The Balance Sheet

Purpose of the Balance Sheet

Traditionallythe oldest statement

Theoretically represents financial position,
including net worth.
Format

Follows the balance sheet equation

Three main elements- Assets, Liabilities and
Equity
In the USA, Assets and Liabilities are
classified as current or non-current, in
decreasing order of presumed liquidity.
Time Frame

Thebalance sheet reflects conditions at a

point in time, usually, the fiscal year-end.
Core Issues

Recognition (e.g., should I recognize this as an

asset?)
Valuation (If so, for how much?)
Classification (What should I call it?)
Definition of an asset

Theoretically- A resource that has the

potential for providing the firm with a future
economic benefit.
Practical- Same as above, except (a) I have
to be able to quantify it, and (b) it probably
has to arise via an exchange transaction.
GAAP Recognition Criteria

The firm has acquired rights to its use as a

result of a past transaction or exchange,
and
The firm can measure or quantify the future
benefits with a reasonable degree of
precision.
The Subjective Nature of Recognition

The fundamental question-

Do I expense it or capitalize?
Often involves a subjective assessment
concerning whether there will be a probable future
benefit.
Valuation of Assets

The options:
Historical cost
Entry Value
Exit value
Present Value
Valuation-
Why not Current Value?

Entry Value (replacement cost)-

How do you reliably estimate second-hand
values?
Exit value (realizable value)-
Same problem
Present value (of future cash flows)-
How do you estimate future cash flows and
associated risks?
Balance Sheet Issues

The problem of mis-specification.

Adding apples, oranges and tomatoes. What
does the sum mean?
The question of timing and the impact on
relevancy.
The bottom line: The Statement of
Financial Position is NOT a statement of
financial position.
The Issue of Allocation

Property Plant and Equipment-

Includes Building, Machinery, Equipment
Valuation: Historical Cost
Costs capitalized: everything necessary to get
assets ready to operate
Recorded net of depreciation and/or depletion
Methods of Depreciation

Straight Line
Units of Production
Accelerated Methods
Declining Balance
Sum of Years Digits
Example

ABC purchases a vehicle for $ 20,000, with

an estimated life of 5 years (200,000 miles)
and an expected residual value of $ 500.
Depreciation-
Straight line- $ 3850
200% declining balance- $ 8,000
UOP (assuming use of 50,000 miles)- $ 4,875
Depreciation is:

Always an allocation process (as opposed

to truly measuring something, like actual
decline in exit value).

When accelerated methods are used,

More in early years
Lower in later years
Non-Current Assets

Intangibles- Most assets you cannot touch

but that provide future economic benefits to
firm.
Include trademarks, copyrights, franchises,
patents, brands, goodwill
Valuation: Historical Cost
Recorded net of amortization charges
Intangibles are:

Often not systematically amortized but

instead tested periodically to see if stated
values have been impaired.
Are not capitalized if created internally. Due
to conservatism, all research and
development costs are expensed.
 Intangibleassets are the newest, and
arguably most important, asset class today.
From these, much wealth is being created.
Unfortunately:
We have little idea how to measure and
recognize the value of these assets.
Summary of Key Points-Assets

Three issues decide how assets will be

reported- recognition, valuation, and
classification.
Recognition is mainly a question of
capitalization vs expensing. The main issue
is whether any future economic benefit
accrues to the firm.
Summary of Key Points-Assets

The Balance sheet has historically been a

parking lot for historical costs that will be
expensed sometime in the future.
Increasingly, more and more assets are
being stated at current value.
Today, asset valuations on the balance
sheet collectively reflect a mix of values and
costs.
Summary of Key Points-Assets

Manyassets are adjusted after initial

recognition. Adjustments can be:
Allocations- Systematic reductions that dont
really measure anything. (e.g., depreciation)
Measurements- attempts to adjust values based
on changes in exit value that have occurred. (e.g.,
impairment tests of goodwill)
Liabilities

What are they?

Theoretically: probable future sacrifices of
economic benefits
GAAP definition: probable future sacrifices of
economic benefits arising from present
obligations .to transfer assets or to provide
services .in the future as a result of past
transactions or events
Liabilities

What are they?

