Ifsa Chapter5

CHAPTER 5
UNDERSTANDING BALANCE SHEETS

Presenters name
Presenters title
dd Month yyyy
OVERVIEW
Balance sheet elements and format
Accounting issues
- Current and noncurrent assets and liabilities
- Measurement bases of different assets and liabilities
Components of shareholders equity
Balance sheet analysis
Liquidity and solvency
Copyright 2013 CFA Institute
BALANCE SHEET CONTENTS

The balance sheet is also known as the statement of
financial position or statement of financial condition.
The balance sheet discloses, at a specific point in time,
- what an entity owns (or controls),
- what it owes, and
- what the owners claims are.
Assets = Liabilities + Owners equity
BALANCE SHEET ELEMENTS

Assets (A): resources controlled by the company as a
result of past events and from which future economic
benefits are expected to flow to the entity.
Liabilities (L): obligations of a company arising from past
events, the settlement of which is expected to result in an
outflow of economic benefits from the entity.
Equity (E): represents the owners residual interest in the
companys assets after deducting its liabilities.
EQUITY
The balance sheet provides important information about a
companys financial condition.
However, balance sheet amounts of equity (assets, net of liabilities)
should not be viewed as a measure of either the market or intrinsic
value of a companys equity.
Why?
- The balance sheet is a mixed model with respect to measurement
(some items at historical cost, some items at current value).
- Even current value reflects a value that was current at the end of
the reporting period.
- Future cash flows, which affect value, are driven by items
excluded from the balance sheet (e.g., reputation, management
skills).
BALANCE SHEET: EXAMPLE

COLGATE-PALMOLIVE COMPANY (ASSETS)
Colgate's Annual Report


COLGATE-PALMOLIVE COMPANY (LIABILITIES)


COLGATE-PALMOLIVE COMPANY (EQUITY)

BALANCE SHEET FORMAT

Liquidity
- For a company overall, its ability to pay for short-term
obligations
- For a particular asset or liability, its nearness to cash
Balance sheet ordering according to liquidity
- Companies using U.S. GAAP (e.g., Colgate) order items
on the balance sheet from most liquid to least liquid.
- Companies using IFRS order balance sheet information
from least liquid to most liquid.

HENKEL AG (ASSETS)
Henkel's Annual Report

10

LORAL (ASSETS)
LOral's Annual Report

11
CURRENT AND NONCURRENT

ASSETS AND LIABILITIES
Balance sheet must distinguish between and present separately
- current and noncurrent assets
- current and noncurrent liabilities
Exception to the current and noncurrent classifications
requirement, under IFRS:
- Current and noncurrent classifications are not required if a
liquidity-based presentation provides reliable and more
relevant information.
- In a liquidity-based presentation, all assets and liabilities
presented in order of liquidity.
- Liquidity-based presentation are often used by banks.
Classified balance sheet: Balance sheet with separately
classified current and noncurrent assets and liabilities.
12

BARCLAYS PLC (ASSETS)
Barclays' Annual Report

13
CURRENT AND NONCURRENT

ASSETS AND LIABILITIES
Current assets: Assets expected to be sold, used up, or
otherwise realized in cash within one year or one operating
cycle of the business, whichever is greater, after the
reporting period.
Noncurrent assets: Assets not classified as current. Also
known as long-term or long-lived assets.
Current liabilities: Liabilities expected to be settled within
one year or within one operating cycle of the business.
Noncurrent liabilities: All liabilities not classified as
current.
Working capital: The excess of current assets over
current liabilities.
14
MEASUREMENT BASES OF CURRENT ASSETS:

CASH AND CASH EQUIVALENTS
Cash Equivalents: Highly liquid, short-term investments
that are so close to maturity that the risk of significant
change in value from changes in interest rates is minimal.
- Examples:
- demand deposits with banks
- highly liquid investments with original maturities of three
months or less (e.g., U.S. T- bills, commercial paper,
money market funds)
- For cash and cash equivalents, amortized cost and fair
value are likely to be immaterially different.
15
MEASUREMENT BASES OF CASH AND CASH

EQUIVALENTS: EXAMPLE DISCLOSURES
Cash Equivalents. Highly liquid investments with remaining stated maturities
of three months or less when purchased are considered cash equivalents and
recorded at cost.
Procter & Gamble (2011), annual report
Cash and cash equivalents. Cash and cash equivalents consist of cash in
bank accounts, units of cash unit trusts and liquid short-term investments with a
negligible risk of changes in value and a maturity date of less than three months
at the date of acquisition. . . . Units of cash unit trusts are considered to be
assets available for sale. As such, they are valued in the balance sheet at their
market value at the closing date. Any related unrealized gains are accounted for
in Finance costs, net in the income statement. The carrying amount of bank
deposits is a reasonable approximation of their fair value.
LOral (2011), annual report
16

