Chapter 5 Understanding Balance Sheets

Chapter 5 Understanding Balance Sheets
Presenter’s name Presenter’s title dd Month yyyy Customization notes: Hyperlinks to the annual reports of companies used in this presentation are provided at the bottom of certain pages. If the presenter saves the annual report to the same computer drive on which the PowerPoint presentation is saved, clicking the hyperlink will take the presenter to the annual report. Note also that the relevant items are bookmarked in each annual report PDF. To navigate to the bookmarked pages, select the bookmark icon once the PDF is open (2nd down on far left of screen when PDF is opened). LEARNING OUTCOMES Describe the elements of the balance sheet: assets, liabilities, and equity. Describe uses and limitations of the balance sheet in financial analysis. Describe alternative formats of balance sheet presentation. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Describe different types of assets and liabilities and the measurement bases of each. Describe the components of shareholders’ equity. Analyze balance sheets and statements of changes in equity. Convert balance sheets to common-size balance sheets and interpret the common-size balance sheets. Calculate and interpret liquidity and solvency ratios.

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 LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. Pages 193–195 The balance sheet is also called the statement of financial position or statement of financial condition. IFRS uses the term “statement of financial position” (IAS 1, Presentation of Financial Statements), although U.S. GAAP uses the two terms interchangeably (ASC [Balance Sheet–Overall–Overview and Background]). The balance sheet discloses what an entity owns (or controls), what it owes, and what the owners’ claims are at a specific point in time. The equation A = L + E is sometimes summarized as follows: The left side of the equation reflects the resources controlled by the company, and the right side reflects how those resources were financed. Copyright © 2013 CFA Institute

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. LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. Pages 193–195 The financial position of a company is described in terms of its basic elements (assets, liabilities, and equity): Assets (A) are what the company owns (or controls). More formally, assets are 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) are what the company owes. More formally, liabilities represent 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. Commonly known as shareholders’ equity or owners’ equity, equity is determined by subtracting the liabilities from the assets of a company. Equations: A – L = E and A = L + E Depending on the sophistication of the audience, the presenter could use the concept that a company’s equity is analogous to an individual’s net worth: total assets minus total liabilities. For all financial statement items, an item should only be recognized in the financial statements if it is probable that any future economic benefit associated with the item will flow to or from the entity and if the item has a cost or value that can be measured with reliability. Copyright © 2013 CFA Institute

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). LOS. Describe uses and limitations of the balance sheet in financial analysis. Pages 193–195 The balance sheet provides important information about a company’s financial condition, but the 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 for several reasons. First, the balance sheet under current accounting standards is a mixed model with respect to measurement. Some assets and liabilities are measured based on historical cost, sometimes with adjustments, whereas other assets and liabilities are measured based on a current value. The measurement bases may have a significant effect on the amount reported. Second, even the items measured at current value reflect the value that was current at the end of the reporting period. The values of those items obviously can change after the balance sheet is prepared. Third, the value of a company is a function of many factors, including future cash flows expected to be generated by the company and current market conditions. Important aspects of a company’s ability to generate future cash flows—for example, its reputation and management skills—are not included in its balance sheet. Copyright © 2013 CFA Institute

Balance sheet: example Colgate-Palmolive company (assets)
LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. Pages 194–197 This slide shows the assets portion of the balance sheet of Colgate-Palmolive. The assets are typical for a manufacturer: cash; receivables; inventories; property, plant, and equipment; goodwill; and intangibles. We will examine the main types of assets in later slides. Asset composition of firms varies depending on industry. Colgate's Annual Report Copyright © 2013 CFA Institute

Balance sheet: example Colgate-Palmolive company (liabilities)
LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. Pages 194–197 This slide shows the liabilities portion of the balance sheet of Colgate-Palmolive. The types of liabilities are typical for most companies: accounts payable, notes payable, long-term debt (payable), and accrued income taxes (payable). Colgate's Annual Report Copyright © 2013 CFA Institute

Balance sheet: example Colgate-Palmolive company (equity)
LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. Pages 194–197 This slide shows the equity portion of the balance sheet of Colgate-Palmolive. Total equity ($2,541) equals total assets ($12,724) minus total liabilities ($10,183). We will examine the main components of equity in later slides. Colgate's Annual Report Copyright © 2013 CFA Institute

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. LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 195–199 A company’s ability to pay for its short-term operating needs relates to the concept of liquidity. With respect to a company overall, liquidity refers to the availability of cash to meet those short-term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.” A liquid asset is one that can be easily converted into cash in a short period of time at a price close to fair market value. For example, a small holding of an actively traded stock is much more liquid than an asset like a commercial real estate property in a weak property market. Ordering according to liquidity: In general, financial statements prepared in accordance with IFRS present balance sheet information in the reverse order of liquidity compared with U.S. GAAP. For example, using IFRS, assets are presented starting with noncurrent assets followed by current assets, and equity is presented first, followed by noncurrent liabilities and current liabilities. IFRS does not prescribe the reverse ordering. IAS 1, Presentation of Financial Statements, Paragraph 57: “This Standard does not prescribe the order or format in which an entity presents items.” Copyright © 2013 CFA Institute

