Reading 25 - Understanding Balance Sheets Flashcards
1
Q
Define the balance sheet
A
The balance sheet (also called the statement of financial position or statement of financial condition) provides users with information regarding a company’s assets, liabilities, and equity at a specific point in time. It also provides insights into the future earnings capacity of the company as well as indications regarding expected cash flows.
2
Q
Define assets
A
Assets are resources under a company’s control as a result of past transactions that are expected to generate future economic benefits for the company.
3
Q
Define liabilities
A
Liabilities are a company’s obligations from previous transactions that are expected to result in outflows of economic benefits in the future.
Assets and liabilities may arise from business transactions (e.g., the purchase of a piece of equipment) or as a result of accrual accounting. As we saw in Reading 22, differences between the timing of revenue and expense recognition (based on accrual accounting) and the timing of related cash flows give rise to current assets and liabilities.
Assets and liabilities should only be recognized on the financial statements if it is probable that the future economic benefits associated with them will flow to or from the firm, and that the item’s cost or value can be measured with reliability.
4
Q
Define equity
A
Equity represents the residual claim of shareholders on a company’s assets after deducting all liabilities. Other terms commonly used for shareholders’ equity include stockholders’ equity, net assets, and owners’ equity. Equity can be created as a result of operating activities (business transactions that yield operating profits) and financing activities (issuance of common stock).
5
Q
The balance sheet provides useful information regarding a company’s financial position to both investors and lenders. However, balance sheet information should be interpreted carefully. Analysts should be careful not to view equity reported on the balance sheet as either the market or intrinsic value of a company’s net assets because of the following reasons:
A
- Under current accounting standards, measurement bases of different assets and liabilities may vary considerably. For example, some assets and liabilities may be measured at historical cost, while others may be measured at current value. These differences can have a significant impact on reported figures.
- The value of items reported on the balance sheet reflects their value at the end of the reporting period, which may not necessarily remain “current” at a later date.
- The balance sheet does not include qualitative factors (e.g., reputation, management skills, etc.) that have an important impact on the company’s future cash‐generating ability and therefore, its overall value.
6
Q
List the alternative formats of balance sheet presentation.
A
Report format
Account format
Classified balance sheet
Liquidity-based presentation
7
Q
For alternative formats of balance sheet presentation, describe report format.
A
Report format: Assets, liabilities, and equity are presented in a single column. This format is the most commonly used balance sheet presentation format.
8
Q
For alternative formats of balance sheet presentation, describe account format.
A
Account format: Assets are presented on the left-hand side of the balance sheet, with liabilities and equity on the right-hand side.
9
Q
For alternative formats of balance sheet presentation, describe classified balance sheet.
A
Classified balance sheet: Different types of assets and liabilities are grouped into subcategories to give a more effective overview of the company’s financial position. Classifications typically group assets and liabilities into their current and non-current portions.
10
Q
For alternative formats of balance sheet presentation, describe liquidity-based presentation.
A
Liquidity‐based presentation: IFRS allows the preparation of a balance sheet using a liquidity‐based presentation format (rather than a current/non‐current format), if such a format provides more reliable and relevant information. In a liquidity‐based presentation, all assets and liabilities are broadly presented in order of liquidity. This format is typically used by banks.
For a company, liquidity refers to the company’s ability to meet short‐term cash requirements. For an individual asset, liquidity refers to how quickly the asset can be converted to cash at a price close to its fair market value.
11
Q
On a standard balance sheet, what are the two main asset categories?
A
Current assets
Noncurrent assets
12
Q
On a standard balance sheet, what are the three main liability and equity categories?
A
Current liabilities
Non-current liabilities
Equity
13
Q
On a standard balance sheet, what are the noncurrent assets sub categories?
A
Property, plant, and equipment
Goodwill
Other intangible assets
Non-current investments (subsidiaries)
14
Q
What are the requirements by IFRS and U.S. GAAP for balance sheet presentation?
A
Both IFRS and U.S. GAAP require that assets and liabilities be grouped separately into their current and non‐current portions, which makes it easier for analysts to examine the company’s liquidity position as of the balance sheet date. However, it is not required that current assets be presented before non-current assets, or that current liabilities be presented before non-current liabilities (even though this is the case in Nexen’s balance sheet). Further, under IFRS, the current/non‐current classifications are not required if a liquidity‐based presentation provides more relevant and reliable information.