TRADE RECEIVABLES
Trade receivables: Amounts owed to a company by its
customers for products and services already delivered.
- Also referred to as accounts receivable.
- Typically reported at net realizable value, an
approximation of fair value, based on estimates of
collectability.
Aspects of accounts receivable often relevant to an analyst:
- overall level of accounts receivable relative to sales,
- allowance for doubtful accounts, and
- concentration of credit risk.
17
MEASUREMENT BASES OF RECEIVABLES:

LORAL EXAMPLE
Based on the note below, what percentage of its receivables
did LOral estimate will be uncollectible?
Answer:
For 2011, 46.2 divided by 3,042.3 = 1.52%.
For 2010, 48.1 divided by 2,733.4 = 1.76%.
For 2009, 50.2 divided by 2,493.5 = 2.01%.
18
MEASUREMENT BASIS OF CURRENT

ASSETS: INVENTORY
Inventory Cost Flow
Beginning
Inventory
Goods
Purchased
Balance Sheet
Goods
Available
for
Sale
Ending
Inventory
Cost of
Goods Sold
Income Statement
19

INVENTORY
IFRS
U.S. GAAP
Lower of cost or market (LCM):
- Market defined as replacement
cost with a floor (Net realizable
value, or NRV, less normal
profit margin) and a ceiling
(NRV).
- NRV defined as estimated
selling price less estimated
costs of completion and sale.
Lower of cost or net realizable

value (LCNRV):
- NRV defined as estimated
selling price less estimated
costs of completion and sale.
Reversals of prior write-downs are

NOT allowed.
Permits last in, first out (LIFO).
Reversals of prior write-downs

can be made and recognized in
income.
Does not permit LIFO.
20
MEASUREMENT BASES OF NONCURRENT ASSETS:

PROPERTY, PLANT, AND EQUIPMENT
Property, plant, and equipment (PP&E): Tangible assets that are
used in company operations over more than one fiscal period.
Under the cost model, PP&E is reported at historical cost less any
accumulated depreciation and less any impairment losses.
- Depreciation: Systematic allocation of cost over an assets useful
life.
- Land is not depreciated.
- Impairment losses reflect an unanticipated decline in value.
- Reversals of impairment losses are permitted under IFRS but not
under U.S. GAAP.
Under the revaluation model, PP&E is reported at fair value at the
date of revaluation less any subsequent accumulated depreciation.
- The revaluation model is NOT permitted under U.S. GAAP.
21
MEASUREMENT BASES OF NONCURRENT ASSETS:

PROPERTY, PLANT, AND EQUIPMENT
U.S. GAAP
Permit only the cost model for
reporting PP&E.
Reversals of prior impairment

losses are NOT allowed.
IFRS
Permit either cost model or
revaluation model.
- Can use different models for
different classes of assets.
- Must apply same model to all
assets within a particular class.
Reversals of impairment losses

are permitted.
22
MEASUREMENT BASES OF PROPERTY, PLANT,

AND EQUIPMENT: EXAMPLE DISCLOSURE
During 2008, Portugal Telecom changed the accounting policy regarding the
measurement of real estate properties and the ducts infra-structure from the cost
model to the revaluation model. . . . [Revaluation amounts totaled] Euro
1,075,033,022 that was recognized in the Consolidated Statement of
Comprehensive Income. . . .
Portugal Telecom performed another revaluation of the real estate assets and
ducts infrastructure in the year ended 31 December 2011. . . [resulting] in a net
reduction of tangible assets amounting to Euro 131,418,994, of which Euro
126,167,561 was recognized directly in the Consolidated Statement of
Comprehensive Income (Note 44.5) under the caption Revaluation reserve and
Euro 5,251,433 was recognized in the Consolidated Income Statement under
the caption Depreciation and amortization.
Portugal Telecom (2011), Form 20-F, note 37.4
23
MEASUREMENT BASES OF NONCURRENT

ASSETS: INTANGIBLE ASSETS
Intangible assets: Identifiable nonmonetary assets without physical
substance (e.g., patents, licenses, trademarks).
Goodwill, which arises in business combinations and is not a
separately identifiable asset, is covered separately in IFRS.
Measurement models for intangible assets:
- IFRS allow either a cost model or a revaluation model for intangible
assets.
- U.S. GAAP allow only the cost model.
Measurement of intangible assets subsequent to acquisition:
- Intangible asset with finite useful life: Amortize over useful life and
assess for impairment when indicated.
- Intangible asset with indefinite useful life: Do not amortize, but
assess for impairment (annually under IFRS; only after qualitative
assessment under U.S. GAAP).
24
MEASUREMENT BASES OF NONCURRENT

