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Reading 26 Understanding Balance Sheets –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com. All rights reserved. –––––––––––––––––––––––––––––––––––––– 2. COMPONENTS AND FORMAT OF THE BALANCE SHEET The balance sheet (a.k.aStatement of Financial Position or Statement of Financial Condition) provides information about resources owned (or controlled) by a company (assets) and its sources of capital (equity and liabilities) at a specific point in time . This information can be used to assess a company’s ability to meet its short-term obligations, long-term obligations and make distributions to owners. Basic components of the Balance Sheet include: 1) Assets : They represent economic resources of a firm obtained through the firm’s past operations or acquisitions and which are expected to generate future economic benefits to the company. 2) Liabilities : They represent current or future obligations of the firm arising from past events and which result in expected future outflow of economic benefits from the company. 3) Owners’ Equity : It represents the amount of assets that would remain once all creditors are paid i.e. owners’ residual interest. It is also known as net assets, net worth of the firm,and depending on form of organization, also known as “partners’ capital or shareholders’ equity”. Owners’ Equity = Assets – Liabilities Accounting equation or balance sheet equation: Assets = Liabilities + Owners’ Equity Limitations of Balance Sheet in Financial Analysis: Balance sheet amounts of equity should not be used to represent a measure of market or intrinsic value of a company’s equity for following reasons: i. Differences in measurement bases: In balance sheet, some assets & liabilities are reported at historical cost whereas some are reported at current cost. ii. Items that are reported at current cost may have different value after the balance sheet is prepared. iii. Company’s ability to generate future cash flows i.e. company’s reputation and management skills are not included in its balance sheet. Format of the Balance Sheet: There is no standardized format to present balance sheet. However, two commonly used formats include: 1) Account format: In an account format, assets are presented on the left hand side of the page and liabilities and equity are presented on the right hand side. 2) Report format: In a report format, all assets, liabilities, and equity are presented in one column. Format to present line items of assets and liabilities: a) Classified Balance Sheet : In a classified balance sheet, current and non-current assets and liabilities are reported separately on the balance sheet i.e. current assets are grouped together and current liabilities are grouped together. Similarly, noncurrent assets are grouped together, as are noncurrent liabilities. ã Under both IFRS and U.S.GAAP, companies are required to use Classified Balance Sheet format . The separate presentation of current and non-current assets and liabilities facilitates an analyst to assess company’s liquidity position. ã Under IFRS, companies are not required to follow any specific order or format to present items on a current/non-current classified balance sheet. b) Liquidity-based presentation: In liquidity-based presentation,all assets and liabilities are presented in decreasing order of liquidity. This format is generally used by financial companies e.g. banks. ã Under IFRS, current & non-current classifications are not required when a liquidity-based presentation provides reliable and more relevant information. Resources controlled by a firm Sources of capital that finance these resources Reading 26 3. CU 3.1 Current Assets Assets that are expected to be used or sold u one year or one operating cycle* of the busin whichever is greater, are referred to as Curren ã Current assets provide information regardi company’s operating activities and opera capability. * Operating cycle refers to the average amou between acquisition of inventory and the con the inventory back to cash. Note that when a company’s operating cycle is not clearly iden assumed to be one year. Among the current assets, items that required reported on the balance sheet include: ã Cash and cash equivalents ã Trade and other receivables ã Inventories ã Financial assets (with short maturities) Beside these line items, companies may prese line items as needed. 3.1.1) Cash and Cash Equivalents Cash & cash equivalents are financial assets. ã They include highly liquid, short-term invest with maturity of 3 months or less e.g. dem deposits with banks, U.S. Treasury bills, co paper, money market funds etc. ã They involve minor interest rate risk. ã They can be reported either at amortized fair value. For cash & cash equivalents, bo methods will provide the same result. ã They do not include amounts that are pro to use for at least 12 months. 