SESSION 3: BALANCE SHEETS -

ASSETS OWNED & MONEY OWED

Accounting for Finance
The Balance Sheet: Dueling Views

q Record of capital invested: There are some (including

me) who believe that the main function of a balance
sheet is to record how much a business has invested in
its assets-in-place, i.e., the assets that allow for its
current operations to occur.
q Measure of current value: There is a large and perhaps
dominant school of thought among accountants, or at
least accounting rule writers, that a balance sheet should
reflect the value of the business today.
q Liquidation value: There is a third school, with lenders to
the firm among its primary members, who feel that a
balance should reflect what you would get for the assets
of the firm, if you liquidated them today.

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Revisiting the Balance Sheet

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Fixed and Current Assets

q The Old Way: If you are old enough to learned your

accounting two or three decades ago, the way you were
taught to value fixed and current assets was to show
them at original cost, net of accounting depreciation.
q The New Way: As accounting has increasingly adopted
the fair value standard, there has been a move to mark
assets to current market value.
q Divergent Effects: The difference in values that you get
for assets, using the two approaches, varies. It is
q Greater on older assets than on newer ones
q Greater on fixed assets than current assets

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 If you're holding the stake for trading you're required to mark it up to market. In other words you have to make your best estimate then of what that five percent of the
other companies would given your estimate of the value of company today.
if you hold it for business purposes you are holding it for the long term then you might be able to get away reflecting that holding in book value terms.

Financial Assets

¨ Financial assets can take the form of holdings of securities or part

ownership of other companies, private or public.
¨ With holdings of publicly traded securities, the movement to using
current market prices to mark up their values is almost complete.
¨ With equity ownership in other companies, the rules can vary
depending on
¤ Whether the stake is viewed as a majority stake (>50%) or a minority stake.
The former will lead to full consolidation (where 100% of the subsidiaries
revenues and operating income will be included in the parent company’s
financials, with the portion that is not owned shown as minority or non-
controlling interest on the liability side) and with the latter, the actual
stake will be shown as an asset.
¤ With a minority stake, whether it is held for trading or as a long-term
investment. With the former, the holding will be marked to market. With
the latter, it will be shown at book value terms.
goodwill measures the difference between what you paid for a company and what the accounting book value for the company was. it forms the biggest chunk of
intangible assets. it shows up in the balance sheet to make it balanced.

Accountants ask the question did you pay too much or didn't you. If you paid too much the value what you acquired has dropped since the acquisition and you have to
impair goodwill. If it's gone up you don't.

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Intangible Assets

¨ Big game: Accountants talk a big game when it

comes to intangible assets, and from that talk, you
would think that they have figured out how to value
the big intangibles (brand name, management
quality etc.).
¨ But different reality: In reality, accountants are
much better at valuing small-bore intangibles like
licenses and customer lists, where the earnings and
cash flows from the intangible are observable and
forecastable than they are at valuing the big
intangibles.

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Goodwill: The Most Dangerous Intangible

¨ After all the talk of intangibles in accounting, it is telling

that the bulk of intangible assets on accounting balance
sheets across the world take the form of one item:
goodwill.
¨ Goodwill may sound good, but it is a plug variable that
signifies little.
¤ For goodwill to manifest itself on a balance sheet, a company
has to do an acquisition.
¤ When that acquisition occurs, goodwill is measured as the
difference between the price paid on the acquisition and the
target company’s asset value (dressed up book value).
¤ It shows up as an asset because without it in place, balance
sheets would not balance.

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Goodwill Impairment: Valuable information or
Make-work-for-accountants?
¨ Old rules: For much of the last century, goodwill once created in an
acquisition, was written off on autopilot, often amortized over long
periods in equal installments.
¨ New Rules: In the late 1990s, both GAAP and IFRS rewrote the
rules, requiring accountants to revisit goodwill estimates each year,
and make judgments on whether the goodwill had been impaired
or not. To make that judgment, accountants would have to revisit
the target company valuations and decide whether the value had
increased (in which case goodwill would be left unchanged) or
decreased (and goodwill would be impaired).
¨ Is it informational? The rationale for this rule change was to
provide information to markets, but since goodwill impairments
are often based upon market pricing movements (in the sector)
and lag them by months and sometimes years, the effect of
goodwill impairments on stock prices has been negligible.

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Current Liabilities

q Current liabilities can be broadly broken into three

groups:
q Non-interest-bearing liabilities, such as accounts payable and
supplier credit, which represent part of normal operations.
q Interest-bearing short-term borrowings such as commercial
paper, short term debt and the short term portion (<1 year) of
long term debt.
q Deferred salaries, taxes and other amounts due in the short
term.
q When computing non-cash working capital, we do not
include interest-bearing short term debt in the
calculation, moving it instead into the debt column.

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Debt Due

¨ When companies borrow money, it can take three forms:

¤ Corporate bonds, represent debt raised from public markets
¤ Bank loans, debt raised from banks and other lending institiutions
¤ Lease debt, arising out of lease contracts requiring lease payments
in future years. Until 2019, only leases classified as capital leases
qualified, but since 2019, operating lease commitments are also
debt.
¨ The mark-to-market movement on the asset side of the
balance sheet has been muted on the liability side of the
balance sheet. Bank debt, for the most part, is recorded as
originally borrowed, and corporate bonds due, are for the
most part not marked to market.

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Debt details

¨ While balance sheets are the repositories for total

debt due, broken down into current and long term,
there is additional information on debt in the
footnotes, for most companies.
¨ This additional information can be on two fronts:
¤ Individual debt due, with stated interest rates and
maturities.
¤ Additional features on the debt, including floating/fixed
and straight/convertible provisions.
¤ A consolidated table of when debt repayments come due,
by year.

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Shareholder’s Equity

q Old ways: The shareholders’ equity in a business was a

reflection of its entire history, since it started with the
equity brought in to start the business, adds on equity
augmentations over time as well as the cumulation of
retained earnings.
q New ways: The shareholders’ equity in a business
reflects the jumbled mess of mark-to-market accounting,
with all of its contradictions.
q My cynical view: Old or new ways, shareholders’ equity
(or book equity) has little hope of ever being a measure
of the intrinsic value of equity in a business. This quixotic
quest on the part of accounting will do more damage
than good.

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More on shareholders’ equity

¨ Par value: This is a throwback in time and should be ignored.

¨ Company Age: Since shareholders’ equity reflects a company’s
cumulated history of equity raises and retained earnings, young
companies will tend to have far less shareholders’ equity than older
companies, of equivalent market value.
¨ Capitalization effects: Since only capitalized expenses become part
of assets, shareholders’ equity can be skewed by accounting rules
and corporate actions on what is capitalized and what is expensed.
¨ Buyback effects: Both dividends and buybacks reduce shareholders’
equity, by reducing it, but the magnitude of buybacks makes their
effect more dramatic.
¨ Negative equity? There is no mathematical reason why
shareholders’ equity cannot become negative, either because a
company has lost money for an extended period or because of
large buyback/write off.

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