CHAPTER 2:

UNDERSTANDING THE BALANCE SHEET

 LEARNING OBJECTIVES

• Defining the balance sheet

• State the purpose of the balance sheet
• Recognize what accounts appear on the balance sheet
• Able to analyse the balance sheet
 OUTLINE

1. Introduction to the balance sheet

2. Basic elements of the balance sheet
3. Balance sheet analysis
 INTRODUCTION TO THE BALANCE SHEET

• A balance sheet reports a company’s financial position on a specific date.

• The balance sheet presents a comprehensive overview of total asset value and
total resource financing the assets of an enterprise at the point of time.

• Principle of the balance sheet (accounting equation):

Total asset = total resource = liabilities + equity

 COMPONENTS OF THE BALANCE SHEET

1. Current assets (short-term): items that are convertible into cash within one year

2. Non-current assets (long-term): items of a more permanent nature

3. Current liabilities (short-term): obligations due within one year

4. Non-current liabilities (long-term): obligations due beyond one year

5. Shareholders’ equity (permanent): shareholders’ investment and retained earnings

 BALANCE SHEET

Liabilities and
Assets
Equity

Current
liabilities
Current Assets
Non-current
Liabilities

Non-current
Shareholders’
Assets
Equity
 BALANCE SHEET FORMATS

• The account form (horizontal presentation)

• Assets on the left side, and with liabilities and owners’ equity on the right side

• The report form (vertical presentation)

• Assets on the top, followed by the liabilities and equity.
EXAMPLE OF THE BALANCE SHEET
(In horizontal form)
EXAMPLE OF THE BALANCE SHEET
(In vertical form)
 BALANCE SHEET
Assets Liabilities and Stockholders’ Equity
Current Assets Current Liabilities
• Cash and cash equivalents • Current liabilities
• Marketable securities • Short-term loans from banks
• Accounts receivable • Overdrafts
• Inventories • Interest payable for those loans
• Other current assets • A​ccounts payable 
• Wages payable
• Current portion of long-term debt
• Non-current liabilities
• Long-term loans from banks
• Long-term bonds or other securities
• Deferred tax liability

Non-current Assets Stockholders’ Equity

• Property, plant and equipment • Contributed capital
• Investment property • Preferred stock
• Intangible assets • Treasury stock
• Goodwill • Retained earnings
• Patents, software… • Non-controlling interest 10
• Participation in other companies • Accumulated other comprehensive income
 BALANCE SHEET ANALYSIS

Liquidity Debt & Equity Value & Cost

• Current Assets • Capital structure • Market value vs

vs Non-current • Cost of capital Book value
Asset • Retained earning
• Risk • VAS, US GAAP: at cost
• IFRS: true market/fair value
• Opportunity cost
 BALANCE SHEET ANALYSIS
• Vertical analysis, or vertical percentage analysis, is based on the percentage
relationship of each line in the balance sheet to the total.
• Liquidity ratios represent the ability of a company to convert it’s assets to
cash (current ratio, quick ratio).
• Asset management ratios focus on the composition of the firm's assets as
well as changes in the composition of assets over time.
• Debt management ratios are the composition ratios drawn from a vertical
analysis of the right side of the balance sheet (debt-to-assets ratio).
 I. ASSETS
Economic resources are controlled by a company and expected to provide
probable economic benefit in the future
Assets can be recognized if
• There is economic benefit
• Assets have expense or value of asset can be realizably determined

Assets are classified into tow groups

• Current assets: cash and cash equivalents, short-term financial investment, account
receivables, inventory, other current assets
• Non current assets: long term receivable, fixed assets, property, long term financial
investment, other non current assets
 CURRENT ASSETS
Current assets include cash and other assets that will be
converted into cash or used up within one year or the firm’s
operating cycle, whichever is greater. Current assets include:
1. Cash and cash equivalents are short-term, highly liquid investments that are
readily convertible to cash and near enough to maturity that interest rate risk
is insignificant. Cash and cash equivalent are reported on the balance sheet at
amortized cost and fair value.
2. Marketable securities are financial assets that are traded in a public market
and whose value can be readily determined.
 CURRENT ASSETS
3. Account receivable are financial assets that represent amounts
owed to the firm by customers for goods or services sold on
credit. Accounts receivable are reported at net realized value,
which based on estimated bad debt expense.
• Bad debt expense increase the allowance for doubtful
accounts, a contra-asset account.
• A contra-asset account is used to reduce the value of its
controlling account.
 CURRENT ASSETS

4. Inventories are goods held for sale to customers or used in manufacture of goods
to be sold.
• Manufacturing firms separately report inventories of raw materials, work-in-process
and finished goods.
• The cost included in inventory include purchase cost, conversion costs, and other
costs necessary to bring the inventory to its present location and condition.
• Costs that are exclude from inventory include abnormal waste of material, labor, and
overhead, storage costs (unless they are necessary as a part of the production
process), administrative overhead, and selling costs.
 OTHER CURRENT ASSETS

• Prepaid expenses are operating costs have been paid in advance.