15
Q
On a standard balance sheet, define current assets.
A
Current assets: These are liquid assets that are likely to be converted into cash or realized within one year or one operating cycle, whichever is longer. The operating cycle is the average time taken by a company to convert the funds used to purchase inventory or raw materials into cash proceeds from sales to customers. Current assets may be listed in order of liquidity, with cash being the first item listed.
16
Q
On a standard balance sheet, define non-current assets.
A
Non‐current assets (also known as long‐term or long‐life assets): These are less liquid assets and are not expected to be converted into cash within one year or within one operating cycle. They represent the infrastructure that the firm uses in its operations and other investments made from a strategic or long‐term perspective.
17
Q
On a standard balance sheet, define current liabilities.
A
Current liabilities: These are obligations that are likely to be settled within one year or one operating cycle, whichever is longer. Specifically, a liability may be classified as a current liability if:
- It is expected to be settled in the entity’s normal operating cycle;
- It is primarily held for the purpose of trading;
- It is due to be settled within one year after the balance sheet date; or
- The entity does not have an unconditional right to defer settlement of the liability for at least one year after the balance sheet date.1
18
Q
On a standard balance sheet, define non-current liabilities.
A
Non-current liabilities: These liabilities are not expected to be settled within a year or within one operating cycle. Non-current liabilities are a source of long‐term finance for a company.
19
Q
On a standard balance sheet, define working capital.
A
Working capital: The difference between current assets and current liabilities is known as working capital. Working capital is necessary for the smooth functioning of a firm’s daily operations. Low working capital levels suggest that the company might be unable to meet its short‐term obligations. Excessively high levels of working capital indicate that the company is not utilizing its resources efficiently.
20
Q
What are the problems analysts have in understanding individual assets and liabilities reported on the balance sheet?
A
Individual assets and liabilities are reported on the balance sheet using different measurement bases. The challenge for analysts lies in understanding how the reported values of assets and liabilities relate to economic reality and to each other. As stated previously, balance sheet values should not be assumed to be accurate measures of the value of a company. For example, land is usually presented at its historical cost. If prices have increased significantly since the date of acquisition, the total value of assets is understated on the balance sheet.
The balance sheet provides important information about the value of certain assets and information about expected future cash flows, but does not always accurately represent the value of the company as a whole.
21
Q
On a standard balance sheet, what are the current assets sub categories?
A
Cash and cash equivalents
Marketable securities
Trade receivables
Inventories
Other current assets
22
Q
What do accounting standards require for the presentation of current assets?
A
These are assets that can be liquidated or consumed by the company within one year, or one operating cycle, whichever is greater. Accounting standards require that certain specific line items must be shown on a balance sheet if they are material (e.g., cash and cash equivalents, trade and other receivables, inventories, and financial assets [with short maturities]).
23
Q
On a standard balance sheet, under current assets, define cash and cash equivalents.
A
Cash equivalents are highly liquid securities that usually mature in less than 90 days. Since they are so close to maturity, there is minimal risk of any change in their value due to changes in interest rates. Since cash equivalents are financial assets, they may be measured at amortized cost or fair value.
- Amortized cost equals historical cost adjusted for amortization and impairment.
- Fair value under IFRS equals the amount at which the asset can be exchanged in an arm’s length transaction between willing and informed parties. Under U.S. GAAP, fair value is based on exit price—the price received to sell an asset.
The amortized cost and fair values of cash equivalents are usually very similar.
24
Q
On a standard balance sheet, under current assets, define marketable securities.
A
These are also financial assets and include investments in debt and equity securities that are traded on public markets. Their balance sheet values are based on market price.
25
**On a standard balance sheet, under current assets, define trade receivables.**
Also considered financial assets, trade receivables represent amounts owed to the company by customers to whom sales have been made. These amounts are usually reported at net realizable value (an estimate of fair value based on the company’s expectations regarding collectability).
- The relation between accounts receivable and sales is important. A significant increase in accounts receivable relative to sales may imply that the company is having problems collecting cash from customers.
- An increase in the allowance for doubtful accounts (the company’s estimate of uncollectable amounts) results in a lower value reported under trade receivables (assets), and bad debts (expense) being reported on the income statement.
- The more diversified the customer base, the lower the credit risk of accounts receivable.
26
**What is the provision for doubtful accounts called?**
The provision for doubtful accounts is called a contra- asset account as
it is netted against accounts receivable (an asset account).
