FINANCIAL REPORTING AND ANALYSIS:

INCOME STATEMENTS, BALANCE SHEETS,

AND CASH FLOW STATEMENTS

UNDERSTANDING THE BALANCE SHEET

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OR WARRANT THE ACCURACY OF THE PREPARATORY
SOURCES OFFERED BY LOMONOSOV MOSCOW STATE
UNIVERSITY OR VERIFY OR ENDORSE THE PASS RATES
CLAIMED BY LOMONOSOV MOSCOW STATE UNIVERSITY.

CFA®, AND CHARTERED FINANCIAL ANALYST® ARE

TRADEMARKS OWNED BY CFA INSTITUTE.

READING 24 UNDERSTANDING THE BALANCE SHEET 2

 THE ELEMENTS OF THE BALANCE SHEET: ASSETS, LIABILITIES, AND EQUITY

 Assets provide probable future economic benefits controlled by an entity as a

result of previous transactions.

 Assets can be created by operating activities, investing activities (e.g.,

purchasing manufacturing equipment), and financing activities (e.g. issuing
debt).
Asset Account Examples
Cash and equivalents
Account receivable (trade receivables)
Inventory
Prepaid expenses
Investments
Property, plant, and equipment
Intangible assets
Deferred tax assets
Pension assets

READING 24 UNDERSTANDING THE BALANCE SHEET 3

 THE ELEMENTS OF THE BALANCE SHEET: ASSETS, LIABILITIES, AND EQUITY

 Liabilities are obligations owed by an entity from previous transactions that are
expected to result in an outflow of economic benefits in the future.

Liability Account Examples

Accounts payable (trade payables)
Accrued expenses
Unearned revenue
Notes and bonds payable
Capital and financial lease obligations
Deferred tax liabilities
Pension liabilities

READING 24 UNDERSTANDING THE BALANCE SHEET 4

 THE ELEMENTS OF THE BALANCE SHEET: ASSETS, LIABILITIES, AND EQUITY

 Stockholders' equity is the residual interest in assets that remains after

subtracting a firm's liabilities.

 Equity is created by financing activities (e.g., issuing shares of stock) and by

operating activities (e.g. generating net income – retaining earnings).

Equity Accounts Examples

Capital stock
Additional paid-in-capital
(e.g. stock sale price in excess of par)
Treasury stock shares
Accumulated retained earnings
Accumulated other comprehensive income

READING 24 UNDERSTANDING THE BALANCE SHEET 5

 USES AND LIMITATIONS OF THE BALANCE SHEET IN FINANCIAL ANALYSIS

 The balance sheet elements (assets, liabilities and equities) values can
significantly be different from market or “fair” values.

 Some balance sheet elements reported at historical cost (e.g. land), some at
amortized (e.g. license), others reported at fair value (e.g. trading securities).

 Some items may not presented (e.g. reputation, bond covenants, active trials).

READING 24 UNDERSTANDING THE BALANCE SHEET 6

 ALTERNATIVE FORMATS OF BALANCE SHEET PRESENTATION

 There is no standardized balance sheet format. However, two common formats

are the account format and the report format:

• Account format is a layout in which assets are presented on the left hand
side of the page and liabilities and equity are presented on the right.

• In a report format, the assets, liabilities, and equity are presented in one
column.

 A classified balance sheet groups together similar items to arrive at significant

subtotals (e.g. current assets and current liabilities).

READING 24 UNDERSTANDING THE BALANCE SHEET 7

 CURRENT AND NON-CURRENT ASSETS
CURRENT AND NON-CURRENT LIABILITIES

 Current assets include cash and other assets that will likely be converted into
cash or used up within one year after balance sheet date or one operating cycle,
whichever is greater.

 The operating cycle is the time it takes to produce or purchase inventory, sell
the product, and collect the cash.

 Current assets are usually presented in the order of their liquidity, with cash
being the most liquid.

 Noncurrent assets do not meet the definition of current assets because they will
not be converted into cash or used up within one year or operating cycle.

