Reading 19: Understanding Balance Sheet Flashcards
Describe the elements of the balance sheet: assets, liabilities, and equity.
- Assets are resources controlled as result of past transactions that are expected to provide future economic benefits.
- Liabilities are obligations as a result of past events that are expected to require an outflow of economic resources.
- Equity is the owners’ residual interest in the assets after deducting the liabilities.
A financial statement item should be recognized if a future economic benefit to or from the firm is probable and the item’s value or cost can be measured reliably.
Describe 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 pay dividends to shareholders.
Balance sheet assets, liabilities, and equity should not be interpreted as market value or intrinsic value. For most firms, the balance sheet consists of a mixture of values including historical cost, amortized cost, and fair value.
Some assets and liabilities are difficult to quantify and are not reported on the balance sheet.
Describe alternative formats of balance sheet presentation.
A classified balance sheet separately reports current and noncurrent assets and current and noncurrent liabilities. Alternatively, liquidity-based presentations, often used in the banking industry, present assets and liabilities in order of liquidity.
Contrast current and non-current assets and current and non-current liabilities.
- Current (noncurrent) assets are those expected to be used up or converted to cash in less than (more than) one year or the firm’s operating cycle, whichever is greater.
- Current (noncurrent) liabilities are those the firm expects to satisfy in less than (more than) one year or the firm’s operating cycle, whichever is greater.
Describe different types of assets and liabilities and te measurement base of each.
Cash equivalents are short-term, highly liquid financial assets that are readily convertible to cash. Their balance sheet values are generally close to identical using either amortized cost or fair value.
Accounts receivable are reported at net realizable value by estimating bad debt expense.
Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost or market (U.S. GAAP). Cost can be measured using standard costing or the retail method. Different cost flow assumptions can affect inventory values.
Property, plant, and equipment (PP&E) can be reported using the cost model or the revaluation model under IFRS. Under U.S. GAAP, only the cost model is allowed. PP&E is impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment losses are allowed under IFRS but not U.S. GAAP.
Intangible assets created internally are expensed as incurred. Purchased intangibles are reported similar to PP&E. Under IFRS, research costs are expensed as incurred and development costs are capitalized. Both research and development costs are expensed under U.S. GAAP.
Goodwill is the excess of purchase price over the fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Goodwill is not amortized but must be tested for impairment at least annually.
Under IFRS, debt securities acquired with intent hold them to maturity are measured at amortized cost. Debt securities acquired with the intent to collect interest payments but sell before maturity are measured at fair value through other comprehensive income. Debt securities acquired with the intent to sell them in the near term, as well as equity securities and derivatives, are measured at fair value through profit and loss.
IFRS permits firms to elect, irrevocably at the time of purchase, to measure equity securities at fair value through other comprehensive income, or any security at fair value through profit and loss.
Under U.S. GAAP, held-to-maturity securities are reported at amortized cost. Trading securities, available-for-sale securities, and derivatives are reported at fair value. For trading securities and derivatives, unrealized gains and losses are recognized in the income statement. Unrealized gains and losses for available-for-sale securities are reported in equity (other comprehensive income).
Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accrued liabilities are expenses that have been recognized in the income statement but are not yet contractually due. Unearned revenue is cash collected in advance of providing goods and services.
Financial liabilities not issued at face value, like bonds payable, are reported at amortized cost. Held-for-trading liabilities and derivative liabilities are reported at fair value.
Describe the components of shareholders’s equity.
Owners’ equity includes:
* Contributed capital—the amount paid in by common shareholders.
* Preferred stock—capital stock that has certain rights and privileges not possessed by the common shareholders. Classified as debt if mandatorily redeemable.
* Treasury stock—issued common stock that has been repurchased by the firm.
* Retained earnings—the cumulative undistributed earnings of the firm since inception.
* Noncontrolling (minority) interest—the portion of a subsidiary that is not owned by the parent.
* Accumulated other comprehensive income—includes all changes to equity from sources other than net income and transactions with shareholders.
The statement of changes in stockholders’ equity summarizes the transactions during a period that increase or decrease equity, including transactions with shareholders.
Demonstrate the conversion of balance sheets to common-size balance sheets and interpret common-size balance sheets.
A vertical common-size balance sheet expresses each item of the balance sheet as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis).
Calculate and interpret liquidity and solvency ratios.
Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm’s liquidity and solvency.
* 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.
* 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.