27
**On a standard balance sheet, under current assets, define inventory and how it is measured under IFRS and U.S. GAAP.**
These are physical stocks held by the company in the form of finished goods, work-in-progress, or raw materials. Measurement of inventory differs under **IFRS** and **U.S. GAAP**.
- Under **IFRS**, inventory is reported at the lower of cost and net realizable value (NRV).
- Under **U.S. GAAP**, inventory is reported at the lower of cost and market.
NRV is calculated as selling price minus selling costs, while cost is determined by the cost flow assumption (LIFO, FIFO, or average cost) that is used. Market value (under **U.S. GAAP**) equals the current replacement cost of inventory, which must lie between NRV minus the normal profit margin and NRV.
28
**Inventory costs should include direct materials, direct labor, and overheads. However, the following amounts should not be included when calculating inventory cost:**
- Abnormal amounts of wasted materials, labor, and overheads.
- Storage costs incurred after the production process is complete.
- Administrative overheads.
- Selling costs.
29
**In limited cases, what methods can be used for valuing inventory? Describe them.**
In limited cases, standard cost or the retail method can be used for valuing inventory. Standard cost should take into account normal levels of materials, labor, and actual capacity. The retail method reduces selling price by gross profit margin to determine the cost of inventory.
Once inventory is sold, its cost is reported as an expense in the incomestatement under “cost of goods sold.”
30
**On a standard balance sheet, under current assets, define other current assets.**
Items that are not material enough to be reported as a separate line item on the balance sheet are aggregated into a single amount and reported as “other current assets.” These may include the following:
Prepaid expenses
Deferred tax assets (DTA)
31
**On a standard balance sheet, under current assets, sub categorized in other current assets, define prepaid expenses.**
Prepaid expenses are normal operating expenses that have been paid in advance, so they
are recognized as assets on the balance sheet. Over time, they are expensed on the income statement and the value of the asset is reduced. For example, suppose that at the beginning of the year a company makes a payment of $60,000 as advance payment for a year’s rent. This results in reduction in cash of $60,000 and a corresponding increase in prepaid expenses (asset). At the end of the first quarter, three months rent of $15,000 will be expensed and the prepaid rent asset will be decreased by $15,000. By the end of the year, the entire $60,000 would have been charged as an expense on the income statement and the balance of the prepaid rent asset account will be zero.
32
**On a standard balance sheet, under current assets, sub categorized in other current assets, define deferred tax assets (DTA).**
Deferred tax assets (DTA) usually arise when a company’s taxes payable exceed its income tax expense. They represent a kind of prepayment of taxes and therefore, count as assets. DTA will be discussed in more detail in Reading 31.
33
**On a standard balance sheet, what are the current liabilities sub categories?**
Trade and other payables
Current borrowings
Current portion of non-current borrowings
Current taxes payable
Accrued liabilities
Unearned revenue
34
**On a standard balance sheet, under current liabilities, define trade payables (account payable).**
Trade payables (accounts payable)
These are amounts owed by the business to its suppliers for purchases on credit. Analysts are usually interested in examining the trend in the levels of trade payables relative to purchases to gain insight into the company’s relationships with its suppliers.
35
**On a standard balance sheet, under current liabilities, define notes payable (current borrowings).**
Notes payables (current borrowings)
These financial liabilities are borrowings from creditors that are documented by a loan agreement. Depending on the agreed repayment date, notes payable may also be included in non-current liabilities.
36
**On a standard balance sheet, under current liabilities, define Current portion of long-term liabilities.**
Current portion of long‐term liabilities
These represent portions of long‐term debt obligations that are expected to be paid within a year of the balance sheet date or within one operating cycle, whichever is greater.
37
**On a standard balance sheet, under current liabilities, define income taxes payable.**
Income taxes payable
These are taxes (based on taxable income) have not actually been paid yet.
38
**On a standard balance sheet, under current liabilities, define accrued liabilities.**
Accrued liabilities
These are expenses that have been recognized on the income statement but have still not been paid for as of the balance sheet date.
39
**On a standard balance sheet, under current liabilities, define unearned revenue (deferred revenue or deferred income).**
Unearned revenue (deferred revenue or deferred income)
This arises when a company receives cash in advance for goods and services that are still to be delivered. The company is obligated to either provide the goods or services or to return the cash received.