 Noncurrent assets form the foundation upon which the firm operates.

READING 24 UNDERSTANDING THE BALANCE SHEET 8

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH

 Current assets

• Cash and cash equivalents. Liquid low-risk securities with maturities less
than 90 days. Measured at fair value or amortized cost.

• Accounts receivable. Amounts expected to be collected from the sale of

goods and services. Cost minus allowance for doubtful accounts (contra
account).

• Inventories. Items held for sale or used in manufacturing (raw materials,

work-in-process, finished goods). Lower cost (including purchase,
transportation, conversion costs) or net realizable value. Cost flow models:
LIFO, FIFO, AVG [not acceptable under IFRS].

READING 24 UNDERSTANDING THE BALANCE SHEET 9

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH

 Current assets

• Marketable securities. Equity and debt securities that are traded in a public
market. Fair value [trading , AFS] or amortized cost [HTM].

• Prepaid expenses. Operating costs paid in advance.

• Deferred tax assets. Taxes that have not been recognized in the income
statement but have been paid. “Firm paid too much taxes and deserves
some money back”. Only for US GAAP, for IFRS all deferred taxes are non-
current.

• Other current accounts. Other current account that are immaterial if shown
separately.

READING 24 UNDERSTANDING THE BALANCE SHEET 10

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH

 Current liabilities
• Accounts payable. Amounts owed to suppliers for goods or services
purchased on credit.
• Notes payable and current portion of long-term debt. Principal portion of
debt due within one year.
• Accrued expenses. He expenses that have been accrued/recognized in the
income statement but not are not due (e.g. interest or rent payable).
• Unearned revenue. Cash collected in advance of providing goods and
services.

READING 24 UNDERSTANDING THE BALANCE SHEET 11

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH

 Non-current assets

• Property plant and equipment [PP&E]. Tangible assets used in production of

goods and services. Includes land, building, equipment etc. Cost [both IFRS
and GAAP methods] or revaluation [IFRS only] models for reporting.

• Cost model – reported using historical cost [purchase, delivery,

installation] minus accumulated depreciation, depletion and
impairment. Regular impairment test – carrying value exceeds the
recovery amount [fair value minus selling costs or value in use – future
cash flows].

• Revaluation model – fair value less accumulated depreciation. Changes

in fair value reflected in shareholder equity and sometimes in income
statement.

READING 24 UNDERSTANDING THE BALANCE SHEET 12

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH

 Non-current assets

• Investment property. Tangible assets that generate rental income or have capital
appreciation potential. Can be reported at fair value or amortized cost.

• Intangible assets – non-monetary assets [and not securities] that lack physical
presence.

• Identifiable assets, intangible assets that can be separately identified (e.g.

patents, copyright, trademark). Reported at cost or revaluation model [if active
market exists]. Amortized over its useful life.

• Unidentifiable assets can not be identified separately (e.g. goodwill). Goodwill

is created in purchase transaction, not amortized but tested for impairment at
least annually.

• Revaluation model – fair value less accumulated depreciation. Changes in fair value
reflected in shareholder equity and sometimes in income statement.

READING 24 UNDERSTANDING THE BALANCE SHEET 13

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH

 Non-current assets

• Intangible assets that created internally [e.g. research and development]

are expenses under US GAAP.

• Under IFRS firm must expense costs during research stage but can capitalize
during development stage.

• Cost that should be expensed under both US GAAP and IFRS:

• Termination costs;
• Advertizing and promotion costs;
• Start-up and training costs;
• Relocation and reorganization costs;

READING 24 UNDERSTANDING THE BALANCE SHEET 14

 DIFFERENT TYPES OF ASSETS AND LIABILITIES AND
THE MEASUREMENT BASES OF EACH
 Non-current liabilities

• Long-term financial liability. Financial liabilities include bank loans, notes,

bonds payable and derivatives. Reported at amortized cost [loans] or at fair
value (e.g. derivative with negative value – liability).