Balance sheet: example Henkel AG (assets)
LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 195–199 This slide shows the asset portion of the balance sheet of Henkel AG & Co., a German company that prepares its financial statements under IFRS. Henkel has laundry and home care, cosmetics/toiletries, and adhesive technologies businesses. The company has numerous well-known brands, including Persil, Purex, and Dial. Henkel’s balance sheet illustrates the following differences from Colgate’s balance sheet: It illustrates the ordering of assets from least liquid to most liquid, with noncurrent intangible assets at the top and cash at the bottom. It uses the title “consolidated statement of financial position” rather than balance sheet. It presents the older year 2010 to the left of the more recent year 2011. It supplies the number of the relevant footnote on the face of the balance sheet. It presents additional columns showing each line item of assets as a percentage of total assets. Henkel's Annual Report Copyright © 2013 CFA Institute

Balance sheet: example L’ORÉAL (assets)
LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 195–199 This slide shows the asset portion of the balance sheet of L’Oréal SA, a French cosmetics company that prepares its financial statements under IFRS. L’Oréal’s balance sheet illustrates the following differences from Colgate’s and Henkel’s balance sheets: Like Henkel and different from Colgate, L’Oréal’s balance sheet orders assets from least liquid to most liquid, with noncurrent intangible assets at the top and cash at the bottom. Like Colgate and different from Henkel, it uses the title “balance sheet” rather than “consolidated statement of financial position.” Like Colgate and different from Henkel, it presents the most recent year in the left-most column. Like Colgate and different from Henkel, it presents the older year 2010 to the left of the more recent year 2011. Like Henkel and different from Colgate, it supplies the number of the relevant footnote on the face of the balance sheet. L’Oréal’s balance sheet also illustrates the requirement under IFRS for a third balance sheet (and related notes) as of the beginning of the earliest comparative period presented when an entity restates its financial statements. L’Oréal's Annual Report Copyright © 2013 CFA Institute

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. LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 195–199 The definition of current/noncurrent is provided later. The separate presentation of current and noncurrent assets and liabilities enables an analyst to examine a company’s liquidity position (at least as of the end of the fiscal period). Both IFRS and U.S. GAAP require that the balance sheet distinguish between current and noncurrent assets and between current and noncurrent liabilities and present these as separate classifications. A balance sheet with separately classified current and noncurrent assets and liabilities is referred to as a classified balance sheet. An exception to this requirement, under IFRS, is that the current and noncurrent classifications are not required if a liquidity-based presentation provides reliable and more relevant information. IAS 1, paragraph 60: “An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance with paragraphs 66–76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity.” All three of the companies featured in the previous examples show a subtotal for current assets and current liabilities. Copyright © 2013 CFA Institute

Balance sheet: example Barclays plc (assets)
LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 195–199 Both IFRS and U.S. GAAP require that the balance sheet distinguish between current and noncurrent assets and between current and noncurrent liabilities and present these as separate classifications. An exception to this requirement, under IFRS, is that the current and noncurrent classifications are not required if a liquidity-based presentation provides reliable and more relevant information. IAS 1, paragraph 60: “An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance with paragraphs 66–76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity.” All three of the companies featured in the previous examples show a subtotal for current assets and current liabilities. This slide shows the asset portion of the balance sheet of Barclays PLC (Barclays), a U.K.-headquartered global financial services provider engaged in retail banking, credit cards, wholesale banking, investment banking, wealth management, and investment management services. Barclays reports under IFRS. The balance sheet illustrates a liquidity-based presentation. Barclays' Annual Report Copyright © 2013 CFA Institute

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. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 197–198 Assets held primarily for the purpose of trading or 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 are classified as current assets. A company’s operating cycle is the average amount of time that elapses between acquiring inventory and collecting the cash from sales to customers. For a manufacturer, this is the average amount of time between acquiring raw materials and converting these into cash from a sale. Examples of companies that might be expected to have operating cycles longer than one year include those operating in the tobacco, distillery, and lumber industries. Even though these types of companies often hold inventories longer than one year, the inventory is classified as a current asset because it is expected to be sold within an operating cycle. Assets not expected to be sold or used up within one year or one operating cycle of the business, whichever is greater, are classified as noncurrent (or long-term or long-lived) assets. Current assets are generally maintained for operating purposes, and these assets include, in addition to cash, items expected to be converted into cash (e.g., trade receivables), used up (e.g., office supplies, prepaid expenses), or sold (e.g., inventories) in the current period. Current assets provide information about the operating activities and the operating capability of the entity. For example, the item “trade receivables” or “accounts receivable” would indicate that a company provides credit to its customers. Noncurrent assets represent the infrastructure from which the entity operates and are not consumed or sold in the current period. Investments in such assets are made from a strategic and longer-term perspective. Similarly, liabilities expected to be settled within one year or within one operating cycle of the business, whichever is greater, after the reporting period are classified as current liabilities. The specific criteria for classification of a liability as current include the following: It is expected to be settled in the entity’s normal operating cycle. It is held primarily for the purpose of being traded. It is due to be settled within one year after the balance sheet date. The entity does not have an unconditional right to defer settlement of the liability for at least one year after the balance sheet date. IFRS specify that some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entity’s normal operating cycle. Such operating items are classified as current liabilities even if they will be settled more than one year after the balance sheet date. When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be one year. All other liabilities are classified as noncurrent liabilities. Noncurrent liabilities include financial liabilities that provide financing on a long-term basis. The excess of current assets over current liabilities is called “working capital.” The level of working capital tells analysts something about the ability of an entity to meet liabilities as they fall due. Although adequate working capital is essential, working capital should not be too large because funds may be tied up that could be used more productively elsewhere. Copyright © 2013 CFA Institute

