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OVERVIEW

CHAPTER 5
UNDERSTANDING BALANCE SHEETS Balance sheet elements and format
Accounting issues
Presenters name
Presenters title
- Current and noncurrent assets and liabilities
dd Month yyyy - Measurement bases of different assets and liabilities
Components of shareholders equity
Balance sheet analysis
Liquidity and solvency

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BALANCE SHEET CONTENTS BALANCE SHEET ELEMENTS

The balance sheet is also known as the statement of Assets (A): resources controlled by the company as a
financial position or statement of financial condition. result of past events and from which future economic
The balance sheet discloses, at a specific point in time, benefits are expected to flow to the entity.
- what an entity owns (or controls),
- what it owes, and Liabilities (L): obligations of a company arising from past
events, the settlement of which is expected to result in an
- what the owners claims are.
outflow of economic benefits from the entity.

Assets = Liabilities + Owners equity Equity (E): represents the owners residual interest in the
companys assets after deducting its liabilities.

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BALANCE SHEET: EXAMPLE
EQUITY
COLGATE-PALMOLIVE COMPANY (ASSETS)
The balance sheet provides important information about a
companys financial condition.
However, balance sheet amounts of equity (assets, net of liabilities)
should not be viewed as a measure of either the market or intrinsic
value of a companys equity.
Why?
- The balance sheet is a mixed model with respect to measurement
(some items at historical cost, some items at current value).
- Even current value reflects a value that was current at the end of
the reporting period.
- Future cash flows, which affect value, are driven by items
excluded from the balance sheet (e.g., reputation, management
skills).
Colgate's Annual Report
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BALANCE SHEET: EXAMPLE BALANCE SHEET: EXAMPLE


COLGATE-PALMOLIVE COMPANY (LIABILITIES) COLGATE-PALMOLIVE COMPANY (EQUITY)

Colgate's Annual Report Colgate's Annual Report


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BALANCE SHEET: EXAMPLE
BALANCE SHEET FORMAT
HENKEL AG (ASSETS)
Liquidity
- For a company overall, its ability to pay for short-term
obligations
- For a particular asset or liability, its nearness to cash
Balance sheet ordering according to liquidity
- Companies using U.S. GAAP (e.g., Colgate) order items
on the balance sheet from most liquid to least liquid.
- Companies using IFRS order balance sheet information
from least liquid to most liquid.

Henkel's Annual Report

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BALANCE SHEET: EXAMPLE CURRENT AND NONCURRENT


LORAL (ASSETS) ASSETS AND LIABILITIES
Balance sheet must distinguish between and present separately
- current and noncurrent assets
- current and noncurrent liabilities
Exception to the current and noncurrent classifications
requirement, under IFRS:
- Current and noncurrent classifications are not required if a
liquidity-based presentation provides reliable and more
relevant information.
- In a liquidity-based presentation, all assets and liabilities
presented in order of liquidity.
- Liquidity-based presentation are often used by banks.
Classified balance sheet: Balance sheet with separately
classified current and noncurrent assets and liabilities.
LOral's Annual Report
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BALANCE SHEET: EXAMPLE CURRENT AND NONCURRENT
BARCLAYS PLC (ASSETS) ASSETS AND LIABILITIES
Current assets: Assets expected to be sold, used up, or
otherwise realized in cash within one year or one operating
cycle of the business, whichever is greater, after the
reporting period.
Noncurrent assets: Assets not classified as current. Also
known as long-term or long-lived assets.
Current liabilities: Liabilities expected to be settled within
one year or within one operating cycle of the business.
Noncurrent liabilities: All liabilities not classified as
current.
Working capital: The excess of current assets over
current liabilities.
Barclays' Annual Report
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MEASUREMENT BASES OF CURRENT ASSETS: MEASUREMENT BASES OF CASH AND CASH


