3-1

Analysis of the Balance Sheet

3
CHAPTER
 3-2

Analyzing Financing
(Liabilities & Equity)
Activities

Liabilities Off Balance ? Equity

Sheet

Classification Analyze of
1) Current & Non current Leases ? Equity
2) Operating & Financing

Contingencies ?
Capital Retain
Analyze of
Stocks Earning
Liabilities
 3-3

Analyzing Financing
Activities

Liabilities

Classification
1) Current & Non current
 3-4

Liabilities
Classification
Current (short-term) Noncurrent (Long-Term)
Liabilities Liabilities

Obligations payable Obligations not

within one year payable within one
year
 3-5

Analyzing Financing
Activities

Liabilities

Classification
1) Current & Non current
2) Operating & Financing

Analyze of
Liabilities
 3-6

Liabilities
Important Features in Analyzing Liabilities
• Terms of indebtedness (such as maturity, interest
rate, payment pattern, and amount).
• Restrictions on deploying resources and pursuing
business activities.
• Ability and flexibility in pursuing further financing.
• Prohibitions on disbursements such as dividends.
• Obligations for working capital, debt to equity, and other
financial figures.
 3-7

Analyzing Financing
Activities

Liabilities

Classification
1) Current & Non current Leases
2) Operating & Financing

Analyze of
Liabilities
 3-8

Leases

Leasing Facts
Lease – contractual agreement between a
lessor (owner) and a lessee (user or renter) that
gives the lessee the right to use an asset
owned by the lessor for the lease term.

MLP – minimum lease payments

(MLP) of the lessee to the lessor
according to the lease contract
 3-9

Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all benefits
and risks of ownership—accounted for as an asset acquisition and a liability
incurrence by the lessee, and as a sale and financing transaction by the lessor
A lessee classifies as a capital lease if,
at its inception, the lease meets any of four criteria:
(i) lease transfers ownership of property to lessee by end of the lease
term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the
property
(iv) present value of rentals and other minimum lease payments at
beginning of lease term is 90% or more of the fair value of leased property

(2) Operating Lease Accounting For leases other than capital leases—the lessee
(lessor) accounts for the minimum lease payment as a rental expense (income)
Accounting Entry ?
 3-10

Analyzing Financing
Activities

Liabilities Off Balance

Sheet

Classification
1) Current & Non current Leases
2) Operating & Financing

Contingencies
Analyze of
Liabilities
 3-11

Off-Balance-Sheet Financing
Illustration of SPE Transaction to Sell
Accounts Receivable
• A special purpose entity is formed by the sponsoring
company and is capitalized with equity investment,
some of which must be from independent third
parties.
• The SPE leverages this equity investment with
borrowings from the credit markets and purchases
earning assets from or for the sponsoring company.
• The cash flow from the earning assets is used to
repay the debt and provide a return to the equity
investors.
 3-12

Analyzing Financing
Activities

Liabilities Off Balance Equity

Sheet

Classification
1) Current & Non current Leases
2) Operating & Financing

Contingencies&
Commitment
Analyze of
Liabilities
 3-13

Shareholders’ Equity
Basics of Equity Financing

Equity — refers to owner (shareholder) financing;

Characteristics include:
• Equity holders usually subordinate to creditors
• Reflects claims of owners (shareholders) on net assets
• Exposed to maximum risk and return
 3-14

Shareholders’ Equity
Two basic components

• Capital Stock
• Retained Earnings
• Reserves
 3-15

Analyzing Financing
Activities

Liabilities Off Balance Equity

Sheet

Classification Analyze of
1) Current & Non current Leases Equity
2) Operating & Financing

Contingencies&
Commitment
Analyze of
Liabilities
 3-16

Analyzing Financing
Activities

Liabilities Off Balance Equity

Sheet

Classification Analyze of
1) Current & Non current Leases Equity
2) Operating & Financing