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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 200–201 Accounting standards require that certain specific line items, if they are material, must be shown on a balance sheet. Among the current assets’ required line items are cash and cash equivalents, trade and other receivables, inventories, and financial assets (with short maturities). Companies present other line items as needed, consistent with the requirements to separately present each material class of similar items. Cash and Cash Equivalents. Cash and cash equivalents are financial assets. Financial assets, in general, are measured and reported at either amortized cost or fair value. Amortized cost is the historical cost (initially recognized cost) of the asset adjusted for amortization and impairment. Under IFRS, fair value is the amount at which an asset could be exchanged or a liability settled in an arm’s length transaction between knowledgeable and willing parties. Under U.S. GAAP, the definition is similar but it is based on an exit price, the price received to sell an asset or paid to transfer a liability, rather than an entry price. For cash and cash equivalents, amortized cost and fair value are likely to be immaterially different. Examples of cash equivalents are demand deposits with banks and highly liquid investments (such as U.S. Treasury bills, commercial paper, and money market funds) with original maturities of three months or less. Cash and cash equivalents excludes amounts that are restricted in use for at least 12 months. For all companies, the statement of cash flows presents information about the changes in cash over a period. Copyright © 2013 CFA Institute

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 LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 200–201 This slide presents example disclosures regarding cash and cash equivalents. The Procter & Gamble disclosure states that the company records cash equivalents at cost. The L’Oréal disclosure illustrates the measurement of cash equivalents at market value. 1.20. 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. Investments in shares and cash, which are held in an account blocked for more than three months, cannot be recorded under cash and are presented under Other current assets. Bank overdrafts are considered to be financing and are presented in Current borrowings and debt. 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. Copyright © 2013 CFA Institute

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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 201–203 Trade receivables, or accounts receivable, are another type of financial asset. These are amounts owed to a company by its customers for products and services already delivered. They are typically reported at net realizable value, an approximation of fair value, based on estimates of collectability. Several aspects of accounts receivable are usually relevant to an analyst. First, the overall level of accounts receivable relative to sales (a topic to be addressed further in ratio analysis) is important because a significant increase in accounts receivable relative to sales could signal that the company is having problems collecting cash from its customers. Second, the allowance for doubtful accounts reflects the company’s estimate of amounts that will ultimately be uncollectible. Additions to the allowance in a particular period are reflected as bad debt expenses, and the balance of the allowance for doubtful accounts reduces the gross receivables amount to a net amount that is an estimate of fair value. When specific receivables are deemed to be uncollectible, they are written off by reducing accounts receivable and the allowance for doubtful accounts. The allowance for doubtful accounts is called a contra asset account because it is netted against (i.e., reduces) the balance of accounts receivable, which is an asset account. The age of an accounts receivable balance refers to the length of time the receivable has been outstanding, including how many days past the due date. Another relevant aspect of accounts receivable is the concentration of credit risk. For example, a company’s credit risk is more limited when it has a large number of customers diversified across various industries and countries versus only one or a few customers accounting for a large percent of either revenue or receivables. Copyright © 2013 CFA Institute

Measurement bases of receivables: L’ORÉAL Example
Based on the note below, what percentage of its receivables did L’Oréal estimate will be uncollectible? LOS. Describe different types of assets and liabilities and the measurement bases of each. LOS. Analyze balance sheets and statements of changes in equity. Pages 201–203, 227–229 This example illustrates valuation of accounts receivable net of allowance for doubtful accounts (i.e., estimated uncollectible amounts). This example also illustrates analysis relating the amount of allowance to the amount of gross receivables. The amount of allowance for doubtful accounts is related to bad debt expense and thus to reported net income. Bad debt expense is an expense of the period, based on a company’s estimate of the percentage of credit sales in the period, for which cash will ultimately not be collected. The allowance for bad debts is a contra asset account, which is netted against the asset accounts receivable. To record the estimated bad debts, a company recognizes a bad debt expense (which affects net income) and increases the balance in the allowance for doubtful accounts by the same amount. To record the write-off of a particular account receivable, a company reduces the balance in the allowance for doubtful accounts and reduces the balance in accounts receivable by the same amount. L’Oréal’s allowance decreased as a percentage of gross receivables over the past three years. In general, some factors that could cause a company’s allowance for doubtful accounts to decrease as a percentage of accounts receivable include the following: Improvements in the credit quality of the company’s existing customers (whether driven by a customer-specific improvement or by an improvement in the overall economy); Stricter credit policies (for example, refusing to allow less creditworthy customers to make credit purchases and instead requiring them to pay cash, to provide collateral, or to provide some additional form of financial backing); and/or Stricter risk management policies (for example, buying more insurance against potential defaults). In addition to these business factors, because the allowance is based on management’s estimates of collectability, management can potentially bias these estimates to manipulate reported earnings. L’Oréal’s note further discloses that its “Group policy is to recommend credit insurance coverage as far as local conditions allow. The non-collection risk on trade receivables is therefore minimized, and this is reflected in the level of the allowance, which is less than 2% of gross receivables.” Elsewhere in the annual report, L’Oréal’s discussion of risk notes that “due to the large number and variety of distribution channels at worldwide level, the likelihood of occurrence of significant damage on the scale of the Group remains limited. The 10 largest customers/distributors represent around 18% of the Group’s sales.” 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%. Copyright © 2013 CFA Institute

