Balance Sheet

A.k.a. statement of condition or statement of

financial position

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Overview
• Balance sheet
– Contents & valuation
– Overview
– Capital structure
– Current ratio
– Individual line items
• Common-size analysis
Balance Sheet (BS)
Also called the statement of condition or
the statement of financial position
Shows the financial condition or
financial position of a company on a
particular date
Summarizes what the firm owns and
what the firm owes to outsiders and
to internal owners
Financial Condition
• Assets = Liabilities + Stockholders’
equity
Assets are what the firm owns.
Liabilities are what the firm owes to
outsiders.
Stockholders’ equity is what the firm owes
to internal owners.
Balance sheet - Consolidation
When a parent owns more than 50% of
the voting stock of a subsidiary, the
financial statements are combined
even though they are separate legal
entities.
The statements are consolidated, because
the companies are in substance one
company, given the proportion of
control by the parent.
Balance Sheet Date

Prepared on a particular date at the end of

an accounting period
End of accounting period can be the end of
a calendar year, fiscal year, or interim
period such as a year, a quarter, etc.

2-6
Comparative Data
SEC requires that the annual report
includes two-year audited balance
sheets and three-year audited
statements of income and cash flow.
Comparative data provides a reference
point for determining changes in
financial position over time.

2-7
Common-Size Balance Sheet
Expresses each item on the balance sheet as a percentage of
total assets
Reveals the composition of assets
Form of vertical ratio analysis that allows comparison of
firms
Useful for evaluating trends within a firm and to make
industry comparisons

2-8
R.E.C. Inc. Common-Size Balance Sheet
Assets

Segregated according to how they are

utilized
• Current Assets
• Property, Plant, and Equipment
• Accumulated depreciation and amortization
• Other Assets
R.E.C. Inc. Consolidated Balance Sheets as December
31, 2007 and 2006 (in Thousands)
2010 2009
Cash $ 4,061 $ 2,382
Marketable securities 5,272 8,004
Accounts receivable, less doubtful accounts 8,960 8,350
Inventories 47,041 36,769
Prepaid expenses 512 759
Total current assets 65,846 56,264
Property, Plant, and Equipment
Land 811 811
Buildings and leasehold improvements 18,273 11,928
Equipment 21,523 13,768
40,607 26,507
Less accumulated depreciation and amortization 11,528 7,530
Net property, plant, and equipment 29,079 18,977
Other Assets 373 668
Total Assets $95,298 $75,909
_________ _________
Current Assets

Include cash and assets expected to be

converted to cash within one year or one
operating cycle
Refer to assets that are continually used up
and replenished
Current Assets

Include cash and assets expected to be

converted to cash within one year or one
operating cycle
Refer to assets that are continually used up
and replenished
Current Assets

Operating cycle
Time required to purchase or manufacture
inventory, sell the product, and collect the
cash
Working capital
Also called net working capital
Current assets less current liabilities
Current Assets

• Cash
• Marketable Securities
• Accounts Receivable
• Inventories
• Prepaid Expenses
Cash and Marketable Securities

Cash
Cash awaiting deposit
Cash in a bank account
Marketable Securities
Short-term investments of cash that is not
needed
U.S. Treasury bills, certificates, notes, bonds,
commercial paper
Cash and Marketable Securities
Valuation of marketable securities
requires the separation of investment
securities into three categories.
1. Held to maturity
2. Trading securities
3. Securities available for sale
Cash and Marketable Securities
Held to maturity
Positive intent and ability to hold to
maturity
Reported at amortized cost
Trading securities
Held for resale in the short term
Reported at fair value with unrealized gains
and losses included in earnings
Cash and Marketable Securities
Securities available for sale
Debt and equity securities that are not
classified as one of the other two categories
Reported at fair value with unrealized gains
or losses included in comprehensive
income
Accounts Receivable

