Loss	(40)
	Cash flow hedges - Loss	(56)
	Minimum pension liability	(26)
	Cumulative translation adjustments	42
Comprehensive Income		6,914
Issuance of Common Stock		1,282
Repurchase of common stock		(6,200)
Dividends		(2,360)
Ending Balance		75,128

Exercise –

1) Sale of tickets completed for a sporting event (tickets non-refundable). How proceeds should be treated?

a. Revenue is deferred till the sporting event in held

2) Internal Goodwill not reported, Patent bought to be reported (if it is useful for coming years)

3) Purchase 500,000 shares at $15 of company A, hence, Assets acquired = $6 million; Fair value of equipment is $1 million more than book value. Find Goodwill.

a. GW = Price Paid – Fair Value of asset acquired = 15*500,000 – (6,000,000+1,000,000) = $500,000

4) At beginning of year, company P purchased 1000 shares @ $80 of Company S. During the year, S paid dividend of $4 per share. At the end of the year, Company’s S share price was $75.

5) What amount Company P should report on its BS, if investment in Company S is a trading security and available-for-sale security

a. Both Trading & Available-for-sale security is reported at fair value at the year-end = $75*1,000 = $75,000

6) What amount Company P should report on its IS, if investment in Company S is a trading security and available-for-sale security

a. Trading Security; Notional Loss = $(75-80)*1,000 = - $5,000. Dividend Payout of Company S is revenue for Company P (inflow of dividend to P = 1,000*$4). Hence, net income is + $4,000 - $5,000 = -$1,000

b. Available-for-sale security; No notional loss. Only dividend payout as Revenue in IS for Company P = 1,000*$4 = $4,000

7) Company ‘A’ Balance Sheet is as follows –

Investment in company B (available-for-sale security); Original Cost = 120,000	150,000
Deferred Taxes	86,000
Common Stock, $1 par value	550,000
Preferred Stock, $100 par value	175,000
Retained Earnings	893,000
Accumulated other comprehensive income	46,000

Total Owner’s equity for Company ‘A’ is closest to -

a. Top 2 items are assets; Bottom 4 items are equity. Investment in company B has risen from 120,000 (fair value) to 150,000; but the same is already taken care off in Other Comprehensive income. Answer is $1,664,000