Part 4. Understanding Balance Sheets

Question 1

Balance sheet

Answer 1

This reports the firms financial position at a point in time, which consists of assets, liabilities and equity.

Question 2

Assets

Answer 2

Resources controlled as a result of past transactions that are expected to provide future economic benefits.

Question 3

Liabilities

Answer 3

Obligations as a result of past events that are expected to require an outflow of economic resources.

Question 4

Equity

Answer 4

The owners residual interest in assets after deducting liabilities, sometimes referred to as ‘net assets’.

Question 5

Uses of balance sheet

Answer 5

To assess a firms liquidity, solvency and ability to make distributions to shareholders.

Liquidity = the ability to meet short term obligations.
Solvency = the ability to meet long term obligations.

Question 6

Classified balance sheet

Answer 6

Both IFRS and US GAAP require firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities.

This is useful in evaluating liquidity.

Question 7

Liquidity based format

Answer 7

If the presentation is more relevant and reliable, often used in the banking industry, present assets and liabilities in order of liquidity.

Question 8

Current assets

Answer 8

It include cash and others assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater.

Usually presented in order of their liquidity, with cash being most liquid, and reveal information about operating activities of the firm.

Question 9

Operating cycle

Answer 9

The time it takes to produce or purchase inventory, sell the product and collect the cash.

Question 10

Current liabilities

Answer 10

Obligations that will be satisfied within one year or one operating cycle, whichever is greater.

A liability that meets any of the following criteria is considered current:

• settlement is expected during the normal operating cycle.
• settlement is expected within one year.
• held primarily for trading purposes.
• there is no unconditional right to defer settlement for more than one year.

Question 11

Working capital

Answer 11

= Current assets - current liabilities

• Lack of working capital may indicate liquidity problems.
• Too much working capital may be an indication of inefficient use of assets.

Question 12

Non current assets

Answer 12

It does not meet the definition of current assets as they will not be converted into cash or used up within 1 year or operating cycle.

• To provide information about firms investing activities, which form the foundation upon which the firm operates.

Question 13

Non current liabilities

Answer 13

Does not meet the criteria of current liabilities, to provide information about the firm’s long-term financing activities.

Question 14

Intangible assets

Answer 14

These are non-monetary assets that lack physical substance, which are either identifiable or unidentifiable.

Question 15

Identifiable intangible assets

Answer 15

These can be acquired separately or are the result of rights or privileges conveyed to their owner.

e.g. patents, trademarks, copyrights

Question 16

Unidentifiable intangible assets

Answer 16

These cannot be acquired separately and may have unlimited life, such as goodwill.

Question 17

Expense incurred through intangible assets (under IFRS & US GAAP):

Answer 17

• Startup and training costs
• Administrative overhead
• Advertising and promotion costs
• Relocation and reorganisation costs
• Termination costs

Question 18

Goodwill

Answer 18

• The excess of purchase price over fair value of identifiable net assets (assets - liabilities) acquired in a business acquisition, where acquires are willing to pay more than fair value as target may not have assets reported on balance sheet.
• Only created in purchase acquisition, internally generated goodwill is expensed as incurred.
• This is not amortised but must be tested for impairment at least annually if impaired goodwill is reduced and loss is recognised in income statement. The impaired loss does not affect cashflow; if goodwill is not impaired it can remain on balance sheet indefinitely.
• Not amortised so firms can manipulate net income upward allocating more acquisition price to goodwill, resulting in less depreciation and amortisation expense resulting in higher net income.
• Economic goodwill = the expected future performance of firm, while accounting goodwill is a result of past acquisitions.

Question 19

Financial instruments

Answer 19

These are contracts given to rise both financial asset of one entity and financial liability or equity instrument of another entity, found on the asset and liability side of balance sheet.

Measured at historical cost, amortised cost or fair value.

Question 20

Financial asset

Answer 20

This includes investment securities (stocks and bonds), derivatives, loans and recievables.

Question 21

Held-to-maturity securities

Answer 21

Under US GAAP, debt securities with intent hold them until mature and measured at amortised cost.

amortised cost = (original issue price - any principal payment) + any amortised discount or - any amortised premium - impairment losses.

Question 22

Mark to market

Answer 22

Financial assets measured at fair value, including trading securities, available for sale securities and derivatives.

