The Balance Sheet Statement

Learning Objectives
1. How balance sheet accounts are
measured, classified and presented.
2. How balance sheet information is used.
3. Balance sheet terminology and format
outside the U.S.
4. How footnotes aid to the understanding
of the firm’s accounting policies,
contingent liabilities, subsequent events,
and related-party transactions
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The Accounting Equation

Assets = Liabilities + Equity

 Shareholders’ Equity:
What’s left of the company’s assets
after paying off liabilities.
 It also referred to as net assets.

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Balance sheet classification:
Overview

ASSETS = LIABILITIES + EQUITY

• Currentassets
• Property, plant and • Current liabilities
equipment
• Long-term debt
• Investments
• Other assets
• Other liabilities
• Preferred and Contributed
common stock Capital
• Additional paid-in
capital
• Retained earnings

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Elements of the balance sheet
How the money is
invested Where the money came from

ASSETS = LIABILITIES + EQUITY

• Probablefuture economic benefits

• Obtained from past transactions or events
• Probable future sacrifices of economic benefits
• Arising from present obligations
• To transfer assets or provide services in the future
• As a result of past transactions or events
• The residual interest in net asset

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 Balance sheet Classification and Account
Measurement - Current assets

Amortized cost
or current
market value
Net
realizable
value

Lower of cost or
current market
value

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Assets – classification and measurement
n Resources with future economic benefit to a
business entity as a result of a past transaction.
n Current Assets: cash and other assets that are
reasonably expected to be realized in cash or
sold, or consumed during a normal operating
cycle or one year, whichever is longer
 Examples: Cash and cash equivalents, short-
term investments (reported at the fair value),
receivables (estimated amount collectible),
inventory (LCM), prepaid expenses, etc.

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Balance Sheet Classification and Account
Measurement -PPE, Investments and Intangibles

Historical cost minus

accumulated
depreciation except that
fair market value is used
when “impaired”

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 Assets (contd.)

 Long-term Investments: Comprise of the

following
 Securities (i.e., bonds, stock, long-term notes)
 Fixed assets (i.e., land, building)
 Special funds (i.e., pension fund, bond sinking
fund)
 Nonconsolidated subsidiaries or affiliated
companies

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 Assets (contd.)
 Property, Plant, Equipment (i.e., building,
Land, Machinery and equipment, capital
leases): assets used in firms’ operations
and meet the following criteria:
1. Economic life > 1 year;
2. Acquired for use in operation;
3. Not for resale to customers;
4. $ is material. (materiality)
Depreciation will be applied except for land.
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Assets (contd.)
 Intangible Assets: assets with no
physical substance but have value
based on rights or privileges that
belong to the owner (i.e., goodwill,
patents, franchises, trademarks,…).
 Amortization for limited life
intangibles (i.e., patents, franchises)
and impairment test for indefinite-life
intangibles (i.e., goodwill).
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 Balance Sheet Classification and
Measurement - Liabilities

Amount due
at maturity

Historical
cost

Discounted
present
value

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Liabilities

n Legal obligations required future

payments of assets or services as a
result of a business entity’s past
transactions or events.
A. Current Liabilities
B. Long-term Liabilities
C. Other Liabilities
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A. Current Liabilities

n Obligations must be fulfilled in one

year or one operating cycle,
whichever is longer. (will require the
use of current assets or the creation
of current liability) (i.e., A/P, N/P,
accrual payable, unearned revenue,
income tax payable, current portion of
L-T debt)
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Contingent Liabilities

n Obligations may arise because of the

occurrence or not occurrence of
future event(s). (i.e., warranty
obligations)

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B. Long-Term Liabilities

n Obligations are not due in next year

or next operating cycle, whichever is
longer. (i.e., bonds payable, pension
liability)

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C. Other Liabilities

n Long-term advances from customers,

deferred income taxes.

