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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.
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, ….
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.
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.
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 OperationsXXX
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)
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.