Balance Sheet Topic 3

Alexei Alvarez Drobush, CFA, FRM

Fabricio Chala, CFA, FRM
Balance Sheet
Components

The balance sheet discloses what an entity owns and what it owes at a
specific point in time.
Also referred as the statement of financial position.
v  Assets: Resources controlled by a company as a result of past events and
from which future economic benefits are expected
v  Liabilities: Obligations of a company arising from past events, and from
which future outflows are expected.
v  Equity: Owner’s residual interest in the company’s assets after deducting
its liabilities.
Accounting equation: E = A - L
Balance Sheet
Components

Assets and liabilities arise as a result of business transactions:

❖  Purchase of a building (and disbursing cash or borrowing money)

❖  Issuing a bond (and raising cash)

Differences between accrued revenue and expenses will result in assets and
liabilities:
❖  Revenue reported before cash is collected

→ Accounts receivable
❖  Cash received before revenue is to be reported
→ Deferred revenue
❖  Expense reported before cash is paid
→ Accounts payable
❖  Cash paid before an expense is to be reported
→ Prepaid expense
Balance Sheet
Format

Report Format Account Format

Assets Assets Equity and
Current assets 5,000 Liabilities
PP&E 6,500 Current 5,000 Current 4,000
assets liabilities
Total assets 11,500
PP&E 6,500 LT debt 1,500
Equity and Liabilities
Total 5,500
Current liabilities 4,000
liabilities
Long-term debt 1,500
Equity 6,000
Total liabilities 5,500
Total 11,500 Total Equity 11,500
Equity 6,000 assets & Liabilities
Total Equity & Liabilities 11,500
Balance Sheet
Presentation

Classified Balance Sheet

Grouping of accounts into
US GAAP subcategories (Current and non-
current).

Liquidity-based Format
All assets and liabilities are
IFRS presented broadly in order of
liquidity. (e.g. Banks)
Balance Sheet
Presentation

Classified Balance Sheet Liquidity-based Format

Source: CFA 2017 Level I Reading 25

Source: CFA 2017 Level I Reading 25

Measurement bases of Assets and Liabilities

❖  How should assets or liabilities be measured in the balance

sheet?
❖  Historical Cost
❖  Current (Market) Value
❖  Under current standards, the balance sheet is a mixed model:
❖  Some assets and liabilities based on historical cost
❖  Other assets and liabilities measured upon a market (current) value
¿Who is an asset?

https://www.coursera.org/learn/financial-accounting/lecture/BRe7N/7-defining-an-asset
An asset…

❖  Physical form is not essential to the existence of an asset

❖  Control does not necessarily imply ownership!
❖  Firms normally obtain assets by purchasing or producing them,
but other transactions or events may generate assets (e.g ? )
Current Assets

Assets that are expected to be sold, used up, or otherwise realized

in cash within one year or one operating cycle of the business,
whichever is greater.
A company’s operating cycle is the average amount of time that
elapses between acquiring inventory and collecting the cash from
sales to customers.
Which types of business might have an operating cycle longer than one
year?
Current Assets
Cash, Marketable Securities

Cash and Cash Equivalents

❖  Highly liquid, short term investments that are close to maturity
(< 3mo). Minimal interest rate risk. (e.g. deposits, US T-bills,
commercial paper, etc.)
Marketable Securities
❖  Financial instruments that are traded in a public markets, and
whose value can be easily determined. (e.g. bonds, equity
securities, etc.)
Current Assets
Accounts Receivable

❖  Amounts owed to a company by its customers for products and services

already delivered.

❖  Typically reported at net realisable value (proxy of fair value), based on

estimates of collectability. The allowance for doubtful accounts (contra
account) is a company’s estimate of amounts that will ultimately be
uncollectible. Additions to the allowance are reflected as Bad debt expenses.

Net accounts receivable = Gross accounts receivable – bad debt allowance

❖  What about write-offs?

❖  What can cause a company’s allowance for doubtful accounts to decrease as a

percentage of accounts receivable? Credit quality of customers, credit policies…

❖  How can management manipulate earnings with accounts receivable?