Customer balances outstanding on credit

sales
Reported on the balance sheet at net
realizable value (actual amount less an
allowance for doubtful accounts)
Accounts Receivable
Allowance for doubtful accounts
Affect balance sheet valuation and bad debt
expense on income statement
Can be important in assessing earnings
quality
Should reflect volume of credit sales, past
experience with customers, customer
base, credit policies, collections practices,
and economic conditions
Information from R.E.C. Inc.
Balance Sheet and Income Statement

Growth Rate
(In Thousands) 2007 2006 (% Change)
Net Sales $215,600 $153,000 40.9
Accounts receivable (total) 9,408 8,767 7.3
Allowance for doubtful accounts 448 417 7.4

To analyze the above information consider

the following:
Information from R.E.C. Inc.
Balance Sheet and Income Statement

Are all three accounts changing in the same

direction and at consistent rates of change?
If the direction and rates are not consistent,
what are possible explanations for these
differences?
If there is not a normal relationship between
growth rates, what are possible reasons for
the abnormal pattern?
Information from R.E.C. Inc.
Balance Sheet and Income Statement

All three accounts increased, but sales

have grown at a much greater rate.
R.E.C. Inc. has collected more sales in
cash, and thus will have potentially
fewer defaults.
Allowance account has increased
appropriately in relation to accounts
receivable.
R.E.C. Inc. Valuation and Qualifying
Accounts

December 31, 2007, 2006, and 2005

Balance at Additions Balance

Beginning Charged to Costs at End
of Year and Expenses Deductions of Year
Allowance for
doubtful accounts
2010 $417 $271 $240 $448
2009 $400 $217 $200 $417
2008 $391 $259 $250 $400
R.E.C. Inc. Valuation and Qualifying
Accounts

“Additions Charged to Costs and Expenses”

is the amount estimated and recorded as
bad debt expense each year on the income
statement.
“Deductions” is the actual amount that the
firm has written off as accounts receivable
they no longer expect to recover from
customers.
R.E.C. Inc. Valuation and Qualifying
Accounts

Analyst should use this schedule to assess

the probability that the firm is
intentionally over- or under-estimating
the allowance account.
R.E.C. Inc. appears to estimate an expense
fairly close to the actual expense that
has been incurred.
Inventories

Items held for sale or used in the manufacture of

products that will be sold
Retail Company (one type of inventory)
• Finished goods
Manufacturing Company (three types of
inventory)
• Raw materials
• Work-in-process
• Finished goods
Inventories
Proportion of inventories at the manufacturing level

Inventories as a Percentage of Total Assets %

Manufacturing

Pharmaceutical preparations 20.4

Household Furniture 33.3

Sporting and athletic goods 39.6

Inventories
Proportion of inventories at the wholesale level

Inventories as a Percentage of Total Assets %

Wholesale
Drugs 30.4
Furniture 30.1
Sporting and recreational goods 44.8
Inventories
Proportion of inventories at the retail level

Inventories as a Percentage of Total Assets %

Retail
Pharmacies and drug stores 34.6
Furniture stores 48.9
Sporting goods stores 57.8
Inventory Accounting Methods
Method used has a considerable impact on a
company’s financial position and operating
results.
Valuation is based on an assumption regarding the
flow of goods, not the actual order in which
products are sold.
Cost flow assumption is made in order to match the
cost of products sold to the revenue generated.
 Inventory Basics
Cost Flow

Beginning Goods Ending

Inventory Available Inventory
Goods For
Purchased Cost of
Sale
Goods Sold

Balance Sheet Income Statement

Inventory Accounting Methods
Three cost flow assumptions most
frequently used by U.S. companies
• FIFO (First In, First Out)
• LIFO (Last In, First Out)
• Average cost

2-34
Inventory Accounting Methods

Accounting Method Cost of Goods Sold Inventory Valuation

(Income Statement) (Balance Sheet)

FIFO first purchases last purchases

(close to current cost)
LIFO last purchases
(close to current cost) first purchases