40
**On a standard balance sheet, what are the noncurrent assets sub categories?**
Property, plant, and equipment
Goodwill
Other intangible assets
Non-current investments (subsidiaries)
41
**On a standard balance sheet, under noncurrent assets, define property, plant, and equipment (PP&E).**
Property, plant, and equipment (PP&E)
These are long‐term assets that have physical substance. Examples of tangible assets treated as PP&E include land, plant, machinery, equipment, and any natural resources owned by the company.
Under **IFRS**, PP&E may be valued using either the cost model or the revaluation model. However, companies need to ensure that the chosen method is applied to all the assets within a particular class of assets. **U.S. GAAP** only allows the cost model for reporting PP&E.
42
**On a standard balance sheet, under noncurrent assets, define investment property.**
Investment property
**IFRS** defines investment property as property that is owned (or leased under a finance lease) for rental income and/or capital appreciation. Under **IFRS**, investment property may be valued using the cost model or the fair value model. The chosen model must be applied to all investment properties held by the company. Further, a company may only use the fair value model if it is able to determine the fair value of the investment property on a continuing basis with reliability. **U.S. GAAP** does not include a specific definition for investment property.
43
**On a standard balance sheet, under noncurrent assets, define intangible assets.**
Intangible assets
These are identifiable, non‐monetary assets that lack physical substance. Under **IFRS**, intangible assets may be reported using either the cost model or the revaluation model. However, the revaluation model can only be selected if there is an active market for the asset. **U.S. GAAP** only allows the cost model.
44
**On a standard balance sheet, under noncurrent assets, for intangible assets, define the differences between finite and indefinite useful lives.**
- Intangible assets with finite useful lives are amortized systematically over their lives and may also be impaired depending on circumstances. Impairment principles for these assets are the same as those that apply to PP&E.
- Intangible assets with indefinite useful lives are not amortized, but are tested for impairment at least annually.
Financial statement disclosures provide important information (e.g., useful lives, amortization rates and methods) regarding a company’s intangible assets.
45
**On a standard balance sheet, under noncurrent assets, for intangible assets, define identifiable intangible assets.**
Identifiable intangible assets can be acquired singly and are usually related to rights and privileges that accrue to the their owners over a finite period. Under **IFRS**, identifiable intangible assets may only be recognized if it is probable that future economic benefits will flow to the company and the cost of the asset can be measured reliably. A company may develop intangible assets internally, but such assets can only be recognized under certain circumstances. Under both **IFRS** and **U.S. GAAP**, costs related to the following are usually expensed:
- Start‐up and training costs.
- Administrative and overhead costs.
- Advertising and promotion costs.
- Relocation and reorganization costs.
46
**Acquired intangible assets may be reported as separately identifiable intangibles (rather than goodwill) if:**
- They arise from contractual rights (e.g., licensing agreements), or other legal rights (e.g., patents); or
- Can be separated and sold (e.g., customer lists).
47
**On a standard balance sheet, under noncurrent assets, define goodwill.**
Goodwill (an example of an asset that is not separately identifiable) is the excess of the amount paid to acquire a business over the fair value of its net assets. The purchase price may exceed the fair value of the target company’s identifiable (tangible and intangible) net assets because of the following reasons:
- Certain items of value (e.g., reputation, brand) are not recognized in a company’s financial statements.
- The target company may have incurred research and development expenditures that may have not been recognized on its financial statements but do hold value for the acquirer.
- The acquisition may improve the acquirer’s position against a competitor or there may be possible synergies.
48
**Analysts must understand the difference between accounting and economic goodwill.** **Explain.**
Accounting goodwill is based on accounting standards and is only reported for acquisitions when the purchase price exceeds the fair value of the acquired company’s net assets.
Economic goodwill, which is not reflected on the balance sheet, is based on a company’s performance and its future prospects. Analysts are more concerned with economic goodwill as it contributes to the value of the firm and should be reflected in its stock price.
49
**Under U.S. GAAP and IFRS, how is accounting goodwill dealt with?**
Under **U.S. GAAP** and **IFRS**, accounting goodwill resulting from acquisitions is capitalized. Further, under both sets of standards, goodwill is not amortized, but is tested for impairment annually. An impairment charge reduces net income and decreases the carrying value of goodwill to its actual value. Impairment of goodwill is a non‐cash expense and therefore does not affect cash flows.