• Deferred tax assets are created when the amount of taxes payable
exceeds the amount of income tax expense recognized in the income
statement.
 NON-CURRENT ASSETS
1. Property, plant, and equipment (PP&E) are tangible assets used in the
production of goods and services.
• PP&E includes land and buildings, machinery and equipment, furniture, and
natural resources.
• Under IFRS, PP&E can be reported using the cost model or the revaluation
model.
• Under US.GAAP, only the cost model is allowed.
• Under the cost model, PP&E is reported at amortized cost (historical cost minus
accumulated depreciation, amortization, depletion, impairment losses).
• Under the valuation model, PP&E is reported at fair value less any accumulated
depreciation.
 NON-CURRENT ASSETS

2. Investment property includes assets that generate rental income or

capital appreciation.
• Under IFRS, investment property can either be reported at amortized
cost or fair value.
• Under the fair value model, any change in fair value is recognized in
the income statement.
 NON-CURRENT ASSETS
3. Intangible assets are non-monetary assets that lack physical
substance.
• Identifiable intangible assets can be acquired separately or are
the result of rights or privileges conveyed to its owner over a
finite period such as patents, trademarks and copy rights. Cost
of an identifiable assets is amortized over its useful life.
• Unidentifiable intangible assets can not be acquired
separately and may have an unlimited life . intangible asset
with infinite life are not amortized but are tested for
impairment at least annually (goodwill).
 NON-CURRENT ASSETS
• Goodwill is the excess of purchase price over the fair
value of identifiable assets and liabilities acquired in a
business acquisition.
• Economic goodwill derives from the expected future
performance of the firm
• Accounting goodwill is the result of past acquisition
 EXAMPLE
Wood corporation paid $600 million for the outstanding stock of pine
corporation. At the acquisition date, pine reported the following
balance sheet.

Pine corporation Book value (millions)

Current assets 80
Plant and equipment, net 760
Goodwill 30
Liabilities 400
Stockholders’ equity 470
 EXAMPLE (CONTINUED)

The fair value of the plant and equipment was $120 million more than its
recorded book value. The fair value of all other identifiable assets and
liabilities were equal to their recorded book values. Calculate the amount of
goodwill Wood should report on its consolidated balance sheet.
 SOLUTION
Answer :
• Fair value of net asset = fair value of plant and equipment, net- fair value of
liabilities
= 80+880-400=560 million (USD)
• Goodwill = purchase price-fair value of net assets
=600-560=40 million USD
Notes:
• Firms can manipulate net income upward by allocating more of the acquisition
price to goodwill and less to the identifiable assets
• Analyst should eliminate goodwill from balance sheet and goodwill impairment
charges from income statement
 FINANCIAL ASSETS
• Financial assets include investment securities (stocks and bonds), derivatives, loans,
and receivables.

• Financial instruments are measured at historical cost (unlisted equity investments,

loans, receivables), amortized cost (held-to-maturity securities), or fair value (trading
securities, available-for-sale securities and derivatives).
 II. LIABILITIES

• Are obligations owned by entity from previous transactions that are expected
to result in an outflow of economic benefits in the future.

• Amount has been received but not been recorded as revenue on the income
statement or will have to be returned.

• Amount has been recorded as expense on the income statement but has not
been paid yet.
 CURRENT LIABILITIES
• Current liabilities are obligations that will be satisfied within one
year or operating cycle, whichever is greater.
1. Accounts payable are amounts the firm owes to suppliers for goods or
services purchased on credit.

2. Notes payable are obligations in the form of promissory notes owed to

creditors and lenders.

3. Current portion of long-term debt is the principal portion of debt due

within one year or operating cycle, whichever is greater.
 CURRENT LIABILITIES

4. Accrued liabilities (accrued expenses) are expenses that have

been recognized in the income statement but are not yet
contractually due.

5. Unearned revenue (unearned income, deferred revenue, or

deferred income) is cash collected in advance of providing goods
and services.
 NON-CURRENT LIABILITIES

1. Long-term financial liabilities include bank loans, notes payable,

bonds payable and derivatives.

