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CHAPTER 5

UNDERSTANDING BALANCE SHEETS
Presenter’s name
Presenter’s title
dd Month yyyy

OVERVIEW
• Balance sheet elements and format
• Accounting issues
- Current and noncurrent assets and liabilities
- Measurement bases of different assets and liabilities
• Components of shareholders’ equity
• Balance sheet analysis
• Liquidity and solvency

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BALANCE SHEET CONTENTS
• The balance sheet is also known as the statement of
financial position or statement of financial condition.
• The balance sheet discloses, at a specific point in time,
- what an entity owns (or controls),
- what it owes, and
- what the owners’ claims are.
Assets = Liabilities + Owners’ equity

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• Equity (E): represents the owners’ residual interest in the company’s assets after deducting its liabilities. the settlement of which is expected to result in an outflow of economic benefits from the entity. Copyright © 2013 CFA Institute 4 .BALANCE SHEET ELEMENTS • Assets (A): resources controlled by the company as a result of past events and from which future economic benefits are expected to flow to the entity. • Liabilities (L): obligations of a company arising from past events.

g. management skills). Copyright © 2013 CFA Institute 5 .Future cash flows. • However.. which affect value.EQUITY • The balance sheet provides important information about a company’s financial condition. net of liabilities) should not be viewed as a measure of either the market or intrinsic value of a company’s equity. reputation. . are driven by items excluded from the balance sheet (e. .Even current value reflects a value that was current at the end of the reporting period.The balance sheet is a mixed model with respect to measurement (some items at historical cost. • Why? . some items at current value). balance sheet amounts of equity (assets.

BALANCE SHEET: EXAMPLE COLGATE-PALMOLIVE COMPANY (ASSETS) Colgate's Annual Report Copyright © 2013 CFA Institute 6 .

BALANCE SHEET: EXAMPLE COLGATE-PALMOLIVE COMPANY (LIABILITIES) Colgate's Annual Report Copyright © 2013 CFA Institute 7 .

BALANCE SHEET: EXAMPLE COLGATE-PALMOLIVE COMPANY (EQUITY) Colgate's Annual Report Copyright © 2013 CFA Institute 8 .

S. Colgate) order items on the balance sheet from most liquid to least liquid. .For a company overall.Companies using IFRS order balance sheet information from least liquid to most liquid.For a particular asset or liability.g. Copyright © 2013 CFA Institute 9 .BALANCE SHEET FORMAT • Liquidity .Companies using U. GAAP (e.. its ability to pay for short-term obligations . its “nearness to cash” • Balance sheet ordering according to liquidity .

BALANCE SHEET: EXAMPLE HENKEL AG (ASSETS) Henkel's Annual Report Copyright © 2013 CFA Institute 10 .

BALANCE SHEET: EXAMPLE L’ORÉAL (ASSETS) L’Oréal's Annual Report Copyright © 2013 CFA Institute 11 .

current and noncurrent assets .In a liquidity-based presentation. all assets and liabilities presented in order of liquidity. .current and noncurrent liabilities • Exception to the current and noncurrent classifications requirement. .CURRENT AND NONCURRENT ASSETS AND LIABILITIES • Balance sheet must distinguish between and present separately . • Classified balance sheet: Balance sheet with separately classified current and noncurrent assets and liabilities.Liquidity-based presentation are often used by banks. under IFRS: .Current and noncurrent classifications are not required if a liquidity-based presentation provides reliable and more relevant information. Copyright © 2013 CFA Institute 12 .

BALANCE SHEET: EXAMPLE BARCLAYS PLC (ASSETS) Barclays' Annual Report Copyright © 2013 CFA Institute 13 .

• Noncurrent liabilities: All liabilities not classified as current. used up. 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. • Working capital: The excess of current assets over current liabilities. whichever is greater. Copyright © 2013 CFA Institute 14 . or otherwise realized in cash within one year or one operating cycle of the business. after the reporting period.CURRENT AND NONCURRENT ASSETS AND LIABILITIES • Current assets: Assets expected to be sold. • Noncurrent assets: Assets not classified as current.

bills. U. Copyright © 2013 CFA Institute 15 . commercial paper..highly liquid investments with original maturities of three months or less (e. short-term investments that are so close to maturity that the risk of significant change in value from changes in interest rates is minimal. amortized cost and fair value are likely to be immaterially different.For cash and cash equivalents. T. money market funds) .MEASUREMENT BASES OF CURRENT ASSETS: CASH AND CASH EQUIVALENTS • Cash Equivalents: Highly liquid.g.S.demand deposits with banks . .Examples: .