Measurement basis of current assets: Inventory
Inventory Cost Flow Beginning Inventory Ending Inventory Goods Available for Sale Goods Purchased Cost of Goods Sold LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 203–206 This slide illustrates the cost flow of inventory for a company that purchases inventory items for resale (e.g., a wholesaler or retailer). It illustrates that the measurement basis of inventory on the balance sheet is directly related to measurement of cost of goods sold on the income statement. During the period, the company purchases goods, which are added to its beginning inventory. Beginning inventory plus purchases equals goods available for sale. As the goods are sold and revenues are recognized, the cost of goods sold will be removed from inventory and recorded as an expense. Any items not sold during the period remain in ending inventory. Balance Sheet Income Statement Copyright © 2013 CFA Institute

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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 203–206 Inventory measurement is one area where differences between U.S. GAAP and IFRS are notable. Inventories are measured at the lower of cost and net realizable value under IFRS and at the lower of cost or market under U.S. GAAP. The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Net realizable value (NRV), the measure used by IFRS, is the estimated selling price less the estimated costs of completion and costs necessary to make the sale. Under U.S. GAAP, market value is defined as current replacement cost but with upper and lower limits: It cannot exceed NRV and cannot be lower than NRV less a normal profit margin. If the net realizable value (under IFRS) or market value (under U.S. GAAP) of a company’s inventory falls below its carrying amount, the company must write down the value of the inventory. The loss in value is reflected in the income statement. Under IFRS, if inventory that was written down in a previous period subsequently increases in value, the amount of the original write-down is reversed. Subsequent reversal of an inventory write-down is not permitted under U.S. GAAP. When inventory is sold, the cost of that inventory is reported as an expense, “cost of goods sold.” Accounting standards allow different valuation methods for determining the amounts that are included in cost of goods sold on the income statement and thus the amounts that are reported in inventory on the balance sheet. Inventory valuation methods are referred to as cost formulas and cost flow assumptions under IFRS and U.S. GAAP, respectively. IFRS allows only the first-in, first-out (FIFO), weighted average cost, and specific identification methods. Some accounting standards (such as U.S. GAAP) also allow the last-in, first-out (LIFO) method as an additional inventory valuation method. The LIFO method is not allowed under IFRS. Copyright © 2013 CFA Institute

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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 212–213 Property, plant, and equipment (PP&E) are tangible assets that are used in company operations and expected to be used (provide economic benefits) over more than one fiscal period. Examples of tangible assets treated as property, plant, and equipment include land, buildings, equipment, machinery, furniture, and natural resources, such as mineral and petroleum resources. IFRS permit companies to report PP&E using either a cost model or a revaluation model. Although IFRS permit companies to use the cost model for some classes of assets and the revaluation model for others, the company must apply the same model to all assets within a particular class of assets. U.S. GAAP permit only the cost model for reporting PP&E. Under the cost model, PP&E is carried at amortized cost (historical cost less any accumulated depreciation or accumulated depletion and less any impairment losses). Historical cost generally consists of an asset’s purchase price, its delivery cost, and any other additional costs incurred to make the asset operable (such as costs to install a machine). Depreciation, and depletion, is the process of allocating (recognizing as an expense) the cost of a long-lived asset over its useful life. Land is not depreciated. Because PP&E is presented on the balance sheet net of depreciation and depreciation expense is recognized in the income statement, the choice of depreciation method and the related estimates of useful life and salvage value affect both a company’s balance sheet and income statement. Whereas depreciation is the systematic allocation of cost over an asset’s useful life, impairment losses reflect an unanticipated decline in value. Impairment occurs when the asset’s recoverable amount is less than its carrying amount, with terms defined as follows under IFRS: Recoverable amount: The higher of an asset’s fair value less cost to sell and its value in use. Fair value less cost to sell: The amount obtainable in a sale of the asset in an arm’s-length transaction between knowledgeable willing parties less the costs of the sale. Value in use: The present value of the future cash flows expected to be derived from the asset. When an asset is considered impaired, the company recognizes the impairment loss in the income statement. Reversals of impairment losses are permitted under IFRS but not under U.S. GAAP. Under the revaluation model, the reported and carrying value for PP&E is the fair value at the date of revaluation less any subsequent accumulated depreciation. Changes in the value of PP&E under the revaluation model affect equity directly or profit and loss depending upon the circumstances. Copyright © 2013 CFA Institute

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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 212–213 PP&E measurement is another area where differences between U.S. GAAP and IFRS are notable. This slide summarizes key differences. Copyright © 2013 CFA Institute

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.’” LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 212–213 This excerpt of the disclosure from Portugal Telecom, SGPS, S.A.’s FORM 20-F, for the fiscal year ended 31 December 2011, illustrates use of the revaluation model under IFRS. A more complete excerpt is provided below. Per the disclosure shown: The original revaluation of the classes of PP&E in 2008 created a revaluation reserve of more than €1 billion (a revaluation reserve is a component of shareholders’ equity). In the current year (2011), the revaluation resulted in a net reduction of €131 million, of which €126 million was recognized as comprehensive income and €5 million was recognized on the income statement as part of depreciation and amortization. 3 Significant accounting policies, judgments and estimates c) Tangible assets In 2008, Portugal Telecom changed the accounting policy regarding the measurement of real estate properties and ducts infra-structure from the cost model to the revaluation model, since it believes the latter better reflects the economic value of those asset classes, given the nature of the assets revalued, which are not subject to technological obsolescence. The increase in tangible assets resulting from the revaluation reserves, which are non-distributable reserves, is being amortized in accordance with the criteria used to amortize the revalued assets. Portugal Telecom has adopted the policy to revise the revalued amount every 3 years. The remaining tangible assets are stated at acquisition cost, net of accumulated depreciation, investment subsidies and accumulated impairment losses, if any 37.4. Revaluations 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 (Note 3). The revaluations of the real estate properties and ducts infra-structure were effective as at 30 June 2008 and 30 September 2008, and resulted in a revaluation of the assets by Euro 208,268,320 and 866,764,702, respectively, totaling an amount of Euro 1,075,033,022 that was recognized in the Consolidated Statement of Comprehensive Income. In accordance with the Group’s accounting policy to revalue these assets at least every three years, Portugal Telecom performed another revaluation of the real estate assets and ducts infrastructure in the year ended 31 December 2011, through the same methodology described above. These revaluations were effective as at 31 December 2011 and resulted 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 Copyright © 2013 CFA Institute

