The document discusses key concepts related to the balance sheet, including the purpose, format, time frame, and core issues of recognition, valuation, and classification of assets, liabilities, and shareholders' equity. It notes that assets are recognized based on potential future economic benefits from past transactions and if they can be reasonably measured. Valuation methods include historical cost and present value. Liabilities are probable future sacrifices from obligations from past events that can be measured. Equity is a plug calculated as assets minus liabilities.

1. The Balance Sheet Akshay Samant

2. Purpose of the Balance Sheet Traditionally the oldest statement Theoretically represents financial position, including net worth.

3. Format Follows the balance sheet equation Three main elements- Assets, Liabilities and Equity In the USA, Assets and Liabilities are classified as “current” or “non-current”, in decreasing order of presumed liquidity.

4. Time Frame The balance sheet reflects conditions at a point in time, usually, the fiscal year-end.

5. Core Issues Recognition (e.g., should I recognize this as an asset?) Valuation (If so, for how much?) Classification (What should I call it?)

6. Definition of an asset Theoretically- A resource that has the potential for providing the firm with a future economic benefit . Practical- Same as above, except (a) I have to be able to quantify it, and (b) it probably has to arise via an exchange transaction .

7. GAAP Recognition Criteria The firm has acquired rights to its use as a result of a past transaction or exchange , and The firm can measure or quantify the future benefits with a reasonable degree of precision.

8. The Subjective Nature of Recognition The fundamental question- Do I expense it or capitalize ? Often involves a subjective assessment concerning whether there will be a probable future benefit.

9. Valuation of Assets The options: Historical cost Entry Value Exit value Present Value

10. Valuation- Why not Current Value? Entry Value (replacement cost)- How do you reliably estimate second-hand values? Exit value (realizable value)- Same problem Present value (of future cash flows)- How do you estimate future cash flows and associated risks?

11. Balance Sheet Issues The problem of mis-specification. Adding apples, oranges and tomatoes. What does the sum mean? The question of timing and the impact on relevancy. The bottom line: The Statement of Financial Position is NOT a statement of financial position.

12. The Issue of “Allocation” Property Plant and Equipment- Includes Building, Machinery, Equipment Valuation: Historical Cost Costs capitalized: everything necessary to get assets ready to operate Recorded net of depreciation and/or depletion

13. Methods of Depreciation Straight Line Units of Production Accelerated Methods Declining Balance Sum of Years Digits

14. Example ABC purchases a vehicle for $ 20,000, with an 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

15. Depreciation is: Always an allocation process (as opposed to truly measuring something, like actual decline in exit value). When accelerated methods are used, More in early years Lower in later years

16. Non-Current Assets Intangibles- Most assets you cannot touch but that provide future economic benefits to firm. Include trademarks, copyrights, franchises, patents, brands, goodwill Valuation: Historical Cost Recorded net of amortization charges

17. Intangibles are: Often not systematically amortized but instead tested periodically to see if stated values have been impaired. Are not capitalized if created internally. Due to conservatism, all research and development costs are expensed.

18. Intangible assets are the newest, and arguably most important, asset class today. From these, much wealth is being created. Unfortunately: We have little idea how to measure and recognize the value of these assets.

19. Summary of Key Points-Assets Three issues decide how assets will be reported- recognition, valuation, and classification . Recognition is mainly a question of capitalization vs expensing. The main issue is whether any future economic benefit accrues to the firm.

20. Summary of Key Points-Assets The Balance sheet has historically been a “parking lot” for historical costs that will be expensed sometime in the future. Increasingly, more and more assets are being stated at current value. Today , asset valuations on the balance sheet collectively reflect a mix of values and costs.

21. Summary of Key Points-Assets Many assets are adjusted after initial recognition. Adjustments can be: Allocations - Systematic reductions that don’t really measure anything. (e.g., depreciation) Measurements - attempts to adjust values based on changes in exit value that have occurred. (e.g., impairment tests of goodwill)

22. Liabilities What are they? Theoretically: probable future sacrifices of economic benefits GAAP definition: probable future sacrifices of economic benefits arising from present obligations ….to transfer assets or to provide services ….in the future as a result of past transactions or events

23. 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 .