• Deferred tax liability created then amount of taxes payable in income

statement is greater than taxes payable [reported via tax accounting].
“Entity paid little taxes, can be asked to pay more”.

• Deferred taxes classification as current or non-current is based on [US

GAAP]:
• underlying asset or liability [source of deferred tax if related to
asset/liability];
• expected reversal of items [if not related to asset/liability].
• Under IFRS all deferred taxes are non-current.

READING 24 UNDERSTANDING THE BALANCE SHEET 15

 THE COMPONENTS OF SHAREHOLDERS’ EQUITY

 Shareholders' equity is the residual interest in assets that remains after

subtracting an entity's.

Equity Accounts
Capital stock
Additional paid-in-capital (capital in excess of par)
Treasury stock
Retained earnings
Accumulated other comprehensive income

READING 24 UNDERSTANDING THE BALANCE SHEET 16

 THE COMPONENTS OF SHAREHOLDERS’ EQUITY

 Contributed capital is the total amount paid in by the common and preferred
shareholders [can have fixed coupon, have priority over the claims of common
shareholders in case of liquidation].
 When par value exists, it is reported separately in stockholders' equity.
 Retained earnings are the cumulative earnings [net income] that have not been
paid out to shareholders as dividends.
 Treasury stock is stock that has been reacquired by the issuing firm but not yet
retired, reduces stockholders' equity.
 Accumulated other comprehensive income includes all changes in stockholders'
equity except transactions with shareholders (issuing stock, reacquiring stock,
paying dividends – showed in statement of changes in equity) and except
transactions reported in net income.

READING 24 UNDERSTANDING THE BALANCE SHEET 17

 CONVERTING BALANCE SHEETS TO COMMON-SIZE BALANCE SHEETS AND
INTERPRETATION OF COMMON-SIZE BALANCE SHEETS

 A common-size balance sheet expresses each balance sheet account as a

percentage of total assets, format is also known as vertical common-size
analysis.
 Allows the analyst to evaluate the balance sheet items over time and to
compare a firm's balance sheet items to those of other firms, industry averages.
A Corp B Corp
Cash and equivalents 2 500 5% 1600 9%
Accounts recievable 4 000 8% 1200 7%
Inventory 5 000 10% 800 5%
Currenet assets 11 500 23% 3 600 20%
Plant and equipment 38 000 75% 14 000 80%
Goodwill 1 500 3% 0 0%
Total assets 51 000 100% 17 600 100%

Current liabilities 11 000 22% 1 500 9%

Long-term debt 28 000 55% 4 500 26%
Total liabilities 39 000 76% 6 000 34%
Equity 12 000 24% 11 600 66%
Total liabilities and equity 51 000 100% 17 600 100%

READING 24 UNDERSTANDING THE BALANCE SHEET 18

 LIQUIDITY AND SOLVENCY RATIOS

 Liquidity ratios and solvency ratios are considered pure balance sheet ratios
since both the numerator and denominator are items from the balance sheet.
 Liquidity ratios measure the ability to satisfy short-term obligations.
 Solvency ratios measure the ability to satisfy long-term obligations.
 Liquidity ratios [the higher the liquidity ratios, the more likely the firm will be
able to pay its short-term obligations]:
current assets
current ratio 
current liabilitie s

cash  marketable securitie s  receivables

quick ratio 
current liabilitie s

cash  marketable securitie s

cash ratio 
current liabilitie s

READING 24 UNDERSTANDING THE BALANCE SHEET 19

 LIQUIDITY AND SOLVENCY RATIOS

 Solvency ratios [the higher the solvency ratios, higher the ratio, the greater the
leverage and the greater the risk]:

total long term debt

long- term debt to equity ratio 
total equity
total debt
debt to equity ratio 
total equity
total debt
total debt to equity ratio 
total assets

total assets
financial leverage 
total equity

READING 24 UNDERSTANDING THE BALANCE SHEET 20

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume III  Reading 24

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume III  Reading 24  Practice Problems

READING 24 UNDERSTANDING THE BALANCE SHEET 21