CASH AND CASH EQUIVALENTS EQUIVALENTS: EXAMPLE DISCLOSURES
Cash Equivalents: Highly liquid, short-term investments Cash Equivalents. Highly liquid investments with remaining stated maturities
that are so close to maturity that the risk of significant of three months or less when purchased are considered cash equivalents and
recorded at cost.
change in value from changes in interest rates is minimal.
Procter & Gamble (2011), annual report
- Examples:
- demand deposits with banks
- highly liquid investments with original maturities of three Cash and cash equivalents. Cash and cash equivalents consist of cash in
bank accounts, units of cash unit trusts and liquid short-term investments with a
months or less (e.g., U.S. T- bills, commercial paper, negligible risk of changes in value and a maturity date of less than three months
money market funds) at the date of acquisition. . . . Units of cash unit trusts are considered to be
- For cash and cash equivalents, amortized cost and fair assets available for sale. As such, they are valued in the balance sheet at their
value are likely to be immaterially different. market value at the closing date. Any related unrealized gains are accounted for
in Finance costs, net in the income statement. The carrying amount of bank
deposits is a reasonable approximation of their fair value.
LOral (2011), annual report

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MEASUREMENT BASES OF CURRENT ASSETS: MEASUREMENT BASES OF RECEIVABLES:
TRADE RECEIVABLES LORAL EXAMPLE
Trade receivables: Amounts owed to a company by its Based on the note below, what percentage of its receivables
customers for products and services already delivered. did LOral estimate will be uncollectible?
- Also referred to as accounts receivable.
- Typically reported at net realizable value, an
approximation of fair value, based on estimates of
collectability.
Aspects of accounts receivable often relevant to an analyst:
- overall level of accounts receivable relative to sales, Answer:
- allowance for doubtful accounts, and For 2011, 46.2 divided by 3,042.3 = 1.52%.
- concentration of credit risk. For 2010, 48.1 divided by 2,733.4 = 1.76%.
For 2009, 50.2 divided by 2,493.5 = 2.01%.

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MEASUREMENT BASIS OF CURRENT MEASUREMENT BASES OF CURRENT ASSETS:


ASSETS: INVENTORY INVENTORY
U.S. GAAP IFRS
Inventory Cost Flow
Lower of cost or market (LCM): Lower of cost or net realizable
- Market defined as replacement value (LCNRV):
Beginning cost with a floor (Net realizable - NRV defined as estimated
Ending
Inventory Goods value, or NRV, less normal selling price less estimated
Inventory
Available profit margin) and a ceiling costs of completion and sale.
Goods for (NRV).
Sale Cost of
Purchased - NRV defined as estimated
Goods Sold
selling price less estimated
costs of completion and sale.

Reversals of prior write-downs are


NOT allowed. Reversals of prior write-downs
Balance Sheet Income Statement can be made and recognized in
Permits last in, first out (LIFO). income.
Does not permit LIFO.
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MEASUREMENT BASES OF NONCURRENT ASSETS: MEASUREMENT BASES OF NONCURRENT ASSETS:
PROPERTY, PLANT, AND EQUIPMENT PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment (PP&E): Tangible assets that are U.S. GAAP IFRS
used in company operations over more than one fiscal period. Permit only the cost model for Permit either cost model or
reporting PP&E. revaluation model.
Under the cost model, PP&E is reported at historical cost less any - Can use different models for
accumulated depreciation and less any impairment losses. different classes of assets.
- Depreciation: Systematic allocation of cost over an assets useful - Must apply same model to all
life. assets within a particular class.
- Land is not depreciated.
- Impairment losses reflect an unanticipated decline in value.
- Reversals of impairment losses are permitted under IFRS but not
under U.S. GAAP. Reversals of prior impairment Reversals of impairment losses
Under the revaluation model, PP&E is reported at fair value at the losses are NOT allowed. are permitted.
date of revaluation less any subsequent accumulated depreciation.
- The revaluation model is NOT permitted under U.S. GAAP.