ASSETS: GOODWILL
Goodwill
- Arises when a company acquires another company for a
price in excess of fair market value of net identifiable
assets acquired.
- Is equal to purchase price of business minus fair market
value of net assets acquired.
- Represents value of all favorable attributes that relate to
a business enterprise.
- Is recorded only when there is an exchange transaction
that involves the purchase of an entire business.
- Is not amortized, but must be assessed for impairment.
Accounting goodwill does not equal economic goodwill.
25
MEASUREMENT BASES OF FINANCIAL ASSETS
Measured at Fair
Value
Financial
Assets
Measured at
Amortized Cost:
- Held-to-Maturity
- Debt Instruments
Changes in Value through

Profit and Loss
Trading Securities (stocks and
bonds)
Changes in Value through OCI

IFRS: Designated Equity
Investments
U.S. GAAP: Available-for-Sale
Debt or Equity
26
COMMON TYPES OF CURRENT LIABILITIES

Trade payables, also known as accounts payable: Amounts that a
company owes its vendors for purchases of goods and servicesin
other words, the unpaid amounts of the companys purchases on credit
as of the balance sheet date.
Notes payable: Financial liabilities owed by a company to creditors,
including trade creditors and banks, through a formal loan agreement.
Accrued expenses (also called accrued expenses payable, accrued
liabilities, and other nonfinancial liabilities) are expenses that have
been recognized on a companys income statement but that have not
yet been paid as of the balance sheet date.
Deferred income (also called deferred revenue and unearned
revenue) arises when a company receives payment in advance of
delivery of the goods and services associated with the payment.
27
COMMON TYPES OF NONCURRENT LIABILITIES

Long-term financial liabilities: Include loans (i.e., borrowings
from banks) and notes or bonds payable (i.e., fixed-income
securities issued to investors).
Usually reported at amortized cost on the balance sheet.
In certain cases, liabilities, such as bonds, issued by a
company are reported at fair value.
Deferred tax liabilities: Amount of income taxes payable in
future periods with respect of taxable temporary differences.
Result from temporary timing differences between a
companys income as reported for tax purposes (taxable
income) and income as reported for financial statement
purposes (reported income).
28
COMPONENTS OF SHAREHOLDERS EQUITY

Capital contributed by owners (or common stock or share
capital)
Preferred shares
Treasury shares (or treasury stock)
Retained earnings
Accumulated other comprehensive income (or other
reserves, items recognized directly in equity)
Noncontrolling interest (or minority interest)
29

LORAL (EQUITY AND LIABILITIES)
L'Oral Annual Report

30
ANALYSIS OF BALANCE SHEETS

Liquidity
- A companys ability to meet its short-term financial commitments.
- Assessment focus: The companys ability to convert assets to
cash and to pay for operating needs.
Solvency
- A companys ability to meet its financial obligations over the
longer term.
- Assessment focus: The companys financial structure and its
ability to pay long-term financing obligations.
Analytical Tools
- Common-size analysis.
- Balance sheet ratios.
31
COMMON-SIZE BALANCE SHEETS

($ thousands)
ASSETS
Cash, cash equivalents, marketable securities

Accounts receivable
Inventory
Total current assets
Property, plant, and equipment, net
Goodwill
Total assets
LIABILITIES AND EQUITY
Accounts payable
Total current liabilities
Long-term bonds payable
Total liabilities
Total shareholders equity
Total liabilities and shareholders equity
1,900
500
100
2,500
750
0
3,250
200
1,050
950
2,200
750
300
3,250
3,300
1,500
300
5,100
4,650
0
9,750
0
0
10
10
3,240
3,250
2,500
2,500
10
2,510
740
3,250
600
600
9,000
9,600
150
9,750
32

(percent of total assets)
A
B
C
ASSETS
Cash, cash equivalents, marketable securities 58.46%
6.15% 33.85%
Accounts receivable
15.38% 32.31% 15.38%
Inventory
3.08% 29.23%
3.08%
76.92% 67.69% 52.31%
23.08% 23.08% 47.69%
Goodwill
0.00%
9.23%
0.00%
Total assets
100.00% 100.00% 100.00%
LIABILITIES AND SHAREHOLDERS EQUITY
Accounts payable
0.00% 76.92%
6.15%
0.00% 76.92%
6.15%
0.31%
0.31% 92.31%
Total liabilities
0.31% 77.23% 98.46%
99.69% 22.77%
1.54%
100.00% 100.00% 100.00%
33

