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1 CHAPTER 5 UNDERSTANDING BALANCE SHEETS Presenter’s name Presenter’s title dd Month yyyy

2 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 2

3 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 Copyright © 2013 CFA Institute 3

4 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 company’s assets after deducting its liabilities. Copyright © 2013 CFA Institute 4

5 EQUITY The balance sheet provides important information about a company’s 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 company’s 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). Copyright © 2013 CFA Institute 5

6 BALANCE SHEET: EXAMPLE COLGATE-PALMOLIVE COMPANY (ASSETS) Copyright © 2013 CFA Institute 6 Colgate's Annual Report

7 BALANCE SHEET: EXAMPLE COLGATE-PALMOLIVE COMPANY (LIABILITIES) Copyright © 2013 CFA Institute 7 Colgate's Annual Report

8 BALANCE SHEET: EXAMPLE COLGATE-PALMOLIVE COMPANY (EQUITY) Copyright © 2013 CFA Institute 8 Colgate's Annual Report

9 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. Copyright © 2013 CFA Institute 9

10 BALANCE SHEET: EXAMPLE HENKEL AG (ASSETS) Copyright © 2013 CFA Institute 10 Henkel's Annual Report

11 BALANCE SHEET: EXAMPLE L’ORÉAL (ASSETS) Copyright © 2013 CFA Institute 11 L’Oréal's Annual Report

12 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. Copyright © 2013 CFA Institute 12

13 BALANCE SHEET: EXAMPLE BARCLAYS PLC (ASSETS) Copyright © 2013 CFA Institute 13 Barclays' Annual Report

14 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. Copyright © 2013 CFA Institute 14

15 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. Copyright © 2013 CFA Institute 15

16 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.” L’Oréal (2011), annual report Copyright © 2013 CFA Institute 16

17 MEASUREMENT BASES OF CURRENT ASSETS: 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. Copyright © 2013 CFA Institute 17

18 MEASUREMENT BASES OF RECEIVABLES: L’ORÉAL EXAMPLE Based on the note below, what percentage of its receivables did L’Oréal estimate will be uncollectible? Copyright © 2013 CFA Institute 18 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%.

19 MEASUREMENT BASIS OF CURRENT ASSETS: INVENTORY Goods Purchased Beginning Inventory Goods Available for Sale Ending Inventory Cost of Goods Sold Balance SheetIncome Statement Inventory Cost Flow Copyright © 2013 CFA Institute 19

20 MEASUREMENT BASES OF CURRENT ASSETS: INVENTORY 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. Reversals of prior write-downs are NOT allowed. Permits last in, first out (LIFO). IFRS 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 can be made and recognized in income. Does not permit LIFO. Copyright © 2013 CFA Institute 20

21 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 asset’s 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. Copyright © 2013 CFA Institute 21

22 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. Copyright © 2013 CFA Institute 22

23 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 [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.’” Copyright © 2013 CFA Institute 23 Portugal Telecom (2011), Form 20-F, note 37.4

24 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). Copyright © 2013 CFA Institute 24

25 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. Copyright © 2013 CFA Institute 25

26 MEASUREMENT BASES OF FINANCIAL ASSETS Copyright © 2013 CFA Institute 26 Financial Assets Measured at Fair Value 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 Measured at Amortized Cost: - Held-to-Maturity - Debt Instruments

27 COMMON TYPES OF CURRENT LIABILITIES Trade payables, also known as accounts payable: Amounts that a company owes its vendors for purchases of goods and services—in other words, the unpaid amounts of the company’s 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 company’s 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. Copyright © 2013 CFA Institute 27

28 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 company’s income as reported for tax purposes (taxable income) and income as reported for financial statement purposes (reported income). Copyright © 2013 CFA Institute 28

29 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) Copyright © 2013 CFA Institute 29

30 BALANCE SHEET: EXAMPLE L’ORÉAL (EQUITY AND LIABILITIES) Copyright © 2013 CFA Institute 30 L'Oréal Annual Report

31 ANALYSIS OF BALANCE SHEETS Liquidity -A company’s ability to meet its short-term financial commitments. -Assessment focus: The company’s ability to convert assets to cash and to pay for operating needs. Solvency -A company’s ability to meet its financial obligations over the longer term. -Assessment focus: The company’s financial structure and its ability to pay long-term financing obligations. Analytical Tools -Common-size analysis. -Balance sheet ratios. Copyright © 2013 CFA Institute 31

32 COMMON-SIZE BALANCE SHEETS Copyright © 2013 CFA Institute 32 ($ thousands)ABC ASSETS Cash, cash equivalents, marketable securities1, ,300 Accounts receivable5001,0501,500 Inventory Total current assets2,5002,2005,100 Property, plant, and equipment, net750 4,650 Goodwill03000 Total assets3,250 9,750 LIABILITIES AND EQUITY Accounts payable02, Total current liabilities02, Long-term bonds payable10 9,000 Total liabilities102,5109,600 Total shareholders’ equity3, Total liabilities and shareholders’ equity3,250 9,750

33 COMMON-SIZE BALANCE SHEETS Copyright © 2013 CFA Institute 33 (percent of total assets)ABC ASSETS Cash, cash equivalents, marketable securities58.46%6.15%33.85% Accounts receivable15.38%32.31%15.38% Inventory3.08%29.23%3.08% Total current assets76.92%67.69%52.31% Property, plant, and equipment, net23.08% 47.69% Goodwill0.00%9.23%0.00% Total assets100.00% LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable0.00%76.92%6.15% Total current liabilities0.00%76.92%6.15% Long-term bonds payable0.31% 92.31% Total liabilities0.31%77.23%98.46% Total shareholders’ equity99.69%22.77%1.54% Total liabilities and shareholders’ equity100.00%

34 COMMON-SIZE BALANCE SHEETS Copyright © 2013 CFA Institute 34 (percent of total assets)ABC ASSETS Cash, cash equivalents, marketable securities58%6%34% Accounts receivable15%32%15% Inventory3%29%3% Total current assets77%68%52% Property, plant, and equipment, net23% 48% Goodwill0%9%0% Total assets100% LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable0%77%6% Total current liabilities0%77%6% Long-term bonds payable0% 92% Total liabilities0%77%98% Total shareholders’ equity100%23%2% Total liabilities and shareholders’ equity100%

35 BALANCE SHEET RATIOS: LIQUIDITY RATIOS RatioCalculation CurrentCurrent assets /Current liabilities Quick (acid test) (Cash + Marketable securities + Receivables) / Current liabilities Cash (Cash + Marketable securities) / Current liabilities Copyright © 2013 CFA Institute 35 Liquidity ratios indicate a company’s ability to meet current liabilities.

36 BALANCE SHEET RATIOS: SOLVENCY RATIOS RatioCalculation Long-term debt to equity Total long-term debt  Total equity Debt to equity Total debt  Total equity Total debt (also known as debt to assets) Total debt  Total assets Debt to capital Total debt  (Total debt + Total equity) Financial leverage Total assets  Total equity Copyright © 2013 CFA Institute 36 Solvency ratios indicate financial risk and financial leverage and a company’s ability to meet its financial obligations over time.

37 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. Copyright © 2013 CFA Institute 37


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