The balance-sheet-purpose-of-the-balance-sheet1407

The Balance Sheet

Dileep Panoli

[email protected]

Purpose of the Balance Sheet

Traditionally the 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

The balance 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.

Intangible assets 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.


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.


Many assets are adjusted after initial recognition. Adjustments can be:– Allocations- Systematic reductions that don’t

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, can’t 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.

Shareholder’s 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

Shareholder’s equity is a plug, i.e., the same as recorded assets less liabilities.

Shareholder’s equity does not reflect the market value of shareholder’s 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-PurposeRevenue Recognition under GAAPExpense 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

But is 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

Costs in 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 doesn’t 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 XXXLess: COGS XXXGross Profit XXXLess: Operating Expenses XXXOperating Income XXXAdd: Other Income XXXLess: Other expenses XXXIncome Before Taxes XXXLess Income Tax XXXIncome From Continuing Operations XXX

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.

Accounting based 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 can’t 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


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.


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.