Current Assets
Inventories

❖  Physical products that will eventually be sold to customers

(finished products) or used as inputs in a manufacturing process
(raw materials and work-in-process)
❖  Cost of inventories comprises: costs of purchase, costs of
conversion and other costs incurred in bringing the inventories
to their present location and condition.
❖  Exclude: administrative overheads, selling costs, storage costs
(*exception), etc.

Lower of cost or net NRV: Estimated selling price less the estimated
IFRS
realizable value (NRV) costs of completion and costs to make the sale.
Lower of cost or market Market value can’t be higher than NRV and
US GAAP
value (replacement cost) lower than NRV less a normal profit margin.
Current Assets
Inventories

❖  If NRV or MV falls below the company’s inventory carrying

amountà Write down (Impact on Income Statement?)
❖  What if previously written-down inventory, subsequently
increases in value?
IFRS: the original write-down amount can be reversed - US GAAP: NO!
❖  From Apple’s MD&A and footnotes
“The company reviews its inventory each quarter and records write-
downs of inventory that has become obsolete, exceeds anticipated
demand, or is carried at a value higher than its market value”
Current Assets
Inventories

A widely know case:

If after the write down, Cisco reported $2bn of inventory in their Balance Sheet…
Should you be concerned? Why?
Current Assets

Other Current Assets

❖  Items that are individually not material enough to require a
separate line item, so they are aggregated into a single amount.
(e.g. prepaid expenses)
Deferred Tax Assets
❖  Income taxes incurred prior to the time that the income tax
expense will be recognised on the Income Statement. They may
result:
❖  When the actual income tax payable based on income for tax purposes
in a period exceeds the amount of income tax expense based on the
reported Income Statement due to temporary timing differences.
❖  From carrying forward unused tax losses and credits.
Balance Sheet – Assets
Apple Inc.
¿Are these liabilities?
Current Liabilities

Expected to be settled in the entity’s normal operating cycle or

within 12 months.
Accounts Payable
❖  Amounts that a company owes its vendors for purchases of
goods and services.
Evaluate trend of overall levels of trade payables relative to purchases
Is a high amount necessarily a bad thing?
Notes Payable or Current Portion of Long-Term debt
❖  Financial liabilities owed to creditors.
❖  Only the principal of the current portion of LT debt.
Current Liabilities

Accrued Liabilities
❖  Expenses that have been recognized on the Income Statement
but which have not yet been paid. (e.g. income taxes payable,
accrued interest payable, wages payable, etc.)
Unearned Revenue
❖  Arises when a company receives payment in advance of
delivery of the goods and services. (e.g. lease payments, sales
magazine subscriptions, insurance policies, etc.)
Balance Sheet – Liabilities and Equity
Apple Inc.
Non-Current Assets
Property, Plant and Equipment (PP&E)

Tangible assets used in a company’s operations and expected to

be used over more than one fiscal period.

✍  PP&E is carried at amortised cost (except land):

IFRS & US ✍  Historical cost minus Accum. Depreciation minus impairment losses

Cost Model GAAP ✍  Test for impairment (unanticipated decline in value)

✍  Reversals of impairment: Permitted under IFRS, not US GAAP

Revaluation Model IFRS ✍  Fair value at revaluation – subsequent accum. Depreciation

Non-Current Assets
Intangible Assets

Non-monetary assets without physical substance.

❖  Goodwill: arises in business combinations

Can be acquired singly or is ✍  IFRS: cost or revaluation model (only when there is an
Identifiable the result of a contract (e.g. active market)
patents, licenses, trademarks) ✍  US GAAP: cost model

Can not be acquired singly

Not separately ✍  Not amortised but must be tested for impairment
and have indefinite life (e.g.
identifiable periodically
goodwill)
Non-Current Assets
R&D – Intangible assets only for IFRS

❖  US GAAP: All R&D costs must be expensed when incurred (IS)

❖  IFRS: Company must separately identify the research phase
(seek new knowledge or products) and the development phase
(design or testing of prototypes).
❖  Costs incurred in research phase must be expensed (IS)
❖  Costs incurred in the development stage can be capitalized as
intangible assets if certain criteria are met (e.g. technological feasibility,
ability to sell asset, etc.)
Why would such a difference be made between research and development
phases?
Non-Current Assets
Goodwill