Average Cost average of all purchases average of all purchases

Inventory Accounting Methods

A new company in its Item Purchase

first year of operations Price
purchases five products #1 $5
for sale in the order and #2 $7
at the prices shown. The #3 $8
company sells three of
#4 $9
these items.
#5 $11
Inventory Accounting Methods
The cost flow assumptions for each method
are shown below:

Accounting Goods Sold Goods Remaining

Method in Inventory
FIFO #1, #2, #3 #4, #5

LIFO #5, #4, #3 #2, #1

Average Cost [Total cost/5] x 3 [Total cost/5] x 2

Inventory Accounting Methods

The resulting effect on the income

statement and balance sheet are shown:
Accounting Cost of Goods Sold Inventory Valuation
Method (Income Statement) (Balance Sheet)
FIFO $20 $20

LIFO $28 $12

Average Cost $24 $16

Inventory Accounting Methods
LIFO during inflation
Produces the highest cost of goods sold
expense and the lowest ending inventory
valuation
Reduces taxes and reported earnings
Cost of goods sold valued at current cost of
inventory items
Undervalued inventories on balance sheet
Inventory Accounting Methods
FIFO during inflation

Produces the lowest cost of goods sold

expense and the highest ending inventory
valuation
Increases taxes and reported earnings
Balance sheet inventory valued at current cost
Undervalued inventories on income statement
Effects of changing costs on inventory

• Income statement &

Taxes
During inflation:
– FIFO  highest NI & Tax
– LIFO  lowest NI & Tax

• Balance sheet
During inflation:
– FIFO  End Inv.
approximates replacement
cost
– LIFO  End Inv.
understated

Source of diagram: What the

Numbers Mean. Marshall,
McManus, Viele
Effects of changing costs on inventory

Source: What the

Numbers Mean.
Marshall,
McManus, Viele
Inventory Accounting Methods

Disclosure of inventory cost flow

assumption is found in the notes.
Inventory reported on balance sheet is at
the lower of cost or market.
Companies may use more than one
method for inventories in the U.S.
Prepaid Expenses

Expenses paid in advance

• insurance
• rent
• property taxes
• utilities
Included in current assets if they expire within
one year or one operating cycle
Generally not material to the balance sheet
Property, Plant, and Equipment
(PP&E)

Encompasses a company’s fixed assets

Also called tangible, long-lived, and capital
assets
Not used up during annual operations
Produce economic benefits for more than
one year
Have physical substance
Property, Plant, and Equipment
(PP&E)

Fixed assets other than land are “depreciated”

over the period of time they benefit the
firm.
The process of depreciation is a method of
allocating the cost of long-lived assets.
Original cost less estimate residual value is
spread over the asset’s expected life.
Property, Plant, and Equipment
(PP&E)

On any balance sheet date, PP&E is shown

at book value (the difference between
original cost and accumulated
depreciation to date).
Several choices and estimates must be made
to determine the annual depreciation
expense of an asset.
Property, Plant, and Equipment
Depreciation Methods
Straight-line method allocates an equal
amount of expense to each year of the
depreciation period.
Accelerated method apportions larger
amounts of expense to earlier years of the
asset’s depreciable life.
Units-of-production method bases
depreciation expense on actual use.
Property, Plant, and Equipment
(PP&E)
Land refers to property used in business, not
investment property.
Leasehold investments are additions or
improvements made to leased structures.
Construction in progress are the costs of
constructing new buildings that are not yet
complete.
Equipment represents the original cost of the
machinery and equipment used in business
operations.
Property, Plant, and Equipment
(PP&E)

Proportion of fixed assets in a company’s

asset structure is determined by nature
of the business.
Fixed assets are most prominent at the
manufacturing level.
Property, Plant, and Equipment
Proportion of fixed assets at the manufacturing level

Net Fixed Assets as a Percentage of Total Assets %

Manufacturing
Pharmaceutical preparations 24.0
Household Furniture 23.6
Sporting and athletic goods 14.9