24. Liabilities Classification: Current Listed in order of probable liquidation dates Types: accounts payable, wages payable, dividends, payable, collections received in advance of delivering goods and services Valuation- Usually at historical value.

25. Liabilities Classification Non-current Types: Deferred taxes, bonds, long-term loans Valuation: Historical exchange value, with adjustments for amortization of premiums and discounts.

26. Liabilities The problem of what “probable” means- Potential liabilities are known as “contingent liabilities. Some future event must occur for them to happen. (e.g., a judgment by a court of law) Contingent liabilities are not usually reported in the balance sheet. Instead they are disclosed in the footnotes. The exception is when they can be quantified and are “probably” going to cost the firm future resources to resolve.

27. Key points-Liabilities Financial reporting liabilities reflect probable economic sacrifices of future resources. Reported liabilities arise through exchange transactions . Not all legal, or even economic, liabilities are reported in the balance sheet. Liabilities are not reported at market value , but instead historical value, with adjustments.

28. Shareholder’s Equity Two types: Contributed capital Retained Earnings

29. Types of Stock Common Preferred Preference over common shareholders with respect to dividends, if declared, and at liquidation Usually have no voting rights. Debatable whether preferred shares are really equity.

30. Important things to know about Equity Shareholder’s equity is a plug, i.e., the same as recorded assets less liabilities . Shareholder’s equity does not reflect the market value of shareholder’s holdings. Two kinds of equity- contributed capital and retained earnings . Main things to know-common stock, preference stock, dividends, treasury stock transactions, stock dividends and splits, ….

31. Income Statement Accrual Accounting-Purpose Revenue Recognition under GAAP Expense Recognition under GAAP

32. The Earnings Process Production Sales Generation (Order) Delivery of product or service Payment

33. Possibilities for Earnings Recognition Point of Production, e.g., when goods are made. When an order is received/given. When goods and services are provided/delivered/received. When firm receives/remits cash.

34. Cash Basis Accounting Is a simple reporting of cash receipts and disbursements . Can be manipulated Can be misleading about non-cash expenses/revenues. On the other hand, involves the verifiable flow of a measurable commodity. May not explicitly map to economic profitability.

35. Profitability-What is it? Theoretically: any change in corporate wealth. Practically: earned revenues less costs incurred to produce those revenues The problem: “Earned revenues” and “costs incurred” are abstract ideas. Measurement of these will necessarily vary across different economic agents.

36. The Problem: When has a firm “ earned ” revenues? When has a firm “ incurred ” costs to produce those revenues?

37. Accrual Accounting Is a set of rules/traditions (GAAP) designed to recognize revenue when “earned” as defined by the revenue realization principle . Recognize “expenses” when they are incurred, as defined by GAAP. NOTE: Cash inflows (outflows) associated with revenues (expenses) may occur before, during, or after accrual-based recognition occurs.

38. Revenues When are revenues usually recognized? Generally when sales are completed by “delivery”, in the legal sense, to customers.

39. Revenues But is this really when revenues are “earned”?

40. Some Alternatives to Revenue Recognition at the Time of sale When production is complete (e.g., gold miners). After sales orders are received and during production (e.g., Boeing). When cash is fully received (e.g., credit collectors). As cash is gradually received (e.g., real estate).

41. Costs/Expenses The Ideal: Mapping ( Matching ) all costs incurred to revenues produced and recognized. The problem: Many costs have no clear relation to revenues. As with revenues, its not always clear if a cost has been incurred. Sometimes, it can even be unclear if a cost even exists, or if it does, whether it detracts from revenue or actually increases it (e.g., goodwill).

42. Costs-Types Costs directly traceable to specific revenue transactions (e.g., costs to buy/produce inventory). Costs associated with, and/or systematically allocable to time periods in which revenue is recognized (e.g., rent expense). Costs for which no measurable future benefit can be discerned (e.g., R&D).

