Chapter 4 far

Balace sheets

Also known as the statement of financial position or the statement of financial condition.
The balance sheet discloses at a specific point in time,
What an entity controls
What it owes
What the owners claims are.

Balance sheet elements

Assets: resources controlled by the company as a result of past events with expected future
economic benefit.
Liabilities: obligations of a company arising from past events. Expected to result in an
outflow of economic benefits from the entity.
Equity: represents the owners’ residual interest in the company’s assets, after deducting
liabilities.

Equity
The balance sheet amounts of equity(assets, net of liabilities) should not be viewed as a
measure of either the market or intrinsic value of a company’s equity.
Why?
The balance sheet is a mix of items at historic and some items at cost value.
Even current value reflects a value that was current at the end of the reporting period.
Future cash flows, which affect value, are driven by assets excluded from the balance sheet
(ex: reputation, management skills)

Format of balance sheets.

Liquidity: for a company overall, its ability to pays its short term obligations
For a particularly asset or liability, its nearness to cash

Balance sheet ordering according to liquidity

Companies using u.s. gaap ( e.g. colgate) order assets on the balance sheet from most to
least liquid
Companies using IFRS order balance sheet information from least liquid to most liquid.

Current and non-current assets and liabilities

Balance sheet must distinguish between and present separately:

• current and noncurrent assets
• current and noncurrent liabilities
Exception to the current and noncurrent classifications requirement, under ifrs:
Current and noncurrent classifications are not required.
IN a liquidity presentation, all assets and liabilities are presented as an order of liquidity
Liquidity-based presentations are often used by banks.
Classified balance sheet: Balance sheet with separately classified current and noncurrent
assets and liabilities.

Curent assets: assets expected to be sold within one year or one operating cycle of business,
whichever is greater, after the reporting period.
Non- current assets: All the assets that are not current
Current liabilities: Liabilities expected to be settled within one year or within one operating
cycle of the business
Working capital: The excess of current assets over current liabilities.

Measurement bases of current assets: cash and cash equivalents

Cash equivalents: highly liquid, short term investments that are so close to maturity that the
risk of significant change in value from change in interest rates is minimal.
Examples: demand bank depositis
Highly liquid investments with original maturity of 3 months.
For cash and cash equivalents, amortized cost and fair value are likely to be immaterially
different.

Measurement bases of current assets: trade receivables

Tipically reported at net realizable value, an approximation of fair value, based on estimates
of collectability.
Aspects of accounts receivable relevant to an analyst:

• overall level of accounts receivable relative to sales,

• allowance for doubtful accounts, and
• concentration of credit risk( credit risk is Credit risk is the possibility of a loss resulting
from a borrower's failure to repay a loan or meet contractual obligations)

Measurement bases of current assets: Inventory

 Differences in the measurement of inventory between U.S. GAAP and IFRS

U.S. GAAP:
Lower of cost or market (lcm)- The lower of cost or market rule states that a business must
record the cost of inventory at whichever cost is lower – the original cost or its current
market price. This situation typically arises when inventory has deteriorated, or has become
obsolete, or market prices have declined
 Market defined as replacement cost with a floor (Net realizable value, or NRV, less
normal profit margin) and a ceiling (NRV).
 NRV is defined as estimated selling price less estimated costs of completion and sale.

 Reversals of prior write-downs are NOT allowed.

 Permits LIFO

IFRS:
Lower of cost or NRV. means that inventory should be reported at the lower of its cost or
the amount at which it can be sold. Net realizable value is the expected selling price of
something in the ordinary course of business, less the costs of completion, selling, and
transportation
 NRV defined as estimated selling price less estimated costs of completion and sale
 Reversals of prior write-downs can be made and recognized in income.
 Does not permit LIFO.
Nrv and cost model
Measurement bases of PPE

US GAAP Permits only the cost model and impairment losses are not allowed

IFRS permits either the cost model and the revaluation model.
Can use different classes of assets
Must apply the same model to all assets in a particular class
Reversals of impairment losses are permitted

Cost model and revaluation model

Cost model: The value of noncurrent assets are valued at the price spent to acquire
the assets under cost model. The asset is recognized at the net book value( cost- acc
depreciation)
Revaluation model: The assets are shown at fair value (an estimate of the market
value)
 Measurement bases of noncurrent assets: intangible assets
Goodwill is covered separately in the IFRS

Measurement models:
• IFRS allows either a cost model or a revaluation model for intangible assets..
• U.S. GAAP allows only the cost model.
Measurement of intangible assets after acquisition:
 With finite useful life: amortize over useful life and make the proper impairments
when indicated
 Intangible asset with indefinite useful life: Do not amortize, but assess for
impairment

Measurement bases of noncurrent assets: Goodwill

Arises when a company acquires another company for a price in excess of the fair market
value of net identifiable assets acquired: purchase price the fair market value of data
acquired.
Is not amortized but must be assessed for impairment.
Accounting goodwill does not equal economic goodwill.

Measurement bases of financial assets

 Common type of current liabilities

Accounts payable: Amounts that a company owes its vendors for purchases of goods and
services—in other words, the unpaid amounts of the company’s purchases on credit as of
the balance sheet date.

Notes payable: Financial liabilities owed by a company to creditors, including trade creditors
and banks through a formal loan agreement.

Accrued expenses/accrued liabilities: expenses that have been recognized in a company’s

income but still haven’t been paid as of the balance sheet date.

Deferred income/ unearned revenue: arises when a company receives payment in advance
of delivery of the goods or services associated with the payment.

Long-term financial liabilities: include loans and notes or bonds payable

Usually reported at amortized cost on the balance sheet.
In certain cases, liabilities, such as bonds, issued by a company are reported at fair value.

Deferred tax liabilities: Amount of income taxes payable in future periods with respect of
taxable temporary differences. It’s the result from temporary timing differences between a
company’s income as reported for tax purposes(taxable income) and income reported for
financial statement purposes ( reported income).

Components of shareholders' equity

 Share capital: The money a company gains by issuing common or preferred stock)
 Preferred shares (they usually have no voting rights but have a higher claim on
dividends. In the event of a liquidation, preferred stockholders' claim on assets is
greater than common stockholders
 Treasury shares: refer to previously outstanding stock that has been bought back
from stockholders by the issuing company
 Retained earnings :are the amount of profit a company has left over after paying all
its direct costs, indirect costs, income taxes and its dividends t
 Accumulated other comprehensive income
 Noncontrolling interest (minority interest): minority interest refers to a stake in a
company that is otherwise controlled by a parent company. This usually
occurs in subsidiaries where the parent company owns more than 50% of the
voting shares

Analysis of a balance sheet:

• Liquidity
• A company’s ability to meet its short-term financial commitments.
• Assessment focus: The company’s ability to convert assets to cash and to pay for
operating needs.
• Solvency
• A company’s ability to meet its financial obligations over the longer term.
• Assessment focus: The company’s financial structure and its ability to pay longterm
financing obligations.

• Analytical Tools
• Common-size analysis.
• Balance sheet ratios.

Liquidity ratios:

Solvency ratios