” • Procter & Gamble (2011). annual report Copyright © 2013 CFA Institute 16 . net in the income statement. As such. The carrying amount of bank deposits is a reasonable approximation of their fair value. Units of cash unit trusts are considered to be assets available for sale. Highly liquid investments with remaining stated maturities of three months or less when purchased are considered cash equivalents and recorded at cost.” • L’Oréal (2011). . . Cash and cash equivalents consist of cash in bank accounts. annual report “Cash and cash equivalents.MEASUREMENT BASES OF CASH AND CASH EQUIVALENTS: EXAMPLE DISCLOSURES “Cash Equivalents. Any related unrealized gains are accounted for in Finance costs. . units of cash unit trusts and liquid short-term investments with a negligible risk of changes in value and a maturity date of less than three months at the date of acquisition. they are valued in the balance sheet at their market value at the closing date.

Copyright © 2013 CFA Institute 17 . . • Aspects of accounts receivable often relevant to an analyst: .Typically reported at net realizable value.concentration of credit risk. based on estimates of collectability. an approximation of fair value. .MEASUREMENT BASES OF CURRENT ASSETS: TRADE RECEIVABLES • Trade receivables: Amounts owed to a company by its customers for products and services already delivered. and .overall level of accounts receivable relative to sales.allowance for doubtful accounts.Also referred to as accounts receivable. .

what percentage of its receivables did L’Oréal estimate will be uncollectible? Answer: • For 2011.MEASUREMENT BASES OF RECEIVABLES: L’ORÉAL EXAMPLE Based on the note below. Copyright © 2013 CFA Institute 18 .2 divided by €2.76%.52%.1 divided by €2.2 divided by €3. €50.493. • For 2010.3 = 1.01%. €48. • For 2009.042. €46.4 = 1.5 = 2.733.

MEASUREMENT BASIS OF CURRENT ASSETS: INVENTORY Inventory Cost Flow Beginning Inventory Goods Purchased Balance Sheet Copyright © 2013 CFA Institute Goods Available for Sale Ending Inventory Cost of Goods Sold Income Statement 19 .

S. less normal profit margin) and a ceiling (NRV). Does not permit LIFO. • Reversals of prior write-downs are NOT allowed. • Lower of cost or net realizable value (LCNRV): . first out (LIFO). or NRV. . Copyright © 2013 CFA Institute 20 .Market defined as replacement cost with a floor (Net realizable value.NRV defined as estimated selling price less estimated costs of completion and sale. • Reversals of prior write-downs can be made and recognized in income. GAAP • Lower of cost or market (LCM): .MEASUREMENT BASES OF CURRENT ASSETS: INVENTORY IFRS U. • • Permits last in.NRV defined as estimated selling price less estimated costs of completion and sale.

• Under the revaluation model.Reversals of impairment losses are permitted under IFRS but not under U. AND EQUIPMENT • Property.S. .MEASUREMENT BASES OF NONCURRENT ASSETS: PROPERTY. . Copyright © 2013 CFA Institute 21 . PP&E is reported at historical cost less any accumulated depreciation and less any impairment losses. GAAP. . GAAP. . • Under the cost model.Depreciation: Systematic allocation of cost over an asset’s useful life. plant. PP&E is reported at fair value at the date of revaluation less any subsequent accumulated depreciation.Impairment losses reflect an unanticipated decline in value.S. PLANT.The revaluation model is NOT permitted under U. .Land is not depreciated. and equipment (PP&E): Tangible assets that are used in company operations over more than one fiscal period.

. • Reversals of impairment losses are permitted. PLANT.Can use different models for different classes of assets. 22 . GAAP • Permit only the cost model for reporting PP&E. AND EQUIPMENT U. Copyright © 2013 CFA Institute IFRS • Permit either cost model or revaluation model.S.MEASUREMENT BASES OF NONCURRENT ASSETS: PROPERTY.Must apply same model to all assets within a particular class. . • Reversals of prior impairment losses are NOT allowed.