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). LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 213–217 Intangible assets - For example: Patent: Exclusive right to a product or process, granted by the government to an inventor for a limited time. License: Exclusive right to perform some activity, typically granted by a government to the purchaser of a license for a limited time. Trademark: Exclusive right to word, name, symbol, or device that distinguish goods and services from those manufactured or sold by others. Can be renewed forever as long as it is being used in commerce. Goodwill: Not a separately identifiable asset. Arises when a company acquires another company for a price in excess of fair market value of net identifiable assets acquired. IFRS allow companies to report intangible assets using either a cost model or a revaluation model. The revaluation model can only be selected when there is an active market for an intangible asset so that fair value can be determined by reference to an active market. Such active markets are expected to be uncommon for intangible assets. Examples where they might exist are for some types of licenses (fishing licenses, taxi licenses). U.S. GAAP permit only the cost model. For each intangible asset, a company assesses whether the useful life of the asset is finite or indefinite. Indefinite life: No foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. Finite life: A limited period of benefit to the entity. Amortization and impairment principles apply as follows: An intangible asset with a finite useful life Is amortized on a systematic basis over the best estimate of its useful life, with the amortization method and useful life estimate reviewed at least annually. Impairment principles for an intangible asset with a finite useful life are the same as for PPE. An intangible asset with an indefinite useful life Is not amortized. Instead, at least annually, the reasonableness of assuming an indefinite useful life for the asset is reviewed and the asset is tested for impairment. Note that under U.S. GAAP, ASU changed the requirements for a quantitative assessment of impairment for indefinite-lived intangible assets. Previous guidance required a company to test for impairment on at least an annual basis by comparing the asset’s carrying value with its estimated fair value. The new Accounting Standards Update issued in July 2012 provides that a company can first “assess qualitative factors to determine whether it is more likely than not [defined as > 50%] that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test.” This new guidance is similar to that for goodwill impairment testing in ASU issued in September In other words, if a company determines qualitatively that impairment is not more than 50%, it does not have to undertake quantitative tests (i.e., it has the option to forego an annual calculation of the fair value of an indefinite-lived intangible asset). If an intangible asset is deemed to be impaired, an impairment loss is charged against income in the current period. An impairment loss reduces current earnings. An impairment loss also reduces total assets, so some performance measures, such as return on assets (net income divided by average total assets), may actually increase in future periods. An impairment loss is a noncash item. Copyright © 2013 CFA Institute

Measurement bases of noncurrent assets: 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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 216–219 When one company acquires another, if the purchase price is greater than the acquirer’s interest in the fair value of the identifiable assets and liabilities acquired, the excess is described as goodwill and is recognized as an asset. Why might an acquirer pay more to purchase a company than the fair value of the target company’s identifiable assets net of liabilities? First, as noted, certain items not recognized in a company’s own financial statements (e.g., its reputation, established distribution system, trained employees) have value. Second, a target company’s expenditures in research and development may not have resulted in a separately identifiable asset that meets the criteria for recognition but nonetheless may have created some value. Third, part of the value of an acquisition may arise from strategic positioning versus a competitor or from perceived synergies. For example, the acquisition might have been aimed at protecting the value of all of the acquirer’s own existing assets. Accounting goodwill is not the same as economic goodwill. Accounting goodwill is based on accounting standards and is reported only in the case of acquisitions. Economic goodwill is based on the economic performance of the entity, and it is not necessarily reflected on the balance sheet. Instead, economic goodwill is reflected in the stock price (at least in theory). Some financial statement users believe that goodwill should not be listed on the balance sheet because it cannot be sold separately from the entity. Other financial statement users analyze goodwill and any subsequent impairment charges to assess management’s performance on prior acquisitions. Under both IFRS and U.S. GAAP, accounting goodwill arising from acquisitions is capitalized. Goodwill is not amortized but is tested for impairment. Requirements are similar to those for indefinite-lived, separately identifiable intangible assets described on the previous slide. If goodwill is deemed to be impaired, an impairment loss is charged against income in the current period. An impairment loss reduces current earnings. An impairment loss also reduces total assets, so some performance measures, such as return on assets (net income divided by average total assets), may actually increase in future periods. An impairment loss is a noncash item. Copyright © 2013 CFA Institute