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MEASUREMENT BASES OF PROPERTY, PLANT, MEASUREMENT BASES OF NONCURRENT


AND EQUIPMENT: EXAMPLE DISCLOSURE ASSETS: INTANGIBLE ASSETS
Intangible assets: Identifiable nonmonetary assets without physical
During 2008, Portugal Telecom changed the accounting policy regarding the
substance (e.g., patents, licenses, trademarks).
measurement of real estate properties and the ducts infra-structure from the cost
Goodwill, which arises in business combinations and is not a
model to the revaluation model. . . . [Revaluation amounts totaled] Euro
separately identifiable asset, is covered separately in IFRS.
1,075,033,022 that was recognized in the Consolidated Statement of
Measurement models for intangible assets:
Comprehensive Income. . . .
- IFRS allow either a cost model or a revaluation model for intangible
Portugal Telecom performed another revaluation of the real estate assets and assets.
ducts infrastructure in the year ended 31 December 2011. . . [resulting] in a net - U.S. GAAP allow only the cost model.
reduction of tangible assets amounting to Euro 131,418,994, of which Euro Measurement of intangible assets subsequent to acquisition:
126,167,561 was recognized directly in the Consolidated Statement of - Intangible asset with finite useful life: Amortize over useful life and
Comprehensive Income (Note 44.5) under the caption Revaluation reserve assess for impairment when indicated.
and Euro 5,251,433 was recognized in the Consolidated Income Statement - Intangible asset with indefinite useful life: Do not amortize, but
under the caption Depreciation and amortization. assess for impairment (annually under IFRS; only after qualitative
assessment under U.S. GAAP).
Portugal Telecom (2011), Form 20-F, note 37.4

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MEASUREMENT BASES OF NONCURRENT
MEASUREMENT BASES OF FINANCIAL ASSETS
ASSETS: GOODWILL
Goodwill
- Arises when a company acquires another company for a
price in excess of fair market value of net identifiable
assets acquired.
- Is equal to purchase price of business minus fair market
value of net assets acquired.
- Represents value of all favorable attributes that relate to
a business enterprise.
- Is recorded only when there is an exchange transaction
that involves the purchase of an entire business.
- Is not amortized, but must be assessed for impairment.
Accounting goodwill does not equal economic goodwill.

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COMMON TYPES OF CURRENT LIABILITIES COMMON TYPES OF NONCURRENT LIABILITIES

Trade payables, also known as accounts payable: Amounts that a Long-term financial liabilities: Include loans (i.e., borrowings
company owes its vendors for purchases of goods and servicesin from banks) and notes or bonds payable (i.e., fixed-income
other words, the unpaid amounts of the companys purchases on credit securities issued to investors).
as of the balance sheet date. Usually reported at amortized cost on the balance sheet.
Notes payable: Financial liabilities owed by a company to creditors, In certain cases, liabilities, such as bonds, issued by a
including trade creditors and banks, through a formal loan agreement. company are reported at fair value.
Accrued expenses (also called accrued expenses payable, accrued
liabilities, and other nonfinancial liabilities) are expenses that have
Deferred tax liabilities: Amount of income taxes payable in
been recognized on a companys income statement but that have not
yet been paid as of the balance sheet date.
future periods with respect of taxable temporary differences.
Result from temporary timing differences between a
Deferred income (also called deferred revenue and unearned
companys income as reported for tax purposes (taxable
revenue) arises when a company receives payment in advance of
income) and income as reported for financial statement
delivery of the goods and services associated with the payment.
purposes (reported income).