Source: Data from The Risk Management Association, Annual Statement

Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management
Association. All Rights Reserved.
Property, Plant, and Equipment
Proportion of fixed assets at the wholesale level

Net Fixed Assets as a Percentage of Total Assets %

Wholesale
Drugs 9.7
Furniture 11.9
Sporting and recreational goods 9.5

Source: Data from The Risk Management Association, Annual Statement

Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management
Association. All Rights Reserved.
Property, Plant, and Equipment
Proportion of fixed assets at the wholesale level

Net Fixed Assets as a Percentage of Total Assets %

Retail
Pharmacies and drug stores 12.8
Furniture stores 19.5
Sporting good stores 15.9

Source: Data from The Risk Management Association, Annual Statement

Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management
Association. All Rights Reserved.
Depreciation

• Straight-line depreciation, most common method

Depreciable base (cost less salvage)

= Depreciation Expense
Depreciation period
• Accelerated depreciation (various)
• Sum of years depreciation method
• Units of production
Accounting issue:
Example of straight-line depreciation
Cost of equipment $9,000
Less yr. 1 depreciation expense - 3,000
Book Value at end of year 1 $6,000
Less yr. 2 depreciation expense - 3,000

Book Value at end of year 2 $3,000

Less yr. 3 depreciation expense - 3,000

Book Value at end of year 3 $0
Accounting issue: Depreciation
Example of an accelerated method
Declining balance
• Determine straight-line rate (1/Useful life)
• Determine acceleration factor (e.g. 1.5 x or 2x)
• Depreciation rate = (SL rate * acceleration factor)
• Depreciation expense = Net Book Value * Depreciation
rate
• Discontinue depreciation when Net book value = SV
Asset cost $50,000, salvage value $0, useful life 5 years
Double-declining balance
• Year 1 = $50,000*.2* 2 = $ 20,000
• Year 2 = $30,000*.2* 2 = $ 12,000
• Total depreciation expense = $50,000
Example
Double Declining Method
•  On April 1, 2011, Company A purchased an
equipment at the cost of $140,000.  This
equipment is estimated to have 5 year useful
life.  At the end of the 5th year, the salvage
value (residual value) will be $20,000. 
Company A recognizes depreciation to the
nearest whole month.  Calculate the
depreciation expenses for 2011,  2012 and
2013 using double declining balance
depreciation method.
Solution
Useful life = 5 years  -->  Straight line depreciation rate = 1/5
= 20% per year
       Depreciation rate for double declining balance method 
            = 20% x 200% = 20% x 2 = 40% per year
    Depreciation for 2011
           = $140,000 x 40% x 9/12 = $42,000
   Depreciation for 2012
           = ($140,000 - $42,000) x 40% x 12/12 = $39,200
   Depreciation for 2013      
= ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520
• $35,280 x 40% x 12/12 = $14,112
•  $21,168 x 40% x 12/12 = $8,467 
• Depreciation for 2015 is $1,168 to keep book value same as salvage
value.
    $21,168 - $20,000 = $1,168 (At this point, depreciation stops.)
Other Assets

Can include many other noncurrent items:

• Property held for sale
• Start-up costs in connection with a new business
• Cash surrender value of life insurance policies
• Long-term advance payments
• Long-term investments
• Intangible assets
Other Assets
Goodwill
Intangible assets: non-current assets without physical
substance.
• Distribution rights: Exclusive right to distribute the
company’s products in an area.
• Trademarks: Exclusive right to word, name, symbol,
device that distinguish goods and services from those
manufactured or sold by others. Can be renewed
forever as long as they are being used in commerce.
Capitalize acquired brands and trademarks.
• Patents: Exclusive right to a product or process
granted by the government to an inventor for limited
time. Capitalize internal legal costs or external cost to
acquire.
Other Assets
Goodwill
Most important intangible asset for
analytical purposes because of
potential materiality
Arises when one company acquires
another company for a price in excess
of the fair market value of the net
identifiable assets acquired
Evaluated annually

