The Balance Sheet Statement Learning Objectives How balance sheet accounts are measured, classified and presented. How balance sheet information is used. Balance sheet terminology and format outside the U.S. How footnotes aid to the understanding of the firm’s accounting policies, contingent liabilities, subsequent events, and related-party transactions 4-1

The Accounting Equation Assets = Liabilities + Equity Shareholders’ Equity: What’s left of the company’s assets after paying off liabilities. It also referred to as net assets.

Balance sheet classification: Overview ASSETS LIABILITIES EQUITY = + Current assets Property, plant and equipment Investments Other assets Current liabilities Long-term debt Other liabilities Preferred and common stock Additional paid-in capital Retained earnings Contributed Capital

Elements of the balance sheet How the money is invested Where the money came from ASSETS LIABILITIES EQUITY = + Probable future economic benefits Obtained from past transactions or events Probable future sacrifices of economic benefits Arising from present obligations To transfer assets or provide services in the future As a result of past transactions or events The residual interest in net assets.

Balance sheet Classification and Account Measurement - Current assets Amortized cost or current market value Net realizable value Lower of cost or current market value 4-5

Assets – classification and measurement Resources with future economic benefit to a business entity as a result of a past transaction. Current Assets: cash and other assets that are reasonably expected to be realized in cash or sold, or consumed during a normal operating cycle or one year, whichever is longer Examples: Cash and cash equivalents, short- term investments (reported at the fair value), receivables (estimated amount collectible), inventory (LCM), prepaid expenses, etc.

Balance Sheet Classification and Account Measurement -PPE, Investments and Intangibles Historical cost minus accumulated depreciation except that fair market value is used when “impaired” 4-7

Assets (contd.) Long-term Investments: Comprise of the following 4/19/2017 Assets (contd.) Long-term Investments: Comprise of the following Securities (i.e., bonds, stock, long-term notes) Fixed assets (i.e., land, building) Special funds (i.e., pension fund, bond sinking fund) Nonconsolidated subsidiaries or affiliated companies

Assets (contd.) Property, Plant, Equipment (i.e., building, Land, Machinery and equipment, capital leases): assets used in firms’ operations and meet the following criteria: 1. Economic life > 1 year; 2. Acquired for use in operation; 3. Not for resale to customers; 4. $ is material. (materiality) Depreciation will be applied except for land.

Assets (contd.) Intangible Assets: assets with no physical substance but have value based on rights or privileges that belong to the owner (i.e., goodwill, patents, franchises, trademarks,…). Amortization for limited life intangibles (i.e., patents, franchises) and impairment test for indefinite-life intangibles (i.e., goodwill).

Balance Sheet Classification and Measurement - Liabilities Amount due at maturity Historical cost Discounted present value 4-11

Liabilities Legal obligations required future payments of assets or services as a result of a business entity’s past transactions or events. A. Current Liabilities B. Long-term Liabilities C. Other Liabilities

A. Current Liabilities Obligations must be fulfilled in one year or one operating cycle, whichever is longer. (will require the use of current assets or the creation of current liability) (i.e., A/P, N/P, accrual payable, unearned revenue, income tax payable, current portion of L-T debt)

Contingent Liabilities Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)

B. Long-Term Liabilities Obligations are not due in next year or next operating cycle, whichever is longer. (i.e., bonds payable, pension liability)

C. Other Liabilities Long-term advances from customers, deferred income taxes.

Balance Sheet Classification and Account Measurement -Stockholders’ equity Historical par value Historical cost Combination of different measurement bases 4-17

Stockholders’ Equity Residual claims (assets-liabilities) to the business entity from stockholders including: a. contributed capital b. (+ or -)Accumulated Other Comprehensive Income c. retained earnings (or - deficit) d. (-)treasury stock

a. Contributed Capital Par value of common stock Par value of prefer stock Paid-in capital in excess of par value of common stock or preferred stock

b. Accumulated Other Comprehensive Income Increase of assets without outflows of assets, increase of liabilities, increase of income or issuance of common stock (i.e.,(+) increase in market value of securities-available-for-sale (+ or -), gains or losses of foreign currency adjustments, etc.)

c. Retained Earnings Net income not distributed to stockholders appropriated unappropriated

Balance sheet information 1. Rates of return ROA and ROCE ASSETS 2. Capital structure Debt vs. Equity Helps 3. Liquidity Cash conversion LIABILITIES + EQUITY assess 4. Solvency Ability to pay debt 5. Flexibility Operating and financial Balance Sheet

1. Rate of Return Ratios ROA (return on assets) and ROCE (return on common equity) ratios: Evaluate operating efficiency and profitability. ROA = Net operating profit after taxes (NOPAT) / Average assets ROCE = (Net income – Preferred dividends) / Average common shareholders’ equity

2. Capital Structure The balance sheet provides critical information for understanding an entity’s capital structure. Capital structure refers to how much of an entity’s assets are financed from debt versus equity sources.

3. Liquidity Ratios Liquidity measures how readily assets can be converted to cash relative to how soon liabilities will have to be paid in cash. Current ratio: Indicate the level of current resources available to pay current debts. Current Ratio = Current Assets / Current Liabilities Question: Does higher ratio always indicate better financial status?

4. Solvency Solvency defines the ability of a company to generate sufficient cash flows to maintain its productive capacity and still able to pay off the long-term debt. Debt ratios provide information about the amount of long-term debt in a company’s financial structure. Long-term debt to assets = Long term debt/Total assets

Solvency (contd.) A company that can not make timely payments in the amount required becomes insolvent and may be compelled to reorganize or liquidate.

5. Flexibility Flexibility refers to the ability to adapt or revise to a new strategy for different circumstances. The ability to adjust to unexpected downturn in the economic environment in which it operates or to take advantage of profitable investment opportunities when they arise.

Analytical insights: Understanding the business Which company is: Deere E-Trade Potomac Electric Power Wal-Mart 4-29

Balance sheet presentation: International differences U.S. Format: U.K. Format: Current Assets Fixed Assets + + Long-lived Assets Current Assets - = Current Liabilities - Current Liabilities Non-current Liabilities + Non-current Liabilities = + Stockholders’ Equity Capital Employed 4-30

Financial statement footnotes Footnotes are an integral part of companies’ financial reports. These “notes” help users better understand and interpret the numbers presented in the body of the financial statements. Three important notes: Summary of significant accounting policies. Subsequent event disclosures. Related party transactions 4-31

Limitations of the Balance Sheet 1. Historical costs reporting for most of assets and liabilities. 2. Estimations involved in the value of some assets and liabilities (i.e., the net realizable value of accounts receivable and the cost of warranty). 3. the omission of some valuable items such as goodwill of the company. 4. Off-balance sheet liabilities.

Summary The balance sheet shows the assets owned by a company at a given point in time, and how those assets are financed (debt vs. equity). Be alert for differences in balance sheet measurement bases, account titles, and statement format. Financial statement footnotes provide important information.. 4-33