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BALANCE SHEET: EXAMPLE
COMPONENTS OF SHAREHOLDERS EQUITY
LORAL (EQUITY AND LIABILITIES)
Capital contributed by owners (or common stock or share
capital)
Preferred shares
Treasury shares (or treasury stock)
Retained earnings
Accumulated other comprehensive income (or other
reserves, items recognized directly in equity)
Noncontrolling interest (or minority interest)

L'Oral Annual Report


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ANALYSIS OF BALANCE SHEETS COMMON-SIZE BALANCE SHEETS

Liquidity ($ thousands) A B C
ASSETS
- A companys ability to meet its short-term financial commitments. Cash, cash equivalents, marketable securities 1,900 200 3,300
- Assessment focus: The companys ability to convert assets to Accounts receivable 500 1,050 1,500
Inventory 100 950 300
cash and to pay for operating needs. Total current assets 2,500 2,200 5,100
Solvency Property, plant, and equipment, net 750 750 4,650
Goodwill 0 300 0
- A companys ability to meet its financial obligations over the Total assets 3,250 3,250 9,750
longer term. LIABILITIES AND EQUITY
Accounts payable 0 2,500 600
- Assessment focus: The companys financial structure and its Total current liabilities 0 2,500 600
ability to pay long-term financing obligations. Long-term bonds payable 10 10 9,000
Analytical Tools Total liabilities 10 2,510 9,600
Total shareholders equity 3,240 740 150
- Common-size analysis. Total liabilities and shareholders equity 3,250 3,250 9,750
- Balance sheet ratios.

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COMMON-SIZE BALANCE SHEETS COMMON-SIZE BALANCE SHEETS

(percent of total assets) A B C (percent of total assets) A B C


ASSETS
ASSETS
Cash, cash equivalents, marketable securities 58.46% 6.15% 33.85%
Accounts receivable 15.38% 32.31% 15.38% Cash, cash equivalents, marketable securities 58% 6% 34%
Inventory 3.08% 29.23% 3.08% Accounts receivable 15% 32% 15%
Total current assets 76.92% 67.69% 52.31% Inventory 3% 29% 3%
Property, plant, and equipment, net 23.08% 23.08% 47.69% Total current assets 77% 68% 52%
Goodwill 0.00% 9.23% 0.00% Property, plant, and equipment, net 23% 23% 48%
Total assets 100.00% 100.00% 100.00% Goodwill 0% 9% 0%
LIABILITIES AND SHAREHOLDERS EQUITY Total assets 100% 100% 100%
Accounts payable 0.00% 76.92% 6.15%
LIABILITIES AND SHAREHOLDERS EQUITY
Total current liabilities 0.00% 76.92% 6.15%
Accounts payable 0% 77% 6%
Long-term bonds payable 0.31% 0.31% 92.31%
Total liabilities 0.31% 77.23% 98.46% Total current liabilities 0% 77% 6%
Total shareholders equity 99.69% 22.77% 1.54% Long-term bonds payable 0% 0% 92%
Total liabilities and shareholders equity 100.00% 100.00% 100.00% Total liabilities 0% 77% 98%
Total shareholders equity 100% 23% 2%
Total liabilities and shareholders equity 100% 100% 100%

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BALANCE SHEET RATIOS: LIQUIDITY RATIOS BALANCE SHEET RATIOS: SOLVENCY RATIOS

Solvency ratios indicate financial risk and financial leverage and


Liquidity ratios indicate a companys ability to meet a companys ability to meet its financial obligations over time.
current liabilities.
Ratio Calculation
Ratio Calculation Long-term debt to equity Total long-term debt Total equity
Current Current assets /Current liabilities
Quick (acid test) Debt to equity Total debt Total equity
(Cash + Marketable securities + Receivables) /
Current liabilities Total debt (also known as Total debt Total assets
debt to assets)
Cash (Cash + Marketable securities) / Debt to capital Total debt (Total debt + Total equity)
Current liabilities Financial leverage Total assets Total equity

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SUMMARY

Balance Sheet: what an entity owns (or controls), what it


owes, and what the owners claims are at a specific point in
time.
Balance sheets usually present current and noncurrent
assets and liabilities.
Accounting issues relate primarily to measurement
(historical cost versus fair value).
Tools for balance sheet analysis include common-size
analysis and balance sheet ratios.
Balance sheet ratios indicate liquidity and solvency.

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