Question 23

Trading securities

Answer 23

These are debt securities acquired with intent to sell them over the near term, reported on the balance sheet at fair value, and unrealised gains and losses are recognised in income statement.

Equity security holding treated in the same manner.
Derivative instruments treated the same as trading securities.

Question 24

Available for sale securities

Answer 24

Debt securities that are not expected to be held to maturity or traded in near term, reported on balance sheet at fair value, but unrealised gains or losses are not recognised in income statement, reported as other comprehensive income part of shareholders equity.

• All financial securities, dividend, and interest income and realised gains and losses are recognised in income statement.

Question 25

Long term financial liabilities (Non-Current Liabilities)

Answer 25

These include bank loans, notes payable, bonds payable, and derivatives, if not issued at face amount they are reported as an amortised cost.

In some cases reported at fair value, e.g. include held-for-trading liabilities such as short position in a stock (ST liability), derivative liabilities, non-derivative liabilities with exposure hedged by derivatives.

Question 26

Deferred tax liabilities

Answer 26

The amounts of income taxes payable in future periods as a result of taxable temporary differences.

Created when amount of income tax expense is recognised in income statement greater than taxes payable.

Created when revenues/gaisn recignised in income statement before taxable.

Question 27

Owners equity

Answer 27

The residual interest in assets that remian after subtracting an entity’s liability.

This includes:

• contributed capital
• preferred stock
• treasury stock
• retained earnings
• non-controlling interest
• accumulated other comprehensive income

Question 28

Contributed capital

Answer 28

The amount contributed by equity shareholders.

Question 29

Par value

Answer 29

The stated or legal value with no relationship to fair value, which exists and is reported separately in stockholders equity.

e.g. total proceeds from issuing an equity security are par value of issued shares plus additional paid in capital.

Question 30

Authorised shares

Answer 30

The number of shares may be sold under the firms articles of incorporation.

Question 31

Issued shares

Answer 31

The number of shares that have actually been sold to shareholders.

Question 32

Outstanding shares

Answer 32

Equal to issued shares less shares that have been reacquired by the firm (i.e. treasury stock)

Question 33

Preferred stock

Answer 33

This has certain rights and privledges not conferred by common stock.

e.g. preferred shareholders paid dividends at specific rate usually expressed as % of par value, and have priority over claims of common shareholders in event of liquidation.

This can be classified as debt or equity.

This calls for mandatory redemption in fixed amounts is considered a financial liability.

Question 34

Noncontrolling interest

Answer 34

The minority shareholders pro-rata share of net asstes of a subsidiary not wholly owned by the parent.

Question 35

Retained earnings

Answer 35

The undistributed earnings (net income) of firms since inception, the cumulative earnings that have not been paid out to shareholders as dividends.

Question 36

Treasury stock

Answer 36

The stock that has been reacquired by issuing firm but not yet retired, this reduces stockholders equity, and not represent investment in firm.

This has no voting rights and does not receive dividends.

Question 37

Accumulated other comprehensive income

Answer 37

This includes all changes in stockholders equity except for transactions recognised in income statement (net income), and transactions with shareholders such as issuing stock, reacquiring stock and paying dividends.

Question 38

Statements of changes in stockholders equity

Answer 38

This summarises all transactions that increase or decrease equity accounts for the period.

This includes:

• Transactions with shareholders
• Reconciles begin and end balance of each equity account including capital stock, add. paid in capital, retained earnings & accumulated other comprehensive income.

Question 39

Vertical common-size balance sheet

Answer 39

This expresses each item of balance sheet as a percentage of total assets, which allows for comparison overtime and standaises the balance sheet to eliminate effects of size.

Allows for:

• Time series analysis
• Cross sectional analysis

Question 40

Liquidity ratios

Answer 40

Measures the firms ability to satisfy its short term obligations as they come due.

This includes:

• current ratio
• quick ratio
• cash ratio

Question 41

Solvency ratios

Answer 41

This measures the firms abilitiy to satisfy its LT obligations.

This includes:

• LT debt to equity ratio
• Total debt to equity ratio
• Debt ratio
• Financial leverage ratio

Question 42

Limitations of balance sheet ratio analysis:

Answer 42

• Comparisons with peer firms limited by differences in accounting standards and estimates.
• Lack of homogeneity as firms operate in different industries.
• Interpretation of ratios requires significant judgement.
• Balance sheet data are only measured at a single point in time.