(percent of total assets)
ASSETS
Cash, cash equivalents, marketable securities
Accounts receivable
Inventory
Goodwill
Total assets
LIABILITIES AND SHAREHOLDERS EQUITY
Accounts payable
Total liabilities
58%
6% 34%
15% 32% 15%
3% 29%
3%
77% 68% 52%
23% 23% 48%
0%
9%
0%
100% 100% 100%
0% 77%
6%
0% 77%
6%
0%
0% 92%
0% 77% 98%
100% 23%
2%
100% 100% 100%
34
BALANCE SHEET RATIOS: LIQUIDITY RATIOS

Liquidity ratios indicate a companys ability to meet
current liabilities.
Ratio
Current
Calculation
Current assets /Current liabilities
Quick (acid test)
(Cash + Marketable securities + Receivables)

Current liabilities
Cash
(Cash + Marketable securities) /

Current liabilities
35
BALANCE SHEET RATIOS: SOLVENCY RATIOS

Solvency ratios indicate financial risk and financial leverage and
a companys ability to meet its financial obligations over time.
Ratio
Long-term debt to equity
Calculation
Total long-term debt Total equity
Debt to equity
Total debt Total equity
Total debt (also known as

debt to assets)
Debt to capital
Total debt Total assets
Financial leverage
Total assets Total equity
Total debt (Total debt + Total equity)
36
SUMMARY
Balance Sheet: what an entity owns (or controls), what it
owes, and what the owners claims are at a specific point in
time.
Balance sheets usually present current and noncurrent
assets and liabilities.
Accounting issues relate primarily to measurement
(historical cost versus fair value).
Tools for balance sheet analysis include common-size
analysis and balance sheet ratios.
Balance sheet ratios indicate liquidity and solvency.
37

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CHAPTER 5

UNDERSTANDING BALANCE SHEETS

Copyright 2013 CFA Institute

BALANCE SHEET CONTENTS

Copyright 2013 CFA Institute

BALANCE SHEET ELEMENTS

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

BALANCE SHEET: EXAMPLE

Colgate's Annual Report

BALANCE SHEET: EXAMPLE

Colgate's Annual Report

BALANCE SHEET: EXAMPLE

Colgate's Annual Report

BALANCE SHEET FORMAT

Copyright 2013 CFA Institute

BALANCE SHEET: EXAMPLE

Henkel's Annual Report

BALANCE SHEET: EXAMPLE

LOral's Annual Report

CURRENT AND NONCURRENT

BALANCE SHEET: EXAMPLE

Barclays' Annual Report

CURRENT AND NONCURRENT

MEASUREMENT BASES OF CURRENT ASSETS:

Copyright 2013 CFA Institute

MEASUREMENT BASES OF CASH AND CASH

MEASUREMENT BASES OF CURRENT ASSETS:

Copyright 2013 CFA Institute

MEASUREMENT BASES OF RECEIVABLES:

MEASUREMENT BASIS OF CURRENT

Copyright 2013 CFA Institute

MEASUREMENT BASES OF CURRENT ASSETS:

Lower of cost or net realizable

Reversals of prior write-downs are

Permits last in, first out (LIFO).

Reversals of prior write-downs

Copyright 2013 CFA Institute

MEASUREMENT BASES OF NONCURRENT ASSETS:

MEASUREMENT BASES OF NONCURRENT ASSETS:

Reversals of prior impairment

Copyright 2013 CFA Institute

Reversals of impairment losses

MEASUREMENT BASES OF PROPERTY, PLANT,

Copyright 2013 CFA Institute

MEASUREMENT BASES OF NONCURRENT

Copyright 2013 CFA Institute

MEASUREMENT BASES OF NONCURRENT

MEASUREMENT BASES OF FINANCIAL ASSETS

Copyright 2013 CFA Institute

Changes in Value through

Changes in Value through OCI

COMMON TYPES OF CURRENT LIABILITIES

Copyright 2013 CFA Institute

COMMON TYPES OF NONCURRENT LIABILITIES

Copyright 2013 CFA Institute

COMPONENTS OF SHAREHOLDERS EQUITY

Copyright 2013 CFA Institute

BALANCE SHEET: EXAMPLE

L'Oral Annual Report

ANALYSIS OF BALANCE SHEETS

COMMON-SIZE BALANCE SHEETS

Cash, cash equivalents, marketable securities