167.4 Copyright © 2013 CFA Institute 23 .251. AND EQUIPMENT: EXAMPLE DISCLOSURE “During 2008. [Revaluation amounts totaled] Euro 1. .418.5) under the caption ‘Revaluation reserve’ and Euro 5. . . Portugal Telecom changed the accounting policy regarding the measurement of real estate properties and the ducts infra-structure from the cost model to the revaluation model.075. . note 37.022 that was recognized in the Consolidated Statement of Comprehensive Income. Portugal Telecom performed another revaluation of the real estate assets and ducts infrastructure in the year ended 31 December 2011.994. Form 20-F. of which Euro 126. . .033.433 was recognized in the Consolidated Income Statement under the caption ‘Depreciation and amortization. [resulting] in a net reduction of tangible assets amounting to Euro 131.MEASUREMENT BASES OF PROPERTY.561 was recognized directly in the Consolidated Statement of Comprehensive Income (Note 44. PLANT. .’” Portugal Telecom (2011). .

• Measurement of intangible assets subsequent to acquisition: .MEASUREMENT BASES OF NONCURRENT ASSETS: INTANGIBLE ASSETS • Intangible assets: Identifiable nonmonetary assets without physical substance (e. .g.Intangible asset with finite useful life: Amortize over useful life and assess for impairment when indicated. patents. licenses. • Goodwill.IFRS allow either a cost model or a revaluation model for intangible assets. which arises in business combinations and is not a separately identifiable asset. only after qualitative assessment under U. but assess for impairment (annually under IFRS. trademarks).Intangible asset with indefinite useful life: Do not amortize.U. is covered separately in IFRS. .S. GAAP allow only the cost model. Copyright © 2013 CFA Institute 24 . • Measurement models for intangible assets: .S. GAAP)..

• Accounting goodwill does not equal economic goodwill.Is recorded only when there is an exchange transaction that involves the purchase of an entire business. but must be assessed for impairment.MEASUREMENT BASES OF NONCURRENT ASSETS: GOODWILL Goodwill . . Copyright © 2013 CFA Institute 25 .Is not amortized. .Represents value of all favorable attributes that relate to a business enterprise. .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. .

Held-to-Maturity .Debt Instruments Copyright © 2013 CFA Institute Changes in Value through Profit and Loss Trading Securities (stocks and bonds) Changes in Value through OCI IFRS: Designated Equity Investments U. GAAP: Available-for-Sale Debt or Equity 26 .S.MEASUREMENT BASES OF FINANCIAL ASSETS Measured at Fair Value Financial Assets Measured at Amortized Cost: .

Copyright © 2013 CFA Institute 27 . through a formal loan agreement.” and other “nonfinancial liabilities”) are expenses that have been recognized on a company’s income statement but that have not yet been paid as of the balance sheet date. • Accrued expenses (also called “accrued expenses payable. • Deferred income (also called “deferred revenue” and “unearned revenue”) arises when a company receives payment in advance of delivery of the goods and services associated with the payment. including trade creditors and banks.COMMON TYPES OF CURRENT LIABILITIES • Trade payables. • Notes payable: Financial liabilities owed by a company to creditors. the unpaid amounts of the company’s purchases on credit as of the balance sheet date.” “accrued liabilities. also known as accounts payable: Amounts that a company owes its vendors for purchases of goods and services—in other words.

.COMMON TYPES OF NONCURRENT LIABILITIES • Long-term financial liabilities: Include loans (i. liabilities. fixed-income securities issued to investors). issued by a company are reported at fair value. such as bonds. • Usually reported at amortized cost on the balance sheet. • Deferred tax liabilities: Amount of income taxes payable in future periods with respect of taxable temporary differences. Copyright © 2013 CFA Institute 28 . • In certain cases.e. borrowings from banks) and notes or bonds payable (i..e. • Result from temporary timing differences between a company’s income as reported for tax purposes (taxable income) and income as reported for financial statement purposes (reported income).

items recognized directly in equity) • Noncontrolling interest (or minority interest) Copyright © 2013 CFA Institute 29 .COMPONENTS OF SHAREHOLDERS’ EQUITY • 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.

