The Balance SheetDileep Panolidileeppanoli@gmail.com
Purpose of the Balance Sheet Traditionally the oldest statement Theoretically represents financial position,including net worth.
Format Follows the balance sheet equation Three main elements- Assets, Liabilities andEquity In the USA, Assets and Liabilities areclassified as “current” or “non-current”, indecreasing order of presumed liquidity.
Time Frame The balance sheet reflects conditions at apoint in time, usually, the fiscal year-end.
Core Issues– Recognition (e.g., should I recognize this as anasset?)– Valuation (If so, for how much?)– Classification (What should I call it?)
Definition of an asset Theoretically- A resource that has thepotential for providing the firm with a futureeconomic benefit. Practical- Same as above, except (a) I haveto be able to quantify it, and (b) it probablyhas to arise via an exchange transaction.
GAAP Recognition Criteria The firm has acquired rights to its use as aresult of a past transaction or exchange,and The firm can measure or quantify the futurebenefits with a reasonable degree ofprecision.
The Subjective Nature of Recognition The fundamental question-– Do I expense it or capitalize?– Often involves a subjective assessmentconcerning whether there will be a probable futurebenefit.
Valuation of Assets The options:– Historical cost– Entry Value– Exit value– Present Value
Valuation-Why not Current Value? Entry Value (replacement cost)-– How do you reliably estimate second-handvalues? Exit value (realizable value)-– Same problem Present value (of future cash flows)-– How do you estimate future cash flows andassociated risks?
Balance Sheet Issues The problem of mis-specification. Adding apples, oranges and tomatoes. Whatdoes the sum mean? The question of timing and the impact onrelevancy. The bottom line: The Statement ofFinancial Position is NOT a statement offinancial position.
The Issue of “Allocation” Property Plant and Equipment-– Includes Building, Machinery, Equipment– Valuation: Historical Cost– Costs capitalized: everything necessary to getassets ready to operate– Recorded net of depreciation and/or depletion
Methods of Depreciation Straight Line Units of Production Accelerated Methods– Declining Balance– Sum of Years Digits
Example ABC purchases a vehicle for $ 20,000, withan estimated life of 5 years (200,000 miles)and an expected residual value of $ 500. Depreciation-– Straight line- $ 3850– 200% declining balance- $ 8,000– UOP (assuming use of 50,000 miles)- $ 4,875
Depreciation is: Always an allocation process (as opposedto truly measuring something, like actualdecline in exit value). When accelerated methods are used,– More in early years– Lower in later years
Non-Current Assets Intangibles- Most assets you cannot touchbut that provide future economic benefits tofirm. Include trademarks, copyrights, franchises,patents, brands, goodwill Valuation: Historical Cost Recorded net of amortization charges
Intangibles are: Often not systematically amortized butinstead tested periodically to see if statedvalues have been impaired. Are not capitalized if created internally. Dueto conservatism, all research anddevelopment costs are expensed.
Intangible assets are the newest, andarguably most important, asset class today.From these, much wealth is being created.Unfortunately: We have little idea how to measure andrecognize the value of these assets.
Summary of Key Points-Assets Three issues decide how assets will bereported- recognition, valuation, andclassification. Recognition is mainly a question ofcapitalization vs expensing. The main issueis whether any future economic benefitaccrues to the firm.
Summary of Key Points-Assets The Balance sheet has historically been a“parking lot” for historical costs that will beexpensed sometime in the future. Increasingly, more and more assets arebeing stated at current value. Today, asset valuations on the balancesheet collectively reflect a mix of values andcosts.
Summary of Key Points-Assets Many assets are adjusted after initialrecognition. Adjustments can be:– Allocations- Systematic reductions that don’treally measure anything. (e.g., depreciation)– Measurements- attempts to adjust values basedon changes in exit value that have occurred. (e.g.,impairment tests of goodwill)
Liabilities What are they?– Theoretically: probable future sacrifices ofeconomic benefits– GAAP definition: probable future sacrifices ofeconomic benefits arising from presentobligations ….to transfer assets or to provideservices ….in the future as a result of pasttransactions or events
Liabilities What are they?– Practically (Recognition criteria): Probable future sacrifices of resources Can be measured (quantified) Generally, can’t be avoided. Arise through a past transaction or exchange.
