Book 3 - FRA - Balance Sheet Flashcards
What is a B/S?
The balance sheet (also known as the statement of financial position or statement o f financial condition) reports the firm’s financial position at a point in time. The balance sheet consists of assets, liabilities, and equity.
Describe the uses and limitations of the balance sheet in financial analysis?
The balance sheet can be used to assess a firm’s liquidity, solvency, and ability to make distributions to shareholders. From the firm’s perspective, liquidity is the ability to meet short-term obligations and solvency is the ability to meet long-term obligations.
Describe alternative formats of balance sheet presentation.
Both IFRS and U.S. GAAP require firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities. The current/noncurrent format is known as a classified balance sheet and is useful in evaluating liquidity.
Under IFRS, firms can choose to use a liquidity-based format if the presentation is more relevant and reliable. Liquidity-based presentations, which are often used in the banking industry, present assets and liabilities in the order of liquidity.
Describe cash and cash equivalents.
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. Examples of cash equivalents include Treasury bills, commercial paper, and money market funds. Cash and equivalents are considered financial assets. Generally, financial assets are reported on the balance sheet at amortized cost or fair value. For cash equivalents, either measurement base should result in about the same value.
Describe marketable securities.
Marketable securities are financial assets that are traded in a public market and whose value can be readily determined. Examples include Treasury bills, notes, bonds, and equity securities. Details of the investment are disclosed in the financial footnotes.
Describe accounts receivable and how they are reported.
Accounts receivable (also known as trade receivables) 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 realizable value_, which is based on estimated _bad debt expense_. Bad debt expense increases the allowance for doubtful accounts, a contra-asset account. A contra account is used to reduce the value of its controlling account. Thus, gross receivables less the allowance for doubtful accounts is equal to accounts receivable at net realizable value, the amount the firm expects to collect. When receivables are "written off" (removed from the balance sheet because they are uncollectable), both gross receivables and the allowance account are reduced.
Describe inventories and what is included in its cost.
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 costs 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 excluded 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.
Describe different aproach to inventory accounting under IFRS and GAAP.
Using different cost flow assumptions, firms assign inventory costs to the income statement (cost of goods sold). FIFO and average cost are permitted under both IFRS and U.S. GAAP. LIFO is permitted under U.S. GAAP but is prohibited under IFRS.
Under IFRS, inventories are reported at the l**o**wer of cost or net realizable value. Net realizable value is equal to the selling price less any completion costs and disposal (selling) costs.
Under U.S. GAAP, inventories are reported at the lower of cost or market. Market is usually equal to replacement cost; however, market cannot be greater than net realizable value or less than net realizable value less a normal profit margin.
If net realizable value (IFRS) or market (U.S. GAAP) is less than the inventory’s carrying value, the inventory is written down and a loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be written back up under IFRS. No write-up is allowed under U.S. GAAP; the firm simply reports higher profit when the inventory is sold.
Describe accounts payable.
Accounts payable (also known as trade payables) are amounts the firm owes to suppliers for goods or services purchased on credit. Analyzing payables relative to purchases can signal credit problems with suppliers.
Describe notes payable and current portion of long-term debt.
Notes payable are obligationsin the form of promissory notes owed to creditors and lenders. Notes payable can also be reported as noncurrent liabilities if their maturities are greater than one year. The current portion of long-term debt is the principal portion of debt due within one year or operating cycle, whichever is greater.
Describe accrued liabilities.
Accrued liabilities (accrued expenses) are expenses that have been recognized in the income statement but **_are not yet contractually due_**. Accrued liabilities result from the accrual method of accounting, under which expenses are recognized as incurred. For example, consider a firm that is required to make annual year-end interest payments of $ 1 00,000 on an outstanding bank loan. At the end of March, the firm would recognize one-quarter ($25,000) of the total interest expense in its income statement and an accrued liability would be increased by the same amount, even though the liability is not actually due until the end of the year.
Describe unearned revenue.
Unearned revenue is cash collected in advance of providing goods and services. For example, a magazine publisher receives subscription payments in advance of delivery. When payment is received, assets (cash) and liabilities (unearned revenue) increase by the same amount. As the magazines are delivered, the publisher recognizes revenue in the income statement and reduces the liability.
Describe non-current assets (property, plant, and equipment).
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 U.S. GAAP, only the cost model is allowed. _
Describe investment property.
Under IFRS, investment property includes assets that generate rental income or capital appreciation. U.S. GAAP does not have a specific definition
of investment property.
Under IFRS, investment property can either be reported at amortized cost (just like PP&E) or fair value. Under the fair value model, any change in fair value is recognized in the income statement.
Describe intangible assets.
Intangible assets are non-monetary assets that lack physical substance. Intangible assets are either identifiable or unidentifiable.
Identifiable intangible assets can be acquired separately or are the result of rights or privileges conveyed to their owner. Examples of identifiable intangibles are patents, trademarks, and copyrights.
Unidentifiable intangible assets cannot be acquired separately and may have an unlimited life. The best example of an unidentifiable intangible asset is goodwill.
Under IFRS, identifiable intangibles that are purchased can be reported on the balance sheet using the cost model or the revaluation model, although the revaluation model can only be used if an active market for the intangible asset exists. Both models are basically the same as the measurement models used for PP&E. Under U.S. GAAP, only the cost model is allowed.
Finite-lived intangible assets are amortized over their useful lives and tested for impairment in the same way as PP&E. The amortization method and useful life estimates are reviewed at least annually. Intangible assets with infinite lives are not amortized, but are tested for impairment at least annually.
Descibe and name liquidity ratios.
Liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they come due. Liquidity ratios include the current ratio, the quick ratio, and the cash ratio.
Although all three ratios measure the firm’s ability to pay current liabilities, they should be considered collectively.
For example, assume Firm A has a higher current ratio but a lower quick ratio as compared to Firm B. This is the result of higher inventory as compared to Firm B. The quick ratio (also known as the acid-test ratio) is calculated by excluding inventory from current assets. Similar analysis can be performed by comparing the quick ratio and the cash ratio. The cash ratio is calculated by excluding inventory and receivables.
Describe and name solvency ratios.
Solvency ratios measure the firm’s ability to satisfy its long-term obligations. Solvency ratios include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio, and the financial leverage ratio.
All four ratios measure solvency but they should be considered collectively.
For example, Firm A might have a higher long-term debt-to-equity ratio but a lower total debt-to equity ratio as compared to Firm B. This is an indication that Firm B is utilizing more short-term debt to finance itself.
When calculating solvency ratios, debt is considered to be any interest bearing obligation. On the other hand, the financial leverage ratio captures the impact of all obligations, both interest bearing and non-interest bearing.
Analysts must understand the limitations of balance sheet ratio analysis:
- Comparisons with peer firms are limited by differences in accounting standards and estimates.
- Lack of homogeneity as many firms operate in different industries.
- Interpretation of ratios requires significant judgment.
- Balance sheet data are only measured at a single point in time.