Measurement bases of 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 LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 219–222 Here, financial assets refers to a company’s investments in stocks issued by another company or its investments in the notes, bonds, or other fixed-income instruments issued by another company (or issued by a governmental entity). This discussion pertains to investments where ownership does not give the investor control (which would require consolidation) or significant influence (which would require equity method accounting). In general, there are two basic alternative ways that financial instruments are measured: Fair value: the price that would be received to sell an asset or paid to transfer a liability. Amortized cost: the amount at which an asset was initially recognized, minus any principal repayments, plus or minus any amortization of discount or premium, and minus any reduction for impairment. Financial assets are measured at amortized cost if the asset’s cash flows occur on specified dates and consist solely of principal and interest, and the business model is to hold the asset to maturity. This category of asset is referred to as held-to-maturity. Examples include An investment in a long-term bond issued by another company; for example, the value of the bond will fluctuate with interest rate movements, but if the bond is classified as held-to-maturity, it will be measured at amortized cost. A loan to another company. Financial assets not measured at amortized cost are measured at fair value. How are any unrealized net changes in fair value recognized? Two alternatives are as profit or loss on the income statement, or as other comprehensive income (loss), which bypasses the income statement. Note that these alternatives refer to unrealized changes in fair value (i.e., changes in the value of a financial asset that has not been sold and is still owned at the end of the period). Unrealized gains and losses are also referred to as holding period gains and losses. If a financial asset is sold within the period, a gain is realized if the selling price is greater than the carrying value and a loss is realized if the selling price is less than the carrying value. When a financial asset is sold, any realized gain or loss is reported on the income statement. The category of held for trading (or “trading securities” under U.S. GAAP) refers to a category of financial assets that is acquired primarily for the purpose of selling in the near term. Such assets are likely to be held only for a short period of time. measured at fair value, and any unrealized holding gains or losses are recognized as profit or loss on the income statement. The category of financial assets measured at fair value, with any unrealized holding gains or losses recognized in other comprehensive income, are referred to as available-for-sale assets under U.S. GAAP. They are not trading assets, but they are available to be sold. referred to as “financial assets measured at fair value through other comprehensive income” under IFRS. At the time a company buys an equity investment that is not held for trading, the company is permitted to make an irrevocable election to measure the asset in this manner. The relevant section is Paragraph of IFRS 9, Financial Instruments: “At initial recognition, an entity may make an irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument within the scope of this IFRS that is not held for trading.” Copyright © 2013 CFA Institute

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. LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 207–210 Some of the common types of current liabilities include trade payables, financial liabilities, accrued expenses, and deferred income. 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. An issue relevant to analysts is the trend in overall levels of trade payables relative to purchases (a topic to be addressed further in ratio analysis). Significant changes in accounts payable relative to purchases could signal potential changes in the company’s credit relationships with its suppliers. Notes payable: Financial liabilities owed by a company to creditors, including trade creditors and banks, through a formal loan agreement. Any notes payable, loans payable, or other financial liabilities that are due within one year (or the operating cycle, whichever is longer) appear in the current liability section of the balance sheet. In addition, any portions of long-term liabilities that are due within one year (i.e., the current portion of long-term liabilities) are shown in the current liability section of the balance sheet. Accrued expenses: Also called “accrued expenses payable,” “accrued liabilities,” and “other nonfinancial liabilities.” Expenses that have been recognized on a company’s income statement but that have not yet been paid as of the balance sheet date. Examples include income taxes payable, accrued interest payable, accrued warranty costs, and accrued employee compensation (i.e., wages payable). Deferred income: Also called “deferred revenue” and “unearned revenue.” Income that arises when a company receives payment in advance of delivery of the goods and services associated with the payment. The company has an obligation either to provide the goods or services or to return the cash received. Examples include lease payments received at the beginning of a lease, fees for servicing office equipment received at the beginning of the service period, and payments for magazine subscriptions received at the beginning of the subscription period. Copyright © 2013 CFA Institute

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). LOS. Describe different types of assets and liabilities and the measurement bases of each. Pages 223–224 Two common types of noncurrent liabilities are long-term financial liabilities and deferred tax 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). They are usually reported at amortized cost on the balance sheet. At maturity, the amortized cost of the bond (carrying amount) will be equal to the face value of the bond. Example 1: If a company issues $10,000,000 of bonds at par, the bonds are reported as a long-term liability of $10 million. The carrying amount (amortized cost) from issue to maturity remains at $10 million. Example 2: If a company issues $10,000,000 of bonds at a price of (a discount to par), the bonds are reported as a liability of $9,750,000. Over the bond’s life, the discount of $250,000 is amortized so that the bond will be listed as a liability of $10,000,000 at maturity. Similarly, any bond premium would be amortized for bonds issued at a price in excess of face or par value. In certain cases, liabilities, such as bonds, issued by a company are reported at fair value. Those cases include financial liabilities held for trading, derivatives that are a liability to the company, and some nonderivative instruments, such as those that are hedged by derivatives. Deferred tax liabilities are amounts of income taxes payable in future periods with respect of taxable temporary differences. They 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). They result when taxable income and the actual income tax payable in a period based on it is less than the reported financial statement income before taxes and the income tax expense based on it. They typically arise when items of expense are included in taxable income in earlier periods than for financial statement net income. The difference between taxes payable and income tax expense results in a deferred tax liability. For example, when companies use accelerated depreciation methods for tax purposes and straight-line depreciation methods for financial statement purposes, taxable income is less than income before taxes in the earlier periods. Copyright © 2013 CFA Institute