Practically (Recognition criteria):
Probable future sacrifices of resources
Can be measured (quantified)
Generally, cant be avoided.
Arise through a past transaction or exchange.
Liabilities

Classification:
Current
Listed in order of probable liquidation dates
Types: accounts payable, wages payable, dividends,
payable, collections received in advance of delivering
goods and services
Valuation- Usually at historical value.
Liabilities

Classification
Non-current
Types: Deferred taxes, bonds, long-term loans
Valuation: Historical exchange value, with adjustments
for amortization of premiums and discounts.
Liabilities

The problem of what probable means-

Potential liabilities are known as contingent
liabilities. Some future event must occur for them
to happen. (e.g., a judgment by a court of law)
Contingent liabilities are not usually reported
in the balance sheet. Instead they are disclosed in
the footnotes.
The exception is when they can be quantified and
are probably going to cost the firm future
resources to resolve.
Key points-Liabilities
Financial reporting liabilities reflect probable
economic sacrifices of future resources.
Reported liabilities arise through exchange
transactions.
Not all legal, or even economic, liabilities are
reported in the balance sheet.
Liabilities are not reported at market value, but
instead historical value, with adjustments.
Shareholders Equity

Two types:
Contributed capital
Retained Earnings
Types of Stock

Common
Preferred
Preference over common shareholders with
respect to dividends, if declared, and at liquidation
Usually have no voting rights.
Debatable whether preferred shares are really
equity.
Important things to know about Equity

Shareholders equity is a plug, i.e., the same as

recorded assets less liabilities.
Shareholders equity does not reflect the market
value of shareholders holdings.
Two kinds of equity- contributed capital and
retained earnings.
Main things to know-common stock, preference
stock, dividends, treasury stock transactions, stock
dividends and splits, .
Income Statement

Accrual Accounting-Purpose
Revenue Recognition under
GAAP
Expense Recognition under
GAAP
The Earnings Process

Production
Sales Generation (Order)
Delivery of product or service
Payment
Possibilities for Earnings Recognition

Point of
Production, e.g., when goods are made.
When an order is received/given.
When goods and services are
provided/delivered/received.
When firm receives/remits cash.
Cash Basis Accounting
Is a simple reporting of cash receipts and
disbursements.
Can be manipulated
Can be misleading about non-cash
expenses/revenues.
On the other hand, involves the verifiable flow of a
measurable commodity.
May not explicitly map to economic profitability.
Profitability-What is it?

Theoretically: any change in corporate

wealth.
Practically: earned revenues less costs
incurred to produce those revenues
The problem: Earned revenues and costs
incurred are abstract ideas. Measurement of
these will necessarily vary across different
economic agents.
The Problem:

When has a firm earned revenues?

When has a firm incurred costs to produce
those revenues?
Accrual Accounting
Is a set of rules/traditions (GAAP) designed to
recognize revenue when earned as defined by the
revenue realization principle.
Recognize expenses when they are incurred, as defined
by GAAP.
NOTE: Cash inflows (outflows) associated with revenues
(expenses) may occur before, during, or after accrual-
based recognition occurs.
Revenues

When are revenues usually recognized?

Generally when sales are completed by
delivery, in the legal sense, to customers.
Revenues

Butis this really when revenues are

earned?
Some Alternatives to
Revenue Recognition at the Time of sale

When production is complete (e.g., gold

miners).
After sales orders are received and during
production (e.g., Boeing).
When cash is fully received (e.g., credit
collectors).
As cash is gradually received (e.g., real
estate).
Costs/Expenses
The Ideal: Mapping (Matching) all costs incurred to
revenues produced and recognized.
The problem:
Many costs have no clear relation to revenues.
As with revenues, its not always clear if a cost has been
incurred.
Sometimes, it can even be unclear if a cost even exists, or if
it does, whether it detracts from revenue or actually
increases it (e.g., goodwill).
Costs-Types
Costs directly traceable to specific revenue
transactions (e.g., costs to buy/produce inventory).
Costs associated with, and/or systematically
allocable to time periods in which revenue is
recognized (e.g., rent expense).
Costs for which no measurable future benefit can
be discerned (e.g., R&D).
Cost-Types

Costsin financial reports are expensed

through one of two paths:
Product costs: costs associated with producing
or acquiring goods to be resold.
Period Costs: everything else.
Cost-Types

From an analysis viewpoint, costs can also

be viewed according to their relation to the
production function:
Fixed: Cost level doesnt change across a range
of volume of goods and services produced.
Variable: Systematic variance of cost levels with
production.
 Income, or earnings, is equal to revenues
less expenses.
But does earnings actually reflect the change
in wealth that a firm experiences from one
period to the next?
Income- Fictitious or Real?