50
**How can goodwill significantly affect the comparability of financial statements of companies?**
Goodwill can significantly affect the comparability of financial statements of companies. When performing ratio analysis, income statement values should be adjusted by removing impairment expense (so that operating trends can be identified), and balance sheet values should be adjusted by excluding goodwill when computing financial ratios. Analysts should evaluate future acquisitions of a company in light of the price paid relative to net assets and earnings prospects of the acquired company (economic goodwill).
Companies are required to disclose information that assists users in evaluating the nature and financial impact of business combinations. Information such as the purchase price paid relative to the fair value of a company’s net assets and earnings prospects of the acquired company help analysts to develop expectations about the company’s performance following an acquisition.
51
**On a standard balance sheet, define financial assets.**
Financial assets
Under **IFRS**, a financial instrument is defined as a contract that gives rise to a financial asset for one entity, and a financial liability or equity instrument for another entity.2 Financial assets include investments in securities (e.g., stocks and bonds) and receivables, while financial liabilities include bonds payable and notes payable. A derivative is a complex financial instrument that derives its value from some underlying factor (e.g., interest rate, exchange rate, underlying asset price) and requires little or no initial investment. As we shall learn later, derivatives may be used for hedging purposes or for speculation.
52
**On a standard balance sheet, define mark-to-market.**
Mark‐to‐market is a process of adjusting the values of trading assets and liabilities to reflect their current market values. These adjustments are usually made on a daily basis. Assets that are classified as held for trading and available for sale are subject to mark‐ to‐market adjustments. Exhibit 2-1 breaks down various marketable and non‐marketable financial instruments according to the measurement base used to value them.
53
**Give a break down on various marketable and non****‐****marketable financial instruments according to the measurement base used to value them.**
_Measured at Fair Value_
*Financial assets:*
Financial assets held for trading (stocks and bonds).
Available-for-sale financial assets (stocks and bonds).
Derivatives.
Non-derivative instruments with face value exposures hedged by derivatives.
_Measured at Cost or Amortized Cost_
*Financial assets:*
Unlisted instruments
Held-to-maturity investments
Loans and receivables
54
**Marketable investment securities can be classified under the following categories:**
Available-for sale securities
Held-to-maturity securities
Trading securities
55
**Marketable investment securities can be classified under the following categories: Define available-for-sale securities.**
Available-for-sale securities: These are debt or equity securities that are neither expected to be traded in the near term, nor held till maturity. They may be sold to address the liquidity needs of the company. These securities are reported at fair market value on the balance sheet. While dividend income, interest income, and realized gains and losses on AFS securities are reported on the income statement, unrealized gains and losses are reported in other comprehensive income as a part of shareholders’ equity.
The “available‐for‐sale” classification no longer appears in **IFRS** as of 2010, even though “IFRS 9: Financial Instruments” will be effective from 2013. However, even though the available‐for‐sale category will not exist, **IFRS** will still permit certain equity investments to be measured at fair value with any unrealized gains and losses recognized in other comprehensive income. This classification will be known as financial assets measured at fair value through other comprehensive income.
56
**Marketable investment securities can be classified under the following categories: Define held-to-maturity securities.**
Held‐to‐maturity securities: These are debt securities that are purchased with the intent of holding them till maturity. Held‐to‐maturity securities are carried at amortized cost (Amortized cost = Face value − Unamortized discount + Unamortized premium). For these securities, unrealized gains or losses from changes in market value are ignored and not recognized on
the financial statements. Only interest income and realized gains and losses (gains and losses when these securities are sold) are recognized on the income statement. See Exhibit 2-2.
57
**Marketable investment securities can be classified under the following categories: Define trading securities.**
Trading securities: These are debt and equity securities (e.g., stocks and bonds) that are acquired with the intent of earning trading profits over the near term. These securities are measured at fair market value on the balance sheet. Dividend income, interest income, realized gains and losses, and unrealized gains and losses are all reported on the income statement.
58
**Give a summary for recognized gains and losses on marketable securities and where they’re detailed: Held-to-maturity securities**
_Held-to-maturity securities_
**Balance sheet:** Reported at cost or amortized cost
**Items recognized on the income statement:** Interest income, realized gains and losses.
59
**Give a summary for recognized gains and losses on marketable securities and where they’re detailed: Available-for-sale securities**
_Available-for-sale securities_
**Balance sheet:** Reported fair value, unrealized gains or losses due to changes in market value are reported in other comprehensive income
**Items recognized on the income statement:** Dividend income, interest income, realized gains and losses
60
**Give a summary for recognized gains and losses on marketable securities and where they’re detailed: Trading securities**
_Trading securities_
**Balance sheet:** Reported at fair value
**Items recognized on the income statement:** Dividend income, interest income, realized gains and losses, unrealized gains and losses due to changes in market value.