2-62
Liabilities
Represent claims against assets and include
• Current Liabilities
(accounts payable, notes payable, current
maturities of long-term debt, accrued liabilities,
unearned revenue or deferred credits, deferred
federal income taxes)
• Noncurrent liabilities
(long-term debt, capital lease obligations,
postretirement benefits other than pensions,
commitments and contingencies, hybrid securities)
Liabilities
Current liabilities

Current liabilities must be satisfied in one

year or one operating cycle and include
• Accounts payable
• Notes payable
• Current portion of long-term debt
• Accrued liabilities
• Unearned revenue
• Deferred taxes
2-64
Current Liabilities
Accounts Payable

Short-term obligations that arise from credit

extended by suppliers for the purchase of
goods and services
Account is eliminated when bill is satisfied
Increase and decrease depending on credit
policies, economic conditions, and
cyclical nature of operations
Accounts Payable
R.E.C. Inc. Consolidated Balance Sheets
(in Thousands)

2007 2006
Current Liabilities
Accounts payable $14,294 $7,591
Notes Payable 5,614 6,012
Current maturities of long-term debt 1,884 1,516
Accrued liabilities 5,669 5,313
Total current liabilities 27,461 20,432

Accounts payable almost doubled between 2006 and

2007.
Analysis should include exploration of this increase.
Current Liabilities
Notes Payable

Short-term obligations in the form of

promissory notes
Lines of credit to suppliers or financial
institutions
Current Liabilities
Current maturities of long-term debt

Portion of the principal of long-term debt

that will be repaid during the
upcoming year
Current Liabilities
Accrued Liabilities
Result from recognition of an expense
prior to actual payment of cash
Recorded as reserve accounts
Reserve accounts are
• set up to estimate obligations for certain
items
• identified in the notes
Current Accrued Liabilities

Example:
• Accrued interest expense. A company has a loan
outstanding, for which it owes interest that has not yet
been billed by its lender at the end of an accounting
period
• Accrued payroll taxes. A business incurs a liability to
pay several types of payroll taxes when it pays
compensation to its employees.
• Accrued pension liability. A company incurs a liability to
pay its employees at some point in the future for benefits
earned under a pension plan
Example
Assume that a company has a $100,000 note outstanding,
with 12 percent annual interest due in semiannual
installments on March 31 and September 30. For a balance
sheet prepared on December 31, interest will be accrued
for three months (October, November, and December):
• $100,000 × .12 = $12,000 annual interest;
• $12,000/12 = $1,000 monthly interest;
• $1,000 × 3 = $3,000 accrued interest for three
months.
The December 31 balance sheet would include an
accrued liability of $3,000.
Current Liabilities
Unearned Revenue or Deferred Credits

Result from payments received in

advance for services or products
Transferred to a revenue account when
service is performed or product is
delivered
Current Liabilities
Deferred Federal Income Taxes

Result of temporary differences in the

recognition of revenue and expense for
taxable income relative to reported income
Intended to take advantage of all available tax
deferrals to reduce actual tax payments,
while showing the highest possible amount
of reported net income
Current Liabilities
Deferred Federal Income Taxes

Classified as current or noncurrent on the

balance sheet
Can appear on the balance sheet as a current
asset, current liability, noncurrent asset,
or noncurrent liability
Current Liabilities
Deferred Federal Income Taxes

Temporary differences can be caused by

choice of accounting method for
• Depreciation
• Installment sales
• Long-term contracts and leases
• Warranties and service contracts
• Pensions and other employee benefits
• Subsidiary investment earnings