3.1.2) Marketable Securities Marketable securities are financial assets.They investments in publicly traded debt and equite.g. treasury bills, notes, bonds, common stoc fund shares etc. Their value can be easily det from price information available in the market. 3.1.3) Trade/Account Receivable Accounts receivables are type of financial ass represent amounts owed to a company by its as a result of credit sales. ã They are reported at net realizable value ( estimate of fair value depending on colle Understanding Balance Sheets RRENT ASSETS AND CURRENT LIABILITIES within ss, t assets. ng ting t of time ersion of ifiable, it is to be nt other ments nd mercial cost or th ibited include securities s, mutual rmined . et that customers i.e. an tability). ã Significantly large increase in relative to sales may indicate facing problems in collecting customers. Allowance for doubtful accounts: company’s estimate of amounts uncollectible. It is referred to as C ã Increases in allowance in a p reported as bad debt expen statement and as increase in allowance for doubtful acco sheet. ã Net receivable amount = Gro – balance of allowance for d ã Uncollectible receivables are i. Account receivable acco the amount of uncollectibl ii. Allowance for doubtful ac the amount of uncollectibl Age of accounts receivable: It re the receivable has been outstan number of days past the due dat Concentration Risk: This risk arises small and less-diversified custome single customer accounts for 10% receivables. Factors that lead to decrease in accounts as % of accounts recei i. Decrease in the amount of ii. Improvements in the credit company’s existing customeiii. Stricter credit policies of the iv. Stricter risk management pol company. v. Bias estimatesof manageme reported earnings e.g. in ord earnings, management can collectability and underesti expense for a period. NOTE: Liquid Asset: An asset that can b easily and in shortterm period at market value is called liquid asset Practice:Example 1, Volume 3, Reading 26, P. 220. FinQuiz.com accounts receivable that a company is cash from its It reflects the hat will eventually be ontra-asset account. rticular period are e in the income the balance of nts on the balance ss receivable amount oubtful accounts. written off as follows: nt is decreased by e receivables. ounts is reduced by e receivables. lects the length of time ing including the e. when a company has r base i.e. when a or more of revenue or llowance for doubtful able: redit sales. uality of the rs. company. icies of the nt to manipulate er to inflate reported overestimate ate the bad debt converted into cash price close to its fair . Reading 26 3.1.4) Inventories Inventories refer to physical goods that will ev sold to the company’s customers. They can b the form of finished goods, raw materials, or wprogress. Costs of inventory include: ã All costs of purchase ã Costs of conversion ã Costs incurred in bringing the inventories t present location and condition. Costs of inventory exclude: ã Abnormal amounts of wasted materials, la overheads. ã Storage costs, unless they are required bef further production process. ã Administrative overheads. ã Selling costs. Techniques for the Measurement of Cost : a) Standard Cost: It takes into account the nor of consumption of materials and supplies, l efficiency and capacity utilization. The stan is reviewed regularly and, if required, revise according to current conditions. It should be reviewed on a regular basis to en approximates actual costs. b) Retail method: In this method, cost of the in estimated by deducting gross margin from each homogenous group of items, averag margin should be used. This method takes i account the impact of marked-down price The retail method is commonly used in the retmeasuring inventories of large numbers of rapi changing items with similar margins and for w impracticable to use other costing methods. Under IFRS: ã Inventories are reported at the lower of c the net releasable value (NRV). where, NRV = estimated selling price – estimated costs of completion and costs necessary t the sale ã When NRV< carrying amount, the compa write down the value of the inventory. ã The loss in the value is reported in Income statement. ã If in subsequent years, the written-down in rises in value, IFRS allows that amount of or write-down can be reversed. Understanding Balance Sheets ntually be either in ork-in- their bor and ore mal levels bor, dard cost ure that it entory is ales. For gross to s. il trade for dly ich it is st and selling make y must entory iginal Under U.S.GAAP: ã Inventories are reported at th market value (MV). where, MV = current replacement c lower limits i.e. o Market value should not be >NRV, use NRV. o Market value should not be profit margin). When MV < ( margin), use (NRV – normal ã When MV < carrying amount, write down the value of the i ã The loss in the value is reporte statement. ã Under U.S.GAAP, subsequent inventory write-down is not p Inventory valuation methods (cos and cost flow assumptions under valuation methods refer to valuat determine cost of inventory i.e. a of goods sold. ã Under IFRS, companies