61
**On a standard balance sheet, what are the non-current liabilities sub categories?**
Non-current borrowings
Deferred taxes
Noncurrent provisions
62
**On a standard balance sheet, under non-current liabilities, define long-term financial liabilities.**
These may either be measured at fair value or amortized cost.
63
**Lists some financial liabilities along with their measurement basis.**
_Measured at fair value_
*Financial liabilities:*
Derivatives
Financial liabilities held for trading
Non-derivative instruments with face value exposures hedged by derivatives
_Measured at Cost or Amortized Cost_
*Financial liabilities:*
All other liabilities (bond payable and notes payable)
64
**On a standard balance sheet, under non-current liabilities, define deferred tax liabilities.**
These usually arise when a company’s income tax expense exceeds taxes payable. The company pays less taxes based on its tax return than it should pay according to its financial statements. These unpaid taxes will be paid in future periods and are therefore a liability for the company. Deferred tax liabilities have current and non-current portions.
65
**On a standard balance sheet, what are the equity sub categories?**
Common stock
Preferred shares
Reserves
Retained earnings
Shares repurchased (Treasury stock)
66
**On a standard balance sheet, under equity, define capital contributed by owners.**
**Capital contributed by owners (common stock or issued capital):** Owners contribute capital to an entity by investing in common shares. Common shares have par (stated) values that are required to be listed separately in owners’
equity. Required disclosures also include the number of authorized, issued, and outstanding shares for each class of stock issued by the company. Authorized shares are the maximum number of shares that can be sold under the company’s Articles of Incorporation. Issued shares are the total number of shares that have been sold to shareholders. Outstanding shares equal the number of shares that were issued less the number of shares repurchased (treasury stock).
67
**On a standard balance sheet, under equity, define preferred shares.**
**Preferred shares:** Preferred shareholders receive dividends (at a specified percentage of par value) and have priority over ordinary shareholders in the event of liquidation. Preferred shares may either be classified as equity or financial liabilities depending on their characteristics. For example, perpetual, non‐ redeemable preferred shares are classified as equity, while preferred shares with mandatory redemption are classified as financial liabilities.
68
**On a standard balance sheet, under equity, define treasury shares.**
**Treasury shares:** These are shares that have been bought back by the company. Share repurchases result in a reduction in owners’ equity and in the number of shares outstanding. These shares do not receive dividends and do not have voting rights. While Treasury shares may be reissued at a later date, no gain or loss is recognized when they are reissued.
69
**On a standard balance sheet, under equity, define retained earnings.**
**Retained earnings:** These are the cumulative earnings (net income) of the firm over the years that have not been distributed to shareholders as dividends.
70
**On a standard balance sheet, under equity, define accumulated other comprehensive income.**
**Accumulated other comprehensive income:** This represents cumulative other comprehensive income.
71
**On a standard balance sheet, under equity, define non-controlling interest (minority interest).**
**Non-controlling interest (minority interest):** This is the minority shareholders’ pro rata share of the net assets of a subsidiary that is not wholly owned by the company.
72
**On a standard balance sheet, under equity, define statement of changes in owner’s equity.**
This statement presents the effects of all transactions that increase or decrease a company’s equity over the period. Under **IFRS**, the following information should be included in the statement of changes in equity:
- Total comprehensive income for the period;
- The effects of any accounting changes that have been retrospectively applied to
previous periods.
- Capital transactions with owners and distributions to owners; and
- Reconciliation of the carrying amounts of each component of equity at the
beginning and end of the year.4
Under **U.S. GAAP**, companies are required to provide an analysis of changes in each component of stockholders’equity that is shown in the balance sheet.
73
**How can analysts use and analyze a balance sheet?**
Analysts can gain information regarding a company’s liquidity, solvency, and the economic resources controlled by the company by examining its balance sheet.
- Liquidity refers to a company’s ability to meet its short‐term financial obligations.
- Solvency refers to a company’s ability to meet its long‐term financial obligations.
74
**What are the two techniques that may be used to analyze a company’s balance sheet?**
Two of the techniques that may be used to analyze a company’s balance sheet are common‐size analysis and ratio analysis.