Considerations:
Accounting Income is determined by GAAP.
Different rules = different reported profits
Dividends are paid with cash. A firm can have lots
of reported income and no cash, and vice
versa.
Goals

The goal of financial reporting, and GAAP,

are to:
Report (changes in) financial position.
Report on the profitability of firms.

In the real world, these goals often conflict.

Income Characteristics

Permanent versus transient

Controllable versus uncontrollable
Operational versus non-operational
Income Statement Classification

Income From continuing operations

Single step format
Multiple step format
Income from discontinuing operations
Extraordinary gains and losses
Cumulative effect of changes in accounting
principles
Single Step Format

Revenues XXX
Expenses XXX
Income before Taxes XXX

Income Tax expense XXX

Income from Continuing Operations XXX
Multiple-Step Format
Revenues XXX
Less: COGS XXX
Gross Profit XXX
Less: Operating Expenses XXX
Operating Income XXX
Add: Other Income XXX
Less: Other expenses XXX
Income Before Taxes XXX
Less Income Tax XXX
Income From Continuing OperationsXXX
Income From Continuing Operations

Revenues and expenses of activities in which

a firm anticipates an ongoing involvement.
Can be presented in single-step or multiple-
step format.
Income From Discontinuing Operations

Discontinued operations are those management

has sold or marked for sale or discontinuance.
Business segment to be sold must be a component
of an enterprise whose activities represent either:
A major business line
A separate class of customer
Income and gains/loss on sale should be reported
net of tax.
Disclosure is required.
Extraordinary Gains and Losses
These are arising from events that are both unusual
and infrequent (non-recurring) in nature.
Reported net of tax.
Disclosure is required.
Examples:
Loss due to earthquake.
Expropriation: takeover of property by a government.
Prohibition under a new law.
Cumulative Effect of Changes in Accounting
Principles

Reflects all income effects in previous years

resultant from a change in method, e.g.,
change from accelerated to straight-line
depreciation.
Does not capture changes in estimate or
in basis (e.g., improvements made to a fixed
asset).
Reported net of tax.
Pro-Forma Earnings
Future expected earnings reported in annual reports.
Based on assumptions concerning growth rate and
margins.
Very popular in bull markets (e.g., 1999)-can be used
to justify high market valuations.
Unpopular in bear markets (i.e., when continued
growth no longer seems so certain)
Accounting Myths:

Conservative accounting is good

accounting.

Accountingbased on Professional
Judgement is bad accounting.
A Specific example of the
fictitiousness of accounting: Income
Taxes
Income tax is measured using IRS rules. As
with book income, these rules have, at their
core, a concept of earnings, but reflect a
number of other considerations as well,
including the power of taxpayers to avoid
taxation.
If accounting income is different from IRS-
based tax income, on what basis should the
expense be based?
Income Taxes

The problem: Some of these differences are

timing differences and some are permanent.
If they are timing differences, there will be tax
implications, on a cash basis, occurring in
future periods that were spawned by
revenue/cost streams being recognized now.
Income Taxes

The question: Is the expense a function of simply

what you pay to the IRS each year, irrespective of
how the amount is determined? Or:
To the extent possible, is the expense best
determined as a function of the book income that
precipitated it?
Income Taxes-Balance sheet effects

To the extent that a relatively greater

expense is recognized under IRS rules (e.g.,
depreciation), a tax liability is created.
To the extent that relatively less expense is
recognized under IRS rules, a tax asset is
created.
Income Taxes

BUT: What if these tax assets and liabilities

never reverse? They cant be sold, and in
fact, have no real existence.
This happens with many firms whose growth
rates cause tax assets and liabilities to never
reverse.
What then are tax assets and liabilities?
Statement of Cash Flows

Broken into 3 categories: Operating,

Investing and Financing
Newest of the three statements
Statement of Cash Flows

Operating cash flows can be computed using

the direct or indirect method.
Almost everybody uses the indirect method.
Indirect method requires:
Add-backs for non-cash charges
Adjustments for operating accrual accounts.
Statement of Cash Flows

Corporate Life Cycle is an important context

to consider when interpreting the meaning of
reported cash flows.
The relation between earnings and cash
flows, and changes in this relation, can
provide useful analytical information.