can u average cost and specific id ã Under U.S.GAAP, companies weighted average cost, spe LIFO. ã LIFO is not allowed under IFRS 3.1.5) Other Curre Items that are individually not ma reported as a separate line item are aggregated into a single acc other current assets. Common ite current assets include: i. Prepaid expenses e.g. prepaid are recorded as asset and are periods as they are used up. ii. Deferred tax assets: Deferred t actual income tax payable ba purposes in a period is greater income tax expense based on statement income (accountin taxes) due to temporary timin ã When subsequently the inco the income statement: i. Related tax expense is rec ii. Deferred tax asset accoun amount. ã Deferred tax assets may also tax losses and credits (due to Practice:Example 2, Volume 3, Reading 26, P. 222. FinQuiz.com e lower of cost and st with upper and >NRV. When MV < (NRV – normal NRV – normal profit profit margin). the company must ventory. d in Income reversal of an rmitted. t formulas under IFRS U.S.GAAP): Inventory ion methods used to ount reported in cost e FIFO, weighted ntification. can use FIFO, ific identification and . t Assets terial enough to be n the balance sheet ount referred to as ms included in other rent etc. These items expensed in the future x assets arises when sed on income for tax than amount of the reported financial net income before differences. e is recognized on gnized and t is reduced by that arise when unused temporary timing Reading 26 differences) are carried forward. Important to Note: Deferred tax assets are recognized only when expected that the company will have taxable the future which may be used to offset tempo differences or carried forward tax losses or cre reduce taxes payable. 3.2 Current Liabilities Liabilities that are expected to be settled withi or one operating cycle of the business, which greater, are referred to as Current Liabilities. ã Under IFRS, some liabilities e.g. trade paya accruals for employee and other operatin are classified as current liabilities even if th be settled within more than one year after balance sheet date. ã Examples of current liabilities include: trad payables, financial liabilities, accrued exp and deferred income. Following criteria is used to classify the liability current: 1) Settlement is expected during the normal operating cycle. 2) Settlement is expected within one year. 3) The company does not have any uncon right to defer settlement for at least one y Trade Payables/Accounts payables: They repr amounts that a company owes its suppliers for 4. Non-current Assets: Assets that are not expect used or sold within one year or one operating the business, whichever is greater, are referred Non-Current assets or Long-lived/Long-term as ã Non-current assets provide information re infrastructure from which the entity operat 4.1 Property, Plant and Equipment (P PPE are tangible assets that are used in comp operations and are expected to provide eco benefits over more than one fiscal period e.g. buildings, equipment, machinery, natural reso Under IFRS: ã PPE can be reported either using cost mo revaluation model. Understanding Balance Sheets it is income in rary dits to n one year ver is ble, g costs ey will the enses as l itional ear. esent the purchases of goods and services. accounts payable relative to pur potential changes in the compa with its suppliers. Trade Credi t: It refers to credit pro by its suppliers. It represents a sou company to make purchases. Notes Payable: They represent fin company is obligated to pay to creditors). Current portion of long-term debt term liabilities that is due within o Income taxes payable: They repr that have not yet been paid. Accrued expenses/Accrued liabifinancial liabilities: They represent have been recognized on the in which have not yet been paid as date e.g. accrued interest paya costs, wages payables etc. Deferred Income/Deferred reven Deferred revenues arise when a payment in advance of delivery payments received for magazine beginning of the subscription peri x NON-CURRENT ASSETS ed to be cycle of to as sets. arding es. E) ny omic land, rces etc. el or ã Companies can choose to re assets using cost model while assets using revaluation mod ã However, the company must for all assets within a specific Under U.S.GAAP: ã PPE can be reported using c Cost Model : Under cost method, amortized cost i.e. Amortized cost = Historical cost – depreciation/d losses Practice:Example 3, Volume 3, Reading 26, P. 226. FinQuiz.com Significant changes in hases indicate y’s credit relationships vided to the company rce of financing for a ancial liabilities that a reditors (banks, trade : Any portions of long- e year. sent income taxes lities/Other non- the expenses that ome statement but of the balance sheet le, accrued warranty e/Unearned revenue: ompany receives f goods/services e.g. subscriptions at the od. port some classes of other classes of l. use the same model lass of assets. st model only. PE is reported at accumulated pletion – impairment