Contingencies&
Commitment Capital
Analyze of
Stocks
Liabilities
 3-17

Shareholders’ Equity

Classification of Capital Stock

Preferred Stock — stock with features not possessed by
common stock; typical preferred stock features include:
• Dividend distribution preferences
• Liquidation priorities
• Convertibility (redemption) into common stock
• Non-voting rights ? Berjaya Group Bhd

Common Stock — stock with ownership interest and

bearing ultimate risks and rewards (residual interests) of

company performance
 3-18

Shareholders’ Equity
Components of Capital Stock
Contributed (or Paid-In) Capital — total financing received from
shareholders for capital shares; usually divided into two parts:

• Common (or Preferred) Stock — financing equal to par or

stated value;if stock is no-par, then equal to total financing

• Contributed (or Paid-In) Capital in Excess of Par or Stated

Value — financing in excess of any par or stated value
 3-19

Questions(11 th
pages 205-20)

• Discuss liabilities in the aspect of operating and

financing.
• Discuss the classification of lease and its impact on
accounting.
• How convertible debt/warrants impacts on valuation of
existing shareholders?
• Define big baths? How big bath impacts on company
earning?
 4-20

Analyzing Investing
(Assets)
Activities

Current Assets
 4-21

Current Asset Introduction

Classification
Current
Current (Short-term)
(Short-term) Noncurrent
Noncurrent (Long-
(Long-
Assets
Assets term)
term) Assets
Assets

Resources
Resourcesor orclaims
claimsto to Resources
Resourcesor orclaims
claimstoto
resources
resourcesthat
thatare
are resources
resourcesthat
thatare
are
expected
expectedto tobe
besold,
sold, expected
expectedtotoyield
yield
collected,
collected, or
orused
used within
within benefits
benefitsthat
thatextend
extend
one
oneyear
yearor
orthe
theoperating
operating beyond
beyondone
oneyear
yearor orthe
the
cycle,
cycle, whichever
whicheveris is operating
operatingcycle,
cycle,
longer.
longer. whichever
whicheverisislonger.
longer.
 4-22

Analyzing Investing
Activities

Current Assets

Cash
 4-23

Current Asset Introduction

What are Cash, Cash Equivalents and Liquidity
Cash
Cash
Currency,
Currency,coins
coinsand
andamounts
amountson
ondeposit
depositin
inbank
bank
accounts
accounts

Cash
CashEquivalents
Equivalents

Short-term,
Short-term,highly
highlyliquid
liquidinvestments
investmentsthat
thatare:
are:
1)
1)Readily
Readilyconvertible
convertibleto
toaaknown
knowncash
cashamount.
amount.
2)
2)Close
Closeto
tomaturity
maturitydate
dateand
andnot
notsensitive
sensitiveto
to
interest
interestrate
ratechanges
changes. .
 4-24

Analyzing Investing
Activities

Current Assets

Cash

Importance
& Issue
 4-25

Current Asset Introduction

Analysis the Importance of Cash and Cash
Equivalents
••Liquidity
Liquidityprovide
provideflexibility
flexibilityto
totake
takeadvantages
advantagesof of
opportunities
opportunities
••Able
Abletotomeet
meetobligation
obligation
••Cash
Cashandandcash
cashequivalents
equivalentsarearesometimes
sometimesrequired
requiredto
to
support
supportexisting
existingborrowing
borrowingarrangements
arrangementsororasas
collateral
collateral for
forindebtedness
indebtedness
••HOWEVER
HOWEVERCompanies
Companiesriskriskaareduction
reductionin
inliquidity
liquidity
should
shouldthethemarket
marketvalue
valueofofshort-term
short-terminvestments
investments
decline.
decline. YTL?
YTL?,, EPF
EPFininLondon
London
 4-26

Analyzing Investing
Activities

Current Assets

Account
Cash Receivables

Importance
& Issue
 4-27

Current Asset Introduction

Receivables
Receivables
Receivables are are amounts
amounts duedue from
from others
others
that
that arise
arise from
from the
the sale
sale of
of goods
goods or or services,
services,
or
or the
the loaning
loaning ofof money
money
Accounts
Accounts receivable
receivable refer
refer toto oral
oral promises
promises
of
of indebtedness
indebtedness due due from
from customers
customers
Notes
Notes receivable
receivable refer
refer to
to formal
formal written
written
promises
promises of of indebtedness
indebtedness due due from
from others
others
 4-28