Liabilities Classification:– Current Listed in order of probable liquidation dates Types: accounts payable, wages payable, dividends,payable, collections received in advance of deliveringgoods and services Valuation- Usually at historical value.
Liabilities Classification– Non-current Types: Deferred taxes, bonds, long-term loans Valuation: Historical exchange value, with adjustmentsfor amortization of premiums and discounts.
Liabilities The problem of what “probable” means-– Potential liabilities are known as “contingentliabilities. Some future event must occur for themto happen. (e.g., a judgment by a court of law)– Contingent liabilities are not usually reportedin the balance sheet. Instead they are disclosed inthe footnotes.– The exception is when they can be quantified andare “probably” going to cost the firm futureresources to resolve.
Key points-Liabilities Financial reporting liabilities reflect probableeconomic sacrifices of future resources. Reported liabilities arise through exchangetransactions. Not all legal, or even economic, liabilities arereported in the balance sheet. Liabilities are not reported at market value, butinstead historical value, with adjustments.
Shareholder’s Equity Two types:– Contributed capital– Retained Earnings
Types of Stock Common Preferred– Preference over common shareholders withrespect to dividends, if declared, and at liquidation– Usually have no voting rights.– Debatable whether preferred shares are reallyequity.
Important things to know about Equity Shareholder’s equity is a plug, i.e., the same asrecorded assets less liabilities. Shareholder’s equity does not reflect the marketvalue of shareholder’s holdings. Two kinds of equity- contributed capital andretained earnings. Main things to know-common stock, preferencestock, dividends, treasury stock transactions, stockdividends and splits, ….
Income StatementAccrual Accounting-PurposeRevenue Recognition underGAAPExpense Recognition underGAAP
The Earnings Process Production Sales Generation (Order) Delivery of product or service Payment
Possibilities for Earnings Recognition Point of– Production, e.g., when goods are made.– When an order is received/given.– When goods and services areprovided/delivered/received.– When firm receives/remits cash.
Cash Basis Accounting Is a simple reporting of cash receipts anddisbursements. Can be manipulated Can be misleading about non-cashexpenses/revenues. On the other hand, involves the verifiable flow of ameasurable commodity. May not explicitly map to economic profitability.
Profitability-What is it? Theoretically: any change in corporatewealth. Practically: earned revenues less costsincurred to produce those revenues The problem: “Earned revenues” and “costsincurred” are abstract ideas. Measurement ofthese will necessarily vary across differenteconomic agents.
The Problem: When has a firm “earned” revenues? When has a firm “incurred” costs to producethose revenues?
Accrual Accounting Is a set of rules/traditions (GAAP) designed to– recognize revenue when “earned” as defined by therevenue realization principle.– Recognize “expenses” when they are incurred, as definedby GAAP.NOTE: Cash inflows (outflows) associated with revenues(expenses) may occur before, during, or after accrual-based recognition occurs.
Revenues When are revenues usually recognized?– Generally when sales are completed by“delivery”, in the legal sense, to customers.
Revenues But is this really when revenues are“earned”?
Some Alternatives toRevenue Recognition at the Time of sale When production is complete (e.g., goldminers). After sales orders are received and duringproduction (e.g., Boeing). When cash is fully received (e.g., creditcollectors). As cash is gradually received (e.g., realestate).
Costs/Expenses The Ideal: Mapping (Matching) all costs incurred torevenues produced and recognized. The problem:– Many costs have no clear relation to revenues.– As with revenues, its not always clear if a cost has beenincurred.– Sometimes, it can even be unclear if a cost even exists, or ifit does, whether it detracts from revenue or actuallyincreases it (e.g., goodwill).
Costs-Types Costs directly traceable to specific revenuetransactions (e.g., costs to buy/produce inventory). Costs associated with, and/or systematicallyallocable to time periods in which revenue isrecognized (e.g., rent expense). Costs for which no measurable future benefit canbe discerned (e.g., R&D).
Cost-Types Costs in financial reports are expensedthrough one of two paths:– Product costs: costs associated with producingor acquiring goods to be resold.– Period Costs: everything else.
Cost-Types From an analysis viewpoint, costs can alsobe viewed according to their relation to theproduction function:– Fixed: Cost level doesn’t change across a rangeof volume of goods and services produced.– Variable: Systematic variance of cost levels withproduction.