• If the financial liabilities are not issued at face amount, the liabilities
are usually reported on the balance sheet at amortized cost.

• In some cases, financial liabilities are reported at fair value. (Held-for-

trading liabilities, derivatives liabilities,…)
 NON-CURRENT LIABILITIES
2. Deferred tax liabilities are the amounts of income taxes payable in
future periods as a result of taxable temporary differences.

• Deferred tax liabilities are created when the amount of income tax
expense recognized in the income statement is greater than taxes
payable.

• This can occur when expenses or losses are tax deductible before
they are recognized in the income statement.
 V. SHAREHOLDERS’ EQUITY
Stockholders’ equity is the residual interest in asset that remains after
subtracting a firm’s liabilities.

Shareholders’ equity is classified into:

• Contributed capital

• Preferred stock

• Treasury stock

• Retained earnings

• Non-controlling interest

• Accumulated other comprehensive income

 V. SHAREHOLDERS’ EQUITY
 Contributed capital
• Total amount paid in by the common and preferred
shareholders
• Par value is a legal value and has no relationship to fair
value
• Authorized shares are the number of shares that may
be sold under the firm’s articles of incorporation
• Issued shares are the number of shares that have
actually been sold to shareholders
• Outstanding shares is equal to the issued shares less
treasury shares
 COMPONENTS OF BALANCE SHEET
Treasury stock is stock that has been reacquired by the issuing firm but not yet retired.
Treasury stock reduces stockholders’ equity and has no voting rights as well as dividends
Retained earnings are the undistributed earnings (net income) of the firm since inception
Minority interest is the minority shareholders’ pro-rata share of equity of a subsidiary that
is not wholly owned by the parent
Accumulated other comprehensive income (IFRS and U.S GAAP) includes all changes in
stockholders’ equity except for transactions recognized in the income statement (net
income) and transactions with shareholders such as issuing stock, reacquiring stock and
paying dividends. Example : differences from asset revaluation, differences from foreign
exchange
 MEASUREMENT BASES OF ASSETS
AND LIABILITIES
• Historical cost is the value that was exchanged at the acquisition date.
Historical cost is verifiable and objective; however its relevance to
investment analysis declines over time as prices change.
• Fair value is the amount at which an asset can be bought or sold, or a
liability can be incurred or settled between knowledgeable, willing
parties in an arms’ length transaction. Fair value is relatively
subjective.
• Because the mixture of measurement bases, the balance sheet value is
not the value of the firm. Analyst must adjust the balance sheet to
better asses a firm’s investment potential or creditworthiness.
• INVENTORIES
• CAPITALIZING AND EXPENSING
 INVENTORIES

Method Assumption COGS consist of… Ending inventory

consists of…
FIFO (US and The items first first purchased most recent
IFRS) purchased are the purchases
first to be sold
LIFO (US only) The items last last purchased earliest purchases
purchased are the
first to be sold

Weighted average Items sold are a mix Average cost of all Average cost of all
cost (US and IFRS) of purchases items item
 EXAMPLE 1

• USE THE INVENTORY DATA IN THE FOLLOWING FIGURE TO

CALCULATE THE COGS AND ENDING INVENTORY UNDER THE FIFO,
LIFO, AND WEIGHTED AVERAGE COST METHODS.
Inventory Data
January 1 (beginning inventory) 2 units @ $2 per unit
January 7 purchase 3 units @ $3 per unit
January 19 purchase 5 units @ $5 per unit
COGS available 10 units
Units sold during January 7 units
 INVENTORIES
FIFO LIFO