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) LOS. Describe the components of shareholders’ equity. Pages 225–229 Capital contributed by owners: Also known as common stock or issued capital. The amount contributed to the company by owners. Ownership of a corporation is evidenced through the issuance of common shares. Common shares may have a par value (or stated value) or may be issued as no par shares (depending on regulations governing the incorporation). Disclosures for each class of share issued by the company: Par or stated value, if one exists. Number of shares authorized: The number of shares that may be sold by the company under its articles of incorporation. Number of shares issued: The number of shares that have been sold to investors. Number of shares outstanding: The number of issued shares less treasury shares. Preferred shares: Shares that have rights that take precedence over the rights of common shareholders. Preferential rights generally pertain to receipt of dividends and receipt of assets if the company is liquidated. Classified as equity or financial liabilities based upon their characteristics rather than legal form. perpetual, nonredeemable preferred shares are classified as equity. preferred shares with mandatory redemption at a fixed amount at a future date are classified as financial liabilities. Treasury shares (treasury stock or own shares repurchased): Shares in the company that have been repurchased by the company and are held as treasury shares rather than being cancelled. A company is able to sell (reissue) these shares. A company may repurchase its shares when management considers the shares undervalued, it needs shares to fulfill employees’ stock options, or it wants to limit the effects of dilution from various employee stock compensation plans. A purchase of treasury shares reduces shareholders’ equity by the amount of the acquisition cost and reduces the number of total shares outstanding. If treasury shares are subsequently reissued, a company does not recognize any gain or loss from the reissuance on the income statement. Treasury shares are nonvoting and do not receive any dividends declared by the company. Retained earnings: The cumulative amount of earnings recognized in the company’s income statements that have not been paid to the owners of the company as dividends. Recall that beginning retained earnings plus net income minus dividends equals ending retained earnings. Accumulated other comprehensive income (AOCI): (also known as other reserves; for L’Oreal, “items recognized directly in equity”) the cumulative amount of other comprehensive income or loss. Other comprehensive income refers to income that is not recognized on the income statement. Recall that beginning AOCI + Other comprehensive income = Ending AOCI. Noncontrolling interest (or minority interest): The equity interests of minority shareholders in the subsidiary companies that have been consolidated by the parent (controlling) company but that are not wholly owned by the parent company. Comprehensive income is defined as “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.” FASB ASC Section [Comprehensive Income–Overall–Overview and Background]. There is no explicit definition of comprehensive income in IFRS; the implicit definition is similar to that above. IFRS define income in the glossary as “increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.” Copyright © 2013 CFA Institute

Balance sheet: example L’ORÉAL (equity and liabilities)
LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Pages 194–198 NOTES to Presenter: L’Oréal’s balance sheet illustrates some but not all of the common types of liabilities and categories of equity. Other balance sheet examples can be added to illustrate other types of liabilities and categories of equity. Also, several copies of this slide can be made, inserting one after each of the slides listing the common types of current liabilities, noncurrent liabilities, and components of equity. This slide shows the equity and liability portion of the balance sheet of L’Oréal, a French cosmetics company that prepares its financial statements under IFRS. L’Oréal’s balance sheet orders liabilities from least liquid to most liquid, with noncurrent intangible assets at the top and cash at the bottom. L'Oréal Annual Report Copyright © 2013 CFA Institute

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. LOS. Analyze balance sheets and statements of changes in equity. LOS. Convert balance sheets to common-size balance sheets and interpret the common-size balance sheets. LOS. Calculate and interpret liquidity and solvency ratios. Pages 229–239 Analysis of a company’s balance sheet can provide insight into the company’s liquidity and solvency—as of the balance sheet date—as well as the economic resources the company controls. Liquidity refers to a company’s ability to meet its short-term financial commitments. Assessments of liquidity focus on a company’s ability to convert assets to cash and to pay for operating needs. Solvency refers to a company’s ability to meet its financial obligations over the longer term. Assessments of solvency focus on the company’s financial structure and its ability to pay long-term financing obligations. Note to presenter: Depending on the sophistication of the audience, the difference between liquidity and solvency can be illustrated with an example from the perspective of individuals. One with lots of cash and/or a stream of cash flow is in a better position to pay this month’s utility bill than one with substantial but illiquid assets. Tools: common-size analysis and balance sheet ratios. Copyright © 2013 CFA Institute

common-size balance sheets
($ thousands) A B C ASSETS Cash, cash equivalents, marketable securities 1,900 200 3,300 Accounts receivable 500 1,050 1,500 Inventory 100 950 300 Total current assets 2,500 2,200 5,100 Property, plant, and equipment, net 750 4,650 Goodwill Total assets 3,250 9,750 LIABILITIES AND EQUITY Accounts payable 600 Total current liabilities Long-term bonds payable 10 9,000 Total liabilities 2,510 9,600 Total shareholders’ equity 3,240 740 150 Total liabilities and shareholders’ equity LOS. Analyze balance sheets and statements of changes in equity. LOS. Convert balance sheets to common-size balance sheets and interpret the common-size balance sheets. Pages 229–237 Common-size balance sheets show each line item on the balance sheet as a percentage of total assets. Common-size statements facilitate comparison across time periods (time-series analysis) and across companies (cross-sectional analysis) because the standardization of each line item removes the effect of size. This format can be distinguished as “vertical common-size analysis.” As the chapter on financial statement analysis discusses, there is another type of common-size analysis, which is known as “horizontal common-size analysis;” it states items in relation to a selected base year value. This discussion pertains to vertical common-size analysis. The example follows Exhibit 5-17 in the book. It presents partial income statements (through operating profit) for three hypothetical companies operating in the same industry. Compared with the exhibit in the book, some line items have been combined to fit on this slide. Company A and Company B, each with $3,250 thousand, are smaller (as measured by assets) than Company C, which has $9,750 thousand in assets. How can an analyst meaningfully compare the financial position of these companies? Copyright © 2013 CFA Institute