Analyzing Investing
Activities

Current Assets

Account
Cash Receivables

Importance Valuation
& Issue & Issue
 4-29

Current Asset Introduction

Valuation of Receivables
Receivables
Receivablesare
arereported
reportedat
attheir
their net
netrealizable
realizablevalue
value ::
total
total amount
amountof
ofreceivables
receivables––(LESS)
(LESS)ananallowance
allowancefor
for
uncollectible
uncollectibleaccounts
accounts
Management
Managementestimates
estimatesthe
theallowance
allowanceforfor
uncollectibles
uncollectiblesbased
basedon onexperience,
experience, customer
customer
fortunes,
fortunes, economy
economyand andindustry
industryexpectations,
expectations, and
and
collection
collectionpolicies
policies
MAIN
MAINISSUE
ISSUE
Inadequate
Inadequatefor
forallowance
allowancefor
foruncollectible
uncollectibleaccounts
accounts
result
resultOverstatement
OverstatementofofIncome
Income
 4-30

Current Asset Introduction

Analyzing Receivables
Assessment
Assessmentof ofearnings
earningsquality
qualityisisoften
oftenaffected
affectedby
byan
ananalysis
analysisof
ofreceivables
receivablesand
andtheir
their
collectibility
collectibility

Analysis
Analysismust
mustbe bealert
alertto
tochanges
changesin
inthe
theallowance—computed
allowance—computedrelative
relativeto
tosales,
sales,
receivables, or industry and market conditions.
receivables, or industry and market conditions.

Aim
Aim––provide
provideadequate
adequateof
ofallowances
allowances for
foruncollectible
uncollectibleaccounts
accounts

Two
Twospecial
specialanalysis
analysisquestions:
questions:
(1)
(1)Collection
CollectionRisk
Risk
Review
Review allowancefor
allowance foruncollectibles
uncollectiblesininlight
lightof
ofindustry
industryconditions
conditions
Apply
Applyspecial
specialtools
toolsfor
foranalyzing
analyzingcollectibility:
collectibility:
••Determining
Determiningcompetitors’
competitors’receivables
receivablesas asaapercent
percentof
ofsales—vis-à-vis
sales—vis-à-visthe
the
company under analysis
company under analysis
••Examining
Examiningcustomer
customerconcentration—risk
concentration—riskincreases
increaseswhen
whenreceivables
receivablesare
are
concentrated in one or a few customers
concentrated in one or a few customers
••Investigating
Investigatingthe
theage
agepattern
patternof
ofreceivables—overdue
receivables—overdueand andfor
forhow
howlong
long
••Analyzing
Analyzingadequacy
adequacyof ofallowances
allowancesforfordiscounts,
discounts,returns,
returns,and
andother
othercredits
credits
 4-31

Analyzing Investing
Activities

Current Assets

Account Inventory
Cash Receivables

Importance Valuation
& Issue & Issue
 4-32

Inventories
Definitions
Inventories are goods held for sale, or goods
acquired (or in process of being readied) for
sale

Inventories
1) Material
2) Work In Progress
3) Finished Goods
 4-33

Analyzing Investing
Activities

Current Assets

Account Inventory
Cash Receivables

Importance Valuation Costing

& Issue & Issue & Issue
 4-34

Inventories
Inventory Costing Method

Use of Inventory Methods in Practice

 4-35

Inventories
First-In, First-Out (FIFO)

Oldest
Oldest Costs
Costs of
of Goods
Goods
Costs
Costs Sold
Sold

Recent
Recent Ending
Ending
Costs
Costs Inventory
Inventory
 4-36

Inventories

Last-In, First-Out (LIFO)

Recent
Recent Costs
Costs of
of
Costs
Costs Goods
Goods Sold
Sold

Oldest
Oldest Ending
Ending
Costs
Costs Inventory
Inventory
 4-37

Inventories
Average Cost
When
When aa unit
unit is
is sold,
sold, the
the
average
average costcost of
of each
each
unit
unit in
in inventory
inventory isis
assigned
assigned to to cost
cost of
of
goods
goods sold.
sold.