43. Cost-Types Costs in financial reports are expensed through one of two paths: Product costs : costs associated with producing or acquiring goods to be resold. Period Costs : everything else.

44. Cost-Types From an analysis viewpoint, costs can also be viewed according to their relation to the production function: Fixed : Cost level doesn’t change across a range of volume of goods and services produced. Variable : Systematic variance of cost levels with production.

45. Income, or earnings, is equal to revenues less expenses. But does earnings actually reflect the change in wealth that a firm experiences from one period to the next?

46. Income- Fictitious or “Real”? Considerations: Accounting Income is determined by GAAP . Different rules = different reported profits Dividends are paid with cash. A firm can have lots of reported “income” and no cash, and vice versa .

47. 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.

48. Income Characteristics Permanent versus transient Controllable versus uncontrollable Operational versus non-operational

49. 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 accounting principles

50. Single Step Format Revenues XXX Expenses XXX Income before Taxes XXX Income Tax expense XXX Income from Continuing Operations XXX

51. Multiple-Step Format Revenues XXX Less: COGS XXX Gross Profit XXX Less: Operating Expenses XXX Operating Income XXX Add: Other Income XXX Less: Other expenses XXX Income Before Taxes XXX Less Income Tax XXX Income From Continuing Operations XXX

52. Income From Continuing Operations Revenues and expenses of activities in which a firm anticipates an ongoing involvement . Can be presented in single-step or multiple-step format.

53. Income From Discontinuing Operations “ Discontinued operations” are those management has sold or marked for sale or discontinuance . Business segment to be sold must be a component of an enterprise whose activities represent either: A major business line A separate class of customer Income and gains/loss on sale should be reported net of tax. Disclosure is required.

54. Extraordinary Gains and Losses These are arising from events that are both unusual and 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.

55. Cumulative Effect of Changes in Accounting Principles Reflects all income effects in previous years resultant from a change in method , e.g., change from accelerated to straight-line depreciation. Does not capture changes in estimate or in basis (e.g., improvements made to a fixed asset). Reported net of tax.

56. Pro-Forma Earnings Future expected earnings reported in annual reports. Based on assumptions concerning growth rate and margins. Very popular in bull markets (e.g., 1999)-can be used to justify high market valuations. Unpopular in bear markets (i.e., when continued growth no longer seems so certain)

57. Accounting Myths: “ Conservative” accounting is “good” accounting. Accounting based on “Professional Judgement” is bad accounting.

58. A Specific example of the “fictitiousness” of accounting: Income Taxes Income tax is measured using IRS rules. As with book income, these rules have, at their core, a concept of “earnings”, but reflect a number of other considerations as well, including the power of taxpayers to avoid taxation. If accounting income is different from IRS-based tax income, on what basis should the expense be based?

59. Income Taxes The problem: Some of these differences are timing differences and some are permanent. If they are timing differences, there will be tax implications, on a cash basis, occurring in future periods that were spawned by revenue/cost streams being recognized now.

60. Income Taxes The question: Is the expense a function of simply what you pay to the IRS each year, irrespective of how the amount is determined? Or: To the extent possible, is the expense best determined as a function of the book income that precipitated it?

61. Income Taxes-Balance sheet effects To the extent that a relatively greater expense is recognized under IRS rules (e.g., depreciation), a tax liability is created. To the extent that relatively less expense is recognized under IRS rules, a tax asset is created.

62. Income Taxes BUT: What if these tax assets and liabilities never reverse? They can’t be sold, and in fact, have no “real” existence. This happens with many firms whose growth rates cause tax assets and liabilities to never reverse. What then are tax assets and liabilities?

63. Statement of Cash Flows Broken into 3 categories: Operating, Investing and Financing Newest of the three statements

64. Statement of Cash Flows Operating cash flows can be computed using the direct or indirect method. Almost everybody uses the indirect method. Indirect method requires: Add-backs for non-cash charges Adjustments for operating accrual accounts.

65. Statement of Cash Flows Corporate Life Cycle is an important context to consider when interpreting the meaning of reported cash flows. The relation between earnings and cash flows, and changes in this relation, can provide useful analytical information.