COGS Lower Higher

Ending inventory Higher Lower

Gross profit Higher Lower

Tax Higher Lower

38
 CAPITALIZING AND EXPENSING
• When a firm makes an expenditures, it can either capitalize
the costs as an asset on the balance sheet or expense the
cost in the income statement in the period incurred.
• An expenditure that is capitalized is initially recorded as an
asset on the balance sheet at cost, typically its fair value at
acquisition plus any costs necessary to prepare the asset for
use.
• The cost is allocated to the income statement over the life of
the asset as depreciation expense (for tangible assets) or
amortization expense (for intangible assets with finite lives).
 EXAMPLE 2
• Northwood corp. Purchased new equipment to be used in its manufacturing
plant. The cost of the equipment was $250,000 including $5,000 freight and
$12,000 of taxes. In addition to the equipment cost, northwood paid
$10,000 to install the equipment and $7,500 to train its employees to use
the equipment. Over the asset’s life, northwood paid $35,000 for repair and
maintenance. At the end of five years, northwood extended the life of the
asset by rebuilding the equipment’s motors at a cost of $85,000. What
amounts should be capitalized on northwood’s balance sheet and what
amounts should be expensed in the period incurred?
 EXAMPLE 3
• CAP inc. And NOW inc. Start up with $1,000 cash and $1,000 common
stock. Each year the companies receive total revenues of $1,500 cash and
pay cash expenses, excluding an equipment purchase, of $500. At the
beginning of operations, each company spends $900 to purchase
equipment. CAP estimates the equipment will have a useful life of three
years and an estimated salvage value of $0 at the end of the three years.
NOW estimates a much shorter useful life and expenses the equipment
immediately. The companies have no other assets and make no other
assets purchases during the three years period. Assume the companies pay
no dividends, earn zero interest on cash balances, have a tax rate of 30%,
and use the same accounting method for financial and tax purposes.
 EXAMPLE 3
1. Which company reports higher net income over the three years? Total
cash flow? Cash from operations?
2. Based on ROE and net profit margin, how do the two companies
profitability compare?
3. Why NOW inc. Report change in cash of $70 in year 1 while CAP inc.
Reports total change in cash of ($110)?
CAP Inc. SOLUTION
1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash
NOW Inc. SOLUTION
1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash
CAP Inc. SOLUTION
1 2 3
Revenue $1,500 $1,500 $1,500
Cash expenses 500 500 500
Depreciation 300 300 300
Income before tax 700 700 700
Tax 210 210 210
Net income $490 $490 $490
Cash from operation 790 790 790
Cash used in investing (900) 0 0
Total change in cash ($110) $790 $790
NOW Inc. SOLUTION
1 2 3
Revenue $1,500 $1,500 $1,500
Cash expenses 1,400 500 500
Depreciation 0 0 0
Income before tax 100 1,000 1,000
Tax 30 300 300
Net income 70 700 700
Cash from operation 70 700 700
Cash used in investing 0 0 0
Total change in cash $70 $700 $700
 SOLUTION

Question 1
Neither company reports higher net income nor total cash flow over the three years.
The sum of net income over the three years is identical ($1,470 total) whether the
$900 is capitalized or expensed.
The sum of the change in cash ($1,470 total) is identical under either scenario. CAP
inc. Reports higher cash from operation by an amount of $900 because, under the
capitalization scenario, the $900 purchase is treated as an investing cash flow.
 SOLUTION
CAP 0 1 2 3
Retained earning 0 490 980 1,470
Common stock 1,000 1,000 1,000 1,000
Total shareholders’ equity 1,000 1,490 1,980 2,470
ROE 39% 28% 22%
Net profit margin 33% 33% 33%
 SOLUTION
NOW 0 1 2 3
Retained earning 0 70 770 1,470
Common stock 1,000 1,000 1,000 1,000
Total shareholders’ equity 1,000 1,070 1,770 2,470
ROE 7% 49% 33%
Net profit margin 5% 47% 47%
 SOLUTION
Question 2
• Capitalizing results in higher profitability ratios in the first year, and
lower profitability ratios in the subsequent years.
• Now’s superior growth in net income between year 1 and year 2 is
not attributable to superior performance but rather to a different
accounting decision.
• As a corollary, now’s income and profitability exhibit greater volatility
across the three years, not because of more volatile performance but
rather because of the different accounting decision.
 SOLUTION
Question 3
• Now reports change in cash of $70 in year 1, while CAP
reports total change in cash of $110 because now’s taxes
were $180 lower than CAP.
CAPITALIZATION OF INTEREST COSTS
 FINANCIAL STATEMENT EFFECTS OF
CAPITALIZING VS. EXPENSING

Capitalizing Expensing
Total assets
Shareholders’ equity
Income variability
Net income (first year)
Net income (subsequent years)
Cash flow from operations
Cash flow from investing
Debt ratio & Debt to equity
Interest coverage (first year)
Interest coverage (subsequent years)
 FINANCIAL STATEMENT EFFECTS OF
CAPITALIZING VS. EXPENSING

Capitalizing Expensing
Total assets Higher Lower
Shareholders’ equity Higher Lower
Income variability Lower Higher
Net income (first year) Higher Lower
Net income (subsequent years) Lower Higher
Cash flow from operations Higher Lower
Cash flow from investing Lower Higher
Debt ratio & Debt to equity Lower Higher
Interest coverage (first year) Higher Lower
Interest coverage (subsequent years) Lower Higher