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Balance Sheet Classification and Account
Measurement -Stockholders’ equity

Historical
par value

Historical
cost

Combination of
different
measurement
bases

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Stockholders’ Equity

n Residual claims (assets-liabilities) to

the business entity from stockholders
including:
a. contributed capital
b. (+ or -)Accumulated Other
Comprehensive Income
c. retained earnings (or - deficit)
d. (-)treasury stock

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a. Contributed Capital

n Par value of common stock

n Par value of prefer stock
n Paid-in capital in excess of par value
of common stock or preferred stock

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b. Accumulated Other Comprehensive
Income
n Increase of assets without outflows of
assets, increase of liabilities, increase
of income or issuance of common stock
(i.e.,(+) increase in market value of
securities-available-for-sale (+ or -),
gains or losses of foreign currency
adjustments, etc.)

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c. Retained Earnings

n Net income not distributed to

stockholders
u appropriated
u unappropriated

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Balance sheet information

1. Rates of return ROA and ROCE

2. Capital structure Debt vs. Equity

ASSETS
Helps
assess
3. Liquidity Cash conversion
LIABILITIES
+
EQUITY
4. Solvency Ability to pay debt

5. Flexibility Operating and financial

Balance Sheet

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1. Rate of Return Ratios
 ROA (return on assets) and ROCE (return on
common equity) ratios:
 Evaluate operating efficiency and profitability.

ROA =
Net operating profit after taxes (NOPAT) /
Average assets

ROCE =
(Net income – Preferred dividends) / Average
common shareholders’ equity

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2. Capital Structure

 The balance sheet provides critical

information for understanding an
entity’s capital structure.
 Capital structure refers to how much
of an entity’s assets are financed from
debt versus equity sources.

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3. Liquidity Ratios

 Liquidity measures how readily assets can

be converted to cash relative to how soon
liabilities will have to be paid in cash.
 Current ratio: Indicate the level of current
resources available to pay current debts.
Current Ratio = Current Assets / Current
Liabilities
 Question:
Does higher ratio always indicate better
financial status?
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4. Solvency
 Solvency defines the ability of a company
to generate sufficient cash flows to
maintain its productive capacity and still
able to pay off the long-term debt.
 Debt ratios provide information about the
amount of long-term debt in a company’s
financial structure.
 Long-term debt to assets =
Long term debt/Total assets

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Solvency (contd.)

 A company that can not make timely

payments in the amount required
becomes insolvent and may be
compelled to reorganize or liquidate.

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5. Flexibility

 Flexibility refers to the ability to adapt or

revise to a new strategy for different
circumstances.
 The ability to adjust to unexpected
downturn in the economic environment
in which it operates or to take
advantage of profitable investment
opportunities when they arise.
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 Which company is:
Analytical insights: Deere
E-Trade
Understanding the business Potomac Electric Power
Wal-Mart

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Balance sheet presentation:
International differences

U.S. Format: U.K. Format:

Current Assets Fixed Assets
+ +
Long-lived Assets Current Assets
-
= Current Liabilities
Current Liabilities
-
Non-current Liabilities
+
Non-current Liabilities =
+
Stockholders’ Equity Capital Employed

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Financial statement footnotes
 Footnotes are an integral part of
companies’ financial reports.
 These “notes” help users better
understand and interpret the numbers
presented in the body of the financial
statements.
 Three important notes:
1. Summary of significant accounting
policies.
2. Subsequent event disclosures.
3. Related party transactions 31
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Limitations of the Balance Sheet
n 1. Historical costs reporting for most
of assets and liabilities.
n 2. Estimations involved in the value of
some assets and liabilities (i.e., the net
realizable value of accounts receivable
and the cost of warranty).
n 3. the omission of some valuable items
such as goodwill of the company.
n 4. Off-balance sheet liabilities.
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Summary
1. The balance sheet shows the assets
owned by a company at a given point in
time, and how those assets are
financed (debt vs. equity).
2. Be alert for differences in balance
sheet measurement bases, account
titles, and statement format.
3. Financial statement footnotes provide
important information..

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