(…)The company also released a pro forma

set of financial statements for the combined
Facebook and WhatsApp, as of June 30.
Goodwill and intangible assets rose by $18.1
billion to a combined $19.77 billion.
(…)
Instead, the premium paid for WhatsApp
will be carried on Facebook’s balance sheet
unless Facebook decides to write down the
value of the acquired business.
Facebook CEO Mark Zuckerberg clearly was
willing to pay through the nose to acquire the
user base of WhatsApp, which includes over
450 million people, to defend his company’s
dominance in social networking.
MarketWatch. 29 October 2014
Non-Current Assets
Goodwill

❖  Excess of purchase price over fair value of identifiable assets

and liabilities acquired.
Why would a firm pay more than fair value of identifiable assets and
liabilities?
❖  Goodwill can not be generated internally, ONLY from an
acquisition.
❖  It is not amortised but is tested for impairment, at least
annually.
Check if acquired assets are not capable to generate benefits as
previously thought
IMPORTANT: Analysts often adjust FS by removing the impact of goodwill
Bad…goodwill?

ERA primarily designs, manufactures, sells and supports underground coal

mining equipment in mainland China through Siwei, a stand-alone company
known for its deep expertise in producing mining roof support equipment and
its focus on strong customer relationships. (…)
This acquisition is aligned with Caterpillar's strategic imperative to expand its
leadership in the Chinese coal mining equipment industry, and positions the
Company to capitalize on the robust long-term outlook for coal production in
China. Today, China produces almost half of the world's coal and is forecasted
to grow over the next several years. (…)
Since its inception in 2003, Siwei has been the fastest-growing mining roof
support company in China. Siwei is located in the Henan province in central
China, and is adjacent to the major underground coal-producing provinces.
(…)
We are going to build on Siwei's reputation, great products and customer
relationships, grow and expand its roof support business in China

https://www.prnewswire.com/news-releases/caterpillar-completes-tender-offer-for-era-mining-machinery-limited-including-their-siwei-subsidiary-157603875.html
Bad…goodwill?

http://www.reuters.com/article/caterpillar-china-special-rep/special-report-how-caterpillar-got-bulldozed-in-china-
idUSL3N0IT1SV20140123
Bad…goodwill?

How did the story end?

Caterpillar had to write
down 86% of its USD 677
million purchase.
How come?

Too bullish on China!

Poor due diligence.
Fraud?

Source: Bloomberg
Non-Current Assets
Goodwill - Example

Company ABC paid $ 700 million for company XYZ. The day of
the acquisition XYZ published the following Balance Sheet:
Current Assets 80
PP&E (net) 760

Goodwill 100
Liabilities 400
Equity 540

However, it is estimated that the NRV of PP&E is 800. The rest of

assets and liabilities are well represented on books.
How much goodwill will ABC register on its balance sheet?
Non-Current Assets
Financial Assets

❖  IFRS 9 Financial Instruments, was issued in 2014 and comes into

effect in January 2018.
❖  Financial assets can be measured in three alternative ways:
❖  Amortised cost
❖  Fair value through other comprehensive income (FVTOCI)
❖  Fair value through profit or loss (FVTPL)
Non-Current Assets
Financial Assets – Amortised Cost

❖  The asset is measured the amount at which it was initially

recognised, minus any principal repayments, plus or minus any
amortisation of discount or premium, and minus any reduction
for impairment.
❖  Both of the following conditions are met:
❖  business model’s objective is to hold assets in order to collect
contractual cash flows; and
❖  the contractual terms give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount
outstanding.
Non-Current Assets
Financial Assets – Fair Value

Fair value: the price that would be paid/received in a transaction

❖  Fair value through other comprehensive income
❖  assets are recognised at fair value in the balance sheet and unrealised
gains and losses are recognised in OCI
❖  business model’s objective is achieved by both collecting contractual
cash flows and selling financial assets
❖  Fair value through profit or loss
❖  assets are recognised at fair value in the balance sheet and gains and
losses are recognised entirely in the income statement
❖  any financial assets that are not held in one of the two business models
mentioned are measured at fair value through profit or loss
Non-Current Assets
Financial Assets