BALANCE SHEET: EXAMPLE L’ORÉAL (EQUITY AND LIABILITIES) L'Oréal Annual Report Copyright © 2013 CFA Institute 30 .

.Balance sheet ratios.A company’s ability to meet its financial obligations over the longer term.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 short-term financial commitments.ANALYSIS OF BALANCE SHEETS • Liquidity . . Copyright © 2013 CFA Institute 31 .Assessment focus: The company’s financial structure and its ability to pay long-term financing obligations. • Analytical Tools .Common-size analysis.

750 Copyright © 2013 CFA Institute 32 .250 3.250 600 600 9.250 2.250 200 1.300 1.500 10 2.500 2.510 740 3.200 750 300 3.240 3.100 4.650 0 9. plant.900 500 100 2.500 750 0 3.600 150 9.050 950 2. net Goodwill Total assets LIABILITIES AND EQUITY Accounts payable Total current liabilities Long-term bonds payable Total liabilities Total shareholders’ equity Total liabilities and shareholders’ equity 1. marketable securities Accounts receivable Inventory Total current assets Property. cash equivalents.500 300 5.000 9.750 0 0 10 10 3. and equipment.COMMON-SIZE BALANCE SHEETS ($ thousands) ASSETS A B C Cash.

69% 22.00% LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable 0.00% 9.31% 77.08% 29.38% 32.08% 47.00% 100.85% Accounts receivable 15.23% 3.15% Total current liabilities 0. cash equivalents.15% Long-term bonds payable 0.COMMON-SIZE BALANCE SHEETS (percent of total assets) A B C ASSETS Cash.23% 0.00% Copyright © 2013 CFA Institute 33 . and equipment.69% Goodwill 0.77% 1.08% Total current assets 76.00% 100.46% 6.23% 98. plant.31% Property.00% Total assets 100. marketable securities 58. net 23.15% 33.31% 0.08% 23.31% 15.00% 100.69% 52.00% 100.31% 92.00% 76.54% Total liabilities and shareholders’ equity 100.00% 76.92% 6.92% 6.92% 67.31% Total liabilities 0.38% Inventory 3.46% Total shareholders’ equity 99.

COMMON-SIZE BALANCE SHEETS (percent of total assets) ASSETS Cash. plant. and equipment. net Goodwill Total assets LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable Total current liabilities Long-term bonds payable Total liabilities Total shareholders’ equity Total liabilities and shareholders’ equity Copyright © 2013 CFA Institute A B C 58% 6% 34% 15% 32% 15% 3% 29% 3% 77% 68% 52% 23% 23% 48% 0% 9% 0% 100% 100% 100% 0% 77% 6% 0% 77% 6% 0% 0% 92% 0% 77% 98% 100% 23% 2% 100% 100% 100% 34 . marketable securities Accounts receivable Inventory Total current assets Property. cash equivalents.

BALANCE SHEET RATIOS: LIQUIDITY RATIOS Liquidity ratios indicate a company’s ability to meet current liabilities. Ratio Current Calculation Current assets /Current liabilities Quick (acid test) (Cash + Marketable securities + Receivables) Current liabilities Cash (Cash + Marketable securities) / Current liabilities Copyright © 2013 CFA Institute / 35 .

Ratio Long-term debt to equity Calculation Total long-term debt  Total equity Debt to equity Total debt  Total equity Total debt (also known as debt to assets) Debt to capital Total debt  Total assets Financial leverage Total assets  Total equity Copyright © 2013 CFA Institute Total debt  (Total debt + Total equity) 36 .BALANCE SHEET RATIOS: SOLVENCY RATIOS Solvency ratios indicate financial risk and financial leverage and a company’s ability to meet its financial obligations over time.

• Tools for balance sheet analysis include common-size analysis and balance sheet ratios.SUMMARY • Balance Sheet: what an entity owns (or controls). and what the owners’ claims are at a specific point in time. Copyright © 2013 CFA Institute 37 . • Accounting issues relate primarily to measurement (historical cost versus fair value). • Balance sheets usually present current and noncurrent assets and liabilities. • Balance sheet ratios indicate liquidity and solvency. what it owes.