Cost of Units
Goods ÷ available on
Available for the date of
Sale sale
 4-38

Inventories
Illustration of Costing Methods

Inventory
InventoryononJanuary
January1,1,Year
Year22 40
40@@$500
$500 $$20,000
20,000
Inventories
Inventoriespurchased
purchased
during
duringthe
theyear
year 60
60@@$600
$600 36,000
36,000
Cost
CostofofGoods
Goodsavailable
available
for
forsale
sale 100
100units
units $$56,000
56,000

Note:
Note:30
30units
unitsare
aresold
soldin
inYear
Year22for
for$800
$800each
eachfor
fortotal
total
Revenue
Revenueof of$24,000
$24,000
 4-39

Inventories
Illustration of Costing Methods

Beginning
Beginning Net
Net Cost
Costof
of Ending
Ending
Inventory
Inventory ++ Purchases
Purchases == Goods
GoodsSold
Sold ++ Inventory
Inventory
FIFO
FIFO $20,000
$20,000 ++ $36,000
$36,000 == $15,000
$15,000 ++ $41,000
$41,000
LIFO
LIFO $20,000
$20,000 ++ $36,000
$36,000 == $18,000
$18,000(30@600)
(30@600) ++ $38,000
$38,000
(40@500
(40@500++30@600)
30@600)
Average
Average $20,000
$20,000 ++ $36,000
$36,000 == $16,800
$16,800(30@560)
(30@560) ++ $39,200
$39,200
(30@560)
(30@560)
Assume
Assumesales
salesof
of$35,000
$35,000for
forthe
theperiod—then
period—thengross
grossprofit
profitunder
undereach
each
method
methodis:is:
Sales
Sales –– Cost
CostofofGoods
GoodsSold
Sold == Gross
GrossProfit
Profit
FIFO(30@800) $24,000
FIFO(30@800) $24,000 ---- 15,000
15,000 == $9,000
$9,000
LIFO
LIFO $24,000
$24,000 ---- 18,000
18,000 == $6,000
$6,000
Average
Average $24,000
$24,000 ---- 16,800
16,800 == $7,200Why?
$7,200 Why?
 4-40

Analyzing Investing
Activities

Fixed Assets
Current Assets

Account Tangible Intangible Deferred

Cash Inventory
Receivables Charge

Importance Valuation Costing

& Issue & Issue & Issue
 4-41

Long-Lived Asset Introduction

Definitions
Long-lived
Long-livedassets—resources
assets—resourcesthat
thatare
areused
usedto
togenerate
generaterevenues
revenues(or
(or
reduce
reducecosts)
costs)in
inthe
thelong
longrun
run
Tangible fixed assets such as
property, plant, and equipment

Intangible assets such as

patents, trademarks,
copyrights, and goodwill

Deferred charges such as

research and development
(R&D) expenditures, and natural
resources
 4-42

Analyzing Investing
Activities

Fixed Assets
Current Assets

Account Tangible Intangible Deferred

Cash Inventory
Receivables Charge

Capitalization
Allocation
Importance Valuation Costing Impairment
& Issue & Issue & Issue
 4-43

Long-Lived Asset Introduction

Capitalization
Capitalization—process
Capitalization—processof ofdeferring
deferringaacost
costthat
thatis
isincurred
incurredin
inthe
the
current
currentperiod
periodand
andwhose
whosebenefits
benefitsare
areexpected
expectedtotoextend
extendtotoone
oneorormore
more
future
futureperiods.
periods. (Worldcom
(Worldcomscandal
scandal??))(Projector?)
(Projector?)(accounting
(accountingentry)
entry)