Changes in Value through

Profit and Loss
Trading Securities (stocks and
bonds)
Measured at Fair
Value

Changes in Value through OCI

Financial
Assets IFRS: Designated Equity
Investments
Measured at
Amortised Cost: U.S. GAAP: Available-for-Sale
Debt or Equity
- Held-to-Maturity
- Debt Instruments
Non-Current Assets
Financial Assets – Example

PIMCO bought 10-year bonds issued at par by the Peruvian

government for $15,500,000. Given market interest rate
fluctuations, the value of the bonds nowadays is $16,000,000.
How would you register the unrealised gain of this bond if it is measured
at amortised cost?
If it were measured at fair value through P&L and through OCI?
Non-Current Liabilities

Long-Term Financial Liabilities

❖  Bank loans and bonds
❖  Usually reported at amortised cost on balance sheet. At maturity the
carrying amount of the bond will be equal to its face value.

Deferred Tax Liabilities

❖  Result from temporary timing differences between a company’s earnings

as reported for tax purposes (taxable income) and for financial reporting
purposes (reported income).
Equity

❖  Residual interest in the assets of an entity that remain after

deducting its liabilities
❖  Components:
1.  Capital contributed by owners
2.  Minority interest (or noncontrolling interest)
3.  Retained earnings
4.  Treasury stock
5.  Accumulated other comprehensive income
❖  Further detail can be found in the Statement of Changes in
Shareholders’ Equity
Statement of Changes in Shareholders’ Equity

❖  Reflects information about the increases or decreases to a

company’s wealth.
❖  These changes are a result of:
❖  Net income
❖  Other comprehensive income (transactions with nonowners excluded
from net income)
❖  Issuance or repurchase of stock
❖  Dividends distribution
Statement of Changes in Shareholders’ Equity

Common Retained Accumulated

(in USD millions) Total
Stock Earnings OCI
Balance on 31 Dec 20X6 49,234 26,664 (406) 75,492
Net Income 6,994 6,994
Net unrealized loss on securities at FVTOCI (40) (40)
Net unrealized loss on cash flow hedges (56) (56)

Minimum pension liability (26) (26)

Cumulative translation adjustment 42 42

Comprehensive Income 6,914

Issuance of Stock 1,282 1,282

Repurchase of Stock (6,200) (6,200)

Dividends (2,360)

Balance on 31 Dec 20X7 44,316 31,298 (486) 75,128

FVTOCI: securities measured at Fair Value Through Other Comprehensive Income

What can a balance sheet tell us?

❖  Liquidity
❖  A company’s ability to meet its short-term financial commitments.
❖  Assessment focus: The company’s ability to convert assets to cash and
to pay for operating needs.
❖  Solvency
❖  A company’s ability to meet its financial obligations over the longer
term.
❖  Assessment focus: The company’s financial structure and its ability to
pay long-term financing obligations.
Common-Size Analysis

❖  Involves stating all balance sheet items as a percentage of total

assets.
❖  Common-size statements are useful in comparing:
❖  a company’s current balance sheet with prior-year balance sheet
❖  a company’s balance sheet to other companies in the same industry
Companies in the same industry have similar
balance sheets

❖  Energy and utility companies have the largest amounts of

PP&E. Utilities have the highest level of long-term debt.
❖  Financial companies have the greatest percentage of liabilities
❖  Telecom and utility companies have the lowest level of
receivables
❖  Inventory levels are highest for consumer discretionary and
consumer staples companies
❖  Information technology companies use the least amount of
leverage
Key concepts

❖  Balance sheet ❖  Current Assets

❖  Historical cost ❖  Operating cycle
❖  Market value ❖  Current liabilities
❖  Net Realisable Value ❖  Impairment
❖  Assets ❖  Research
❖  Liabilities ❖  Development
❖  Equity ❖  Goodwill
❖  Allowances ❖  Liquidity
❖  Solvency