Income, or earnings, is equal to revenuesless expenses. But does earnings actually reflect the changein wealth that a firm experiences from oneperiod to the next?
Income- Fictitious or “Real”? Considerations:– Accounting Income is determined by GAAP.Different rules = different reported profits– Dividends are paid with cash. A firm can havelots of reported “income” and no cash, andvice versa.
Goals The goal of financial reporting, and GAAP,are to:– Report (changes in) financial position.– Report on the profitability of firms.– In the real world, these goals often conflict.
Income Characteristics Permanent versus transient Controllable versus uncontrollable Operational versus non-operational
Income Statement Classification Income From continuing operations– Single step format– Multiple step format Income from discontinuing operations Extraordinary gains and losses Cumulative effect of changes in accountingprinciples
Single Step FormatRevenues XXXExpenses XXXIncome before Taxes XXXIncome Tax expense XXXIncome from Continuing Operations XXX
Multiple-Step Format Revenues XXXLess: COGS XXXGross Profit XXXLess: Operating Expenses XXXOperating Income XXXAdd: Other Income XXXLess: Other expenses XXXIncome Before Taxes XXXLess Income Tax XXXIncome From Continuing OperationsXXX
Income From Continuing Operations Revenues and expenses of activities in whicha firm anticipates an ongoing involvement. Can be presented in single-step or multiple-step format.
Income From Discontinuing Operations “Discontinued operations” are those managementhas sold or marked for sale or discontinuance. Business segment to be sold must be a componentof an enterprise whose activities represent either:– A major business line– A separate class of customer Income and gains/loss on sale should be reportednet of tax. Disclosure is required.
Extraordinary Gains and Losses These are arising from events that are both unusualand infrequent (non-recurring) in nature. Reported net of tax. Disclosure is required. Examples:– Loss due to earthquake.– Expropriation: takeover of property by a government.– Prohibition under a new law.
Cumulative Effect of Changes in AccountingPrinciples Reflects all income effects in previous yearsresultant from a change in method, e.g.,change from accelerated to straight-linedepreciation. Does not capture changes in estimate orin basis (e.g., improvements made to a fixedasset). Reported net of tax.
Pro-Forma Earnings Future expected earnings reported in annual reports. Based on assumptions concerning growth rate andmargins. Very popular in bull markets (e.g., 1999)-can beused to justify high market valuations. Unpopular in bear markets (i.e., when continuedgrowth no longer seems so certain)
Accounting Myths: “Conservative” accounting is “good”accounting. Accounting based on “ProfessionalJudgement” is bad accounting.
A Specific example of the“fictitiousness” of accounting: IncomeTaxes Income tax is measured using IRS rules. Aswith book income, these rules have, at theircore, a concept of “earnings”, but reflect anumber of other considerations as well,including the power of taxpayers to avoidtaxation. If accounting income is different from IRS-based tax income, on what basis should theexpense be based?
Income Taxes The problem: Some of these differences aretiming differences and some are permanent. If they are timing differences, there will be taximplications, on a cash basis, occurring infuture periods that were spawned byrevenue/cost streams being recognized now.
Income Taxes– The question: Is the expense a function of simplywhat you pay to the IRS each year, irrespective ofhow the amount is determined? Or:– To the extent possible, is the expense bestdetermined as a function of the book income thatprecipitated it?
Income Taxes-Balance sheet effects To the extent that a relatively greaterexpense is recognized under IRS rules (e.g.,depreciation), a tax liability is created. To the extent that relatively less expense isrecognized under IRS rules, a tax asset iscreated.
Income Taxes BUT: What if these tax assets and liabilitiesnever reverse? They can’t be sold, and infact, have no “real” existence. This happens with many firms whose growthrates cause tax assets and liabilities to neverreverse. What then are tax assets and liabilities?
Statement of Cash Flows Broken into 3 categories: Operating,Investing and Financing Newest of the three statements
Statement of Cash Flows Operating cash flows can be computed usingthe direct or indirect method. Almost everybody uses the indirect method. Indirect method requires:– Add-backs for non-cash charges– Adjustments for operating accrual accounts.
Statement of Cash Flows Corporate Life Cycle is an important contextto consider when interpreting the meaning ofreported cash flows. The relation between earnings and cashflows, and changes in this relation, canprovide useful analytical information.