75
For the two techniques that may be used to analyze a company’s balance sheet, define vertical common-size balance sheet
A vertical common‐size balance sheet expresses each balance sheet item as a percentage of total assets. This allows an analyst to perform historical analysis (time‐series analysis) and cross‐sectional analysis across firms within the same industry.
76
**For the two techniques that may be used to analyze a company’s balance sheet, define balance sheet ratios.**
These are ratios that have balance sheet items in the numerator and the denominator. The two main categories of balance sheet ratios are liquidity ratios, which measure a company’s ability to settle short‐term obligations, and solvency ratios, which evaluate a company’s ability to settle long‐term obligations.
77
**What are the three liquidity ratios? What does the ratio value mean?**
Current ratio
Quick ratio (acid test ratio)
Cash ratio
The *higher* a company’s liquidity ratios, the *greater* the likelihood that the company will be able to meet its short‐term obligations.
78
**For liquidity ratios, what is the current ratio equation?**
Current ratio = Current assets / Current liabilities
79
**For liquidity ratios, what is the quick ratio (acid test ratio)?**
Quick ratio (acid test ratio) = (cash + marketable securities + receivables) / (current liabilities)
80
**For liquidity ratios, what is the cash ratio?**
Cash ratio = (Cash + marketable securities) / Current liabilities
81
**What are the three solvency ratios? What does the ratio value mean?**
Long-term debt-to-equity ratio
Debt-to-equity ratio
Total debt ratio
Financial leverage ratio
*Higher* solvency ratios, on the other hand, are *undesirable* and indicate that the company is highly leveraged and risky.
82
**For solvency ratios, what is the long-term debt-to-equity ratio?**
Long-term debt-to-equity ratio = Total long-term debt / Total equity
83
**For solvency ratios, what is the debt-to-equity ratio?**
Debt-to-equity ratio = Total debt / Total equity
84
**For solvency ratios, what is the total debt ratio?**
Total debt ratio = Total debt / Total assets
85
**For solvency ratios, what is the financial leverage ratio?**
Financial leverage ratio = Total assets / Total equity
86
**Amortized cost**
The historical cost (initially recognised cost) of an asset, adjusted for amortisation and impairment.
87
**Fair value**
The amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s-length transaction; the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
88
**Define income tax payable**
The income tax owed by the company on the basis of taxable income.
89
**Accrued expenses**
Liabilities related to expenses that have been incurred but not yet paid as of the end of an accounting period—an example of an accrued expense is rent that has been incurred but not yet paid, resulting in a liability “rent payable.” Also called *accrued liabilities*.
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**Give a summary of the balance sheet.**
The balance sheet (also referred to as the statement of financial position) discloses what an entity owns (assets) and what it owes (liabilities) at a specific point in time. Equity is the owners’ residual interest in the assets of a company, net of its liabilities. The amount of equity is increased by income earned during the year, or by the issuance of new equity. The amount of equity is decreased by losses, by dividend payments, or by share repurchases.
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**What does the understanding of the balance sheet enable us to do?**
An understanding of the balance sheet enables an analyst to evaluate the liquidity, solvency, and overall financial position of a company.
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**What does the balance sheet distinguish between?**
The balance sheet distinguishes between current and non-current assets and between current and non-current liabilities unless a presentation based on liquidity provides more relevant and reliable information.
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**What does the concept of liquidity mean?**
The concept of liquidity relates to a company’s ability to pay for its near-term operating needs. With respect to a company overall, liquidity refers to the availability of cash to pay those near-term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.”
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**How are some assets and liabilities measured? How can the notes to financial statements help?**
Some assets and liabilities are measured on the basis of fair value and some are measured at historical cost. Notes to financial statements provide information that is helpful in assessing the comparability of measurement bases across companies.
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**Define the difference between current and non-current assets.**
Assets expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as current assets. Assets not expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as non-current assets.
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**Define the difference between current and non-current liabilities.**
Liabilities expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as current liabilities. Liabilities not expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as non-current liabilities.
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**Define trade receivables and how receivables are reported for doubtful accounts.**
Trade receivables, also referred to as accounts receivable, are amounts owed to a company by its customers for products and services already delivered. Receivables are reported net of the allowance for doubtful accounts.