For
Foraacost
costto
tobe
becapitalized,
capitalized,ititmust
mustmeet
meeteach
eachof
ofthe
thefollowing
followingcriteria:
criteria:

••ItItmust
mustarise
arisefrom
fromaa
past
pasttransaction
transactionororevent
event

••ItItmust
mustyield
yieldidentifiable
identifiableand
and
reasonably
reasonablyprobable
probablefuture
futurebenefits
benefits
 4-44

Long-Lived Asset Introduction

Allocation
Allocation—process
Allocation—processof ofperiodically
periodicallyexpensing
expensingaadeferred
deferred
cost
cost(asset)
(asset)to
toone
oneor
ormore
morefuture
futureexpected
expectedbenefit
benefitperiods;
periods;
determined
determinedbybybenefit
benefitperiod,
period,salvage
salvagevalue,
value,and
andallocation
allocation
method
method

Terminology
Terminology
•• Depreciation
Depreciationfor
fortangible
tangiblefixed
fixed
assets
assets
•• Amortization
Amortizationfor
forintangible
intangibleassets
assets
•• Depletion
Depletionfor
fornatural
naturalresources
resources
 4-45

Long-Lived Asset Introduction

Impairment
••Asset
Assetimpairment
impairment isismeant
meant toto
identify
identifyaagroup
groupof
of assets
assetsthat
that are
are no
no
longer
longerproductive.
productive. (Mining
(Mininggroup:
group:
Rio
RioTinto,
Tinto, BHP,
BHP, Anglo
AngloAmerica
America?) ?)

••The
Theassets
assetsare
arenot
not expected
expectedtoto
produce
produceeconomic
economicbenefits
benefitsequal
equal
to
totheir
theircarrying
carryingcost.
cost.

••The
Theassets
assetsshould
shouldbe bewritten
writtendown
down
to
totheir
theirnet
net realizable
realizablevalue
value
measured
measuredeither
eitherbybytheir
theirdisposal
disposal
value
valueororthe
theexpected
expectedeconomic
economic
benefits
benefitsexpected
expectedto tobe
beproduced
produced
from
fromthe
theassets
assets. .
 4-46

Analyzing Investing
Activities

Fixed Assets
Current Assets

Account Tangible Intangible Deferred

Cash Inventory
Receivables Charge

Capitalization
Allocation
Importance Valuation Costing Impairment
& Issue & Issue & Issue

Plant
 4-47

Plant Assets

Factors in Computing Depreciation

The calculation of depreciation requires

three amounts for each asset:
 Cost.
 Salvage Value.
 Useful Life.
 Depreciation Method
 4-48

Plant Assets

Comparing Depreciation Methods

Straight-Line Method

Depreciation Cost - Salvage Value

=
Expense per Year Useful life in periods

SL
 4-49

Analyzing Investing
Activities

Fixed Assets
Current Assets

Account Tangible Intangible Deferred

Cash Inventory
Receivables Charge

Capitalization
Allocation
Importance Valuation Costing Impairment
& Issue & Issue & Issue

Intangible
Plant Assts
Securitization of
Receivables Issues
 4-50

Intangible Assets

Noncurrent
Noncurrentassets
assets Often
Oftenprovide
provide
without
withoutphysical
physical exclusive
exclusiverights
rights
substance.
substance. or
orprivileges.
privileges.

Intangible
Assets
Usually
Usuallyacquired
acquired
Useful
Usefullife
lifeis
is for
foroperational
operational
often
oftendifficult
difficult use.
use.
to
todetermine.
determine.
 4-51

Intangible Assets
Accounting for Intangible Assets
 Patents
Record at cost,
 Copyrights
including
 Leaseholds
purchase price,
 Leasehold
legal fees, and Improvements
filing fees.  Goodwill
 Trademarks and
Trade Names
 Brand Name (BL)
 4-52

Question
Pages263 …
a. Identify the main concerns in analysis of accounts receivable.
b. Describe information, other than that usually available in financial
statements, that we should collect

Explain when an expenditure should be capitalized versus when it should be

expensed
4-53
4-54