2-75
Current Liabilities
Deferred Federal Income Taxes

A valuation allowance is used to reduce

deferred tax assets to expected realizable
amounts when it is determined that it is
more likely than not that some of the
deferred tax assets will not be realized.
Example
• Assume that a company has a total annual revenue of
$500,000; expenses other than depreciation are $250,000; and
depre- ciation expense is $100,000 for tax accounting and
$50,000 for financial reporting (even- tually this difference
would reverse and the reported depreciation expense in later
years would be greater than the tax depreciation expense). The
income for tax and reporting purposes would be computed two
ways, assuming a 34 percent tax rate:
Example continue
• Taxes actually paid ($51,000) are less than the
tax expense ($68,000) reported in the financial
statements. To reconcile the $17,000 difference
between the expense recorded and the cash
outflow, there is a deferred tax liability of
$17,000:
• Reported tax expense $68,000
• Cash paid for taxes 51,000

Deferred tax liability $17,000

Noncurrent Liabilities

Obligations with maturities beyond one year

• Long-term debt
• Capital lease obligations
• Postretirement benefits other than pensions
• Commitments and contingencies
• Hybrid securities
Noncurrent Liabilities
Long-term debt

• Bonds
• Long-Term Notes Payable
• Mortgages
• Obligations under leases
• Pension Liabilities
• Long-Term Warranties
Noncurrent Liabilities
Capital lease obligations

Are, in substance, a “purchase” rather than a

“lease”
Affect both balance sheet and income
statement
Disclosures found in the notes, often under
both the property, plant, and equipment
note and the commitments and
contingencies note
Noncurrent Liabilities
Postretirement benefits other than pensions

Can appear under the liability section of the

balance sheet
Can have a significant impact on corporate
balance sheets
Can also impact profitability by substantially
increasing the recognition of annual
postretirement benefit expense
Noncurrent Liabilities
Commitments and contingencies

Intended to draw attention to the fact that

required disclosures can be found in the
notes to the financial statements
Noncurrent Liabilities
Commitments and contingencies

Commitments refer to contractual agreements

that will have a significant financial
impact on the company in the future.
Contingencies refer to potential liabilities of
the firm such as possible damage awards
assessed in lawsuits.
Noncurrent Liabilities
Hybrid Securities

Have the characteristics of both debt and

equity
Also called mandatorily redeemable
preferred stock
Financial instrument is preferred stock, but
the issuing company must retire the
shares at a future date.
Stockholders’ Equity
Final section of balance sheet
Also called shareholders’ equity
Residual interest in assets that remains
after deducting liabilities
Owners bear greatest risk and benefit
from greatest rewards.
Stockholders’ Equity
Common Stock

Shareholders
• do not ordinarily receive a fixed return
• have voting privileges in proportion to
ownership interest
• can benefit through price appreciation
• can suffer through price depreciation
Dividends are declared at the discretion of a
company’s board of directors.
Stockholders’ Equity
Additional paid-in capital

Reflects the amount by which the original

sales price of the stock shares exceeded
par value
Stockholders’ Equity
Retained Earnings

Sum of every dollar a company has earned

since its inception, less any payments
made to shareholders
Funds a company has elected to reinvest in
the operations of the business rather than
pay out in stock
Measurement of all undistributed earnings
Stockholders’ Equity
Retained Earnings

Key link between income statement and

balance sheet

Beginning Net Ending

retained ± income – Dividends = retained
earnings (loss) earnings
Stockholders’ Equity
Other equity accounts

• Preferred stock
• Accumulated other comprehensive income
• Treasury stock
Other Equity Accounts
Preferred stock

• Carries a fixed annual dividend payments

• Carries no voting rights
Other Equity Accounts
Other comprehensive income

Unrealized gains or losses in the market value of

investments in available-for-sale securities
Any change in the excess of additional pension
liability over unrecognized prior service cost
Certain gains and losses on derivative financial
instruments
Foreign currency translation adjustments resulting
from converting financial statements from a
foreign currency into U.S. dollars
Other Balance Sheet Items

Corporate balance sheets are not limited to

the accounts described in this chapter.
The reader of annual reports will encounter
additional accounts and will also find
many of the same accounts listed under a
variety of different titles.