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**Define inventories.**
Inventories are physical products that will eventually be sold to the company’s customers, either in their current form (finished goods) or as inputs into a process to manufacture a final product (raw materials and work-in-process). Inventories are reported at the lower of cost or net realizable value. If the net realizable value of a company’s inventory falls below its carrying amount, the company must write down the value of the inventory and record an expense.
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**What identification/estimating methods are used for inventory costs?**
Inventory cost is based on specific identification or estimated using the first-in, first-out or weighted average cost methods. Some accounting standards (including US GAAP but not IFRS) also allow last-in, first-out as an additional inventory valuation method.
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**Define accounts payable.**
Accounts payable, also called trade payables, are amounts that a business owes its vendors for purchases of goods and services.
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**Define deferred revenue.**
Deferred revenue (also known as unearned revenue) arises when a company receives payment in advance of delivery of the goods and services associated with the payment received.
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**Define property, plant, and equipment (PPE) in regards to tangible assets on a balance sheet.**
Property, plant, and equipment (PPE) are tangible assets that are used in company operations and expected to be used over more than one fiscal period. Examples of tangible assets include land, buildings, equipment, machinery, furniture, and natural resources such as mineral and petroleum resources.
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**How does the IFRS vs. the US GAAP report property, plants, and equipment (PPE) on a balance sheet?**
IFRS provide companies with the choice to report PPE using either a historical cost model or a revaluation model. US GAAP permit only the historical cost model for reporting PPE.
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**Define depreciation**
Depreciation is the process of recognizing the cost of a long-lived asset over its useful life. (Land is not depreciated.)
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**Under IFRS, how are investment properties reported?**
Under IFRS, property used to earn rental income or capital appreciation is considered to be investment property. IFRS provide companies with the choice to report investment property using either a historical cost model or a fair value model.
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**Define intangible assets**
Intangible assets refer to identifiable non-monetary assets without physical substance. Examples include patents, licenses, and trademarks. For each intangible asset, a company assesses whether the useful life is finite or indefinite.
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**Define an intangible asset**
An intangible asset with a finite useful life is amortised on a systematic basis over the best estimate of its useful life, with the amortisation method and useful-life estimate reviewed at least annually. Impairment principles for an intangible asset with a finite useful life are the same as for PPE.
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**How is an intangible asset reported on a balance sheet?**
An intangible asset with an indefinite useful life is not amortised. Instead, it is tested for impairment at least annually.
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**For internally generated intangible assets, how does the IFRS treat costs incurred during the research phase and development phase?**
For internally generated intangible assets, IFRS require that costs incurred during the research phase must be expensed. Costs incurred in the development stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project.
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**Define goodwill and how it is reported on a balance sheet?**
The most common asset that is not a separately identifiable asset is goodwill, which arises in business combinations. Goodwill is not amortised; instead it is tested for impairment at least annually.
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**Define financial instruments and how are they measured on a balance sheet?**
Financial instruments are contracts that give rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. In general, there are two basic alternative ways that financial instruments are measured: fair value or amortised cost. For financial instruments measured at fair value, there are two basic alternatives in how net changes in fair value are recognized: as profit or loss on the income statement, or as other comprehensive income (loss) which bypasses the income statement.
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**Define typical long-term financial liabilities and how they’re reported on a balance sheet.**
Typical long-term financial liabilities include loans (i.e., borrowings from banks) and notes or bonds payable (i.e., fixed-income securities issued to investors). Liabilities such as bonds issued by a company are usually reported at amortised cost on the balance sheet.
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**Define deferred tax liabilities and how they’re reported on a balance sheet.**
Deferred tax liabilities arise from temporary timing differences between a company’s income as reported for tax purposes and income as reported for financial statement purposes.
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**What are the six potential components that comprise the owners’ equity section of the balance sheet?**
Six potential components that comprise the owners’ equity section of the balance sheet include: contributed capital, preferred shares, treasury shares, retained earnings, accumulated other comprehensive income, and non-controlling interest.
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**Explain the statements of changes in equity.**
The statement of changes in equity reflects information about the increases or decreases in each component of a company’s equity over a period.
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**Define vertical common-size analysis.**
Vertical common-size analysis of the balance sheet involves stating each balance sheet item as a percentage of total assets.
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**Define balance sheet ratios**
Balance sheet ratios include liquidity ratios (measuring the company’s ability to meet its short-term obligations) and solvency ratios (measuring the company’s ability to meet long-term and other obligations).
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