(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% Inventory 3.08% 29.23% Total current assets 76.92% 67.69% 52.31% Property, plant, and equipment, net 23.08% 47.69% Goodwill 0.00% 9.23% Total assets 100.00% LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable Total current liabilities Long-term bonds payable 0.31% 92.31% Total liabilities 77.23% 98.46% Total shareholders’ equity 99.69% 22.77% 1.54% Total liabilities and shareholders’ equity LOS. Analyze balance sheets and statements of changes in equity. LOS. Convert balance sheets to common-size balance sheets and interpret the common-size balance sheets. Pages 229–237 Common-size balance sheets show each line item on the balance sheet as a percentage of total assets. Common-size statements facilitate comparison across time periods (time-series analysis) and across companies (cross-sectional analysis) because the standardization of each line item removes the effect of size. This format can be distinguished as “vertical common-size analysis.” Liquidity: Current assets relative to current liabilities affect the assessment of liquidity. Company A is more liquid than Company B. For Company A, current assets are 77% of assets versus current liabilities at 0%. For Company B, current assets are 68% of assets versus current liabilities at 77%. Referring back to the dollar amounts, Company A shows no current liabilities (its current liabilities round to less than $10 thousand), and it has cash on hand and short-term marketable securities of $1.9 million to meet any near-term financial obligations it might have. In contrast, Company B has $2.5 million of current liabilities, which exceed its available cash and securities of only $200 thousand. How will Company B pay its near-term obligations? Company B will need to collect some of its accounts receivable, sell more inventory, borrow from a bank, and/or raise more long-term capital (e.g., by issuing more bonds or more equity). Company C is also more liquid than Company B. It holds more than 30% of its total assets in cash and short-term marketable securities, and its current liabilities are only 6.2% of the amount of total assets. Composition of current assets affects assessment of liquidity. Most of the assets of Company A and B are current assets; however, Company A has nearly 60% of its total assets in cash and short-term marketable securities, whereas Company B has only 6% of its assets in cash and marketable securities. Solvency: Typically assessed by examining both capital structure and coverage (ability to generate income and cash flow sufficient to cover interest and principal). Because this presentation pertains only to the balance sheet, it examines only capital structure. Company A is more solvent than Company B or C. Less than 1% of Company A’s assets are financed with liabilities. Based on these numbers, it seems very unlikely that Company A would have difficulty paying the interest and principal on its long-term bonds. 98.5% of Company C’s assets are financed with liabilities. If Company C experiences significant fluctuations in cash flows, it may be unable to pay the interest and principal on its long-term bonds. Other observations: Common-size balance sheets can also highlight differences in companies’ strategies. Comparing the asset composition of the companies, Company C has made a greater proportional investment in property, plant, and equipment—possibly because it manufacturers more of its products in-house. Company B’s balance sheet shows goodwill. This signifies that it has made one or more acquisitions in the past. In contrast, the lack of goodwill on the balance sheets of Company A and Company C suggests that these two companies may have pursued a strategy of internal growth rather than growth by acquisition. Company A’s balance sheet has relatively little inventory and no accounts payable. What could explain this composition? It either has not yet established trade credit or is in the process of paying off its obligations in the process of liquidating. It may be in either a start-up or liquidation stage of operations. Caveat: Being more liquid or more solvent does not necessarily translate into “better.” At the extreme, the most liquid and most solvent company would hold only cash as an asset and be financed only with equity (i.e., no debt), but it could not be argued that would be “best.” A wide range of factors affect a company’s liquidity management and capital structure. In practice, differences across companies are more subtle, but the concepts are similar to those illustrated here. An analyst, noting significant differences, would do more research and seek to understand the underlying reasons for the differences and their implications for the future performance of the companies. Copyright © 2013 CFA Institute

(percent of total assets) A B C ASSETS Cash, cash equivalents, marketable securities 58% 6% 34% Accounts receivable 15% 32% Inventory 3% 29% Total current assets 77% 68% 52% Property, plant, and equipment, net 23% 48% Goodwill 0% 9% Total assets 100% LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable Total current liabilities Long-term bonds payable 92% Total liabilities 98% Total shareholders’ equity 2% Total liabilities and shareholders’ equity NOTE to Presenter: This is an alternative slide identical to the previous slide but omitting decimal places. Copyright © 2013 CFA Institute

Balance sheet Ratios: liquidity ratios
Liquidity ratios indicate a company’s ability to meet current liabilities. Ratio Calculation Current Current assets /Current liabilities Quick (acid test) (Cash + Marketable securities + Receivables) / Current liabilities Cash (Cash + Marketable securities) / Current liabilities LOS. Analyze balance sheets and statements of changes in equity. LOS. Calculate and interpret liquidity and solvency ratios. Pages 229–239 Balance sheet ratios are those involving balance sheet items only. Each of the line items on a vertical common-size balance sheet is a ratio in that it expresses a balance sheet amount in relation to total assets. Other balance sheet ratios compare one balance sheet item with another. For example, the current ratio expresses current assets in relation to current liabilities as an indicator of a company’s liquidity. The current ratio expresses current assets in relation to current liabilities. It quantifies how many dollars (or whatever reporting currency) of current assets the company has to pay each dollar of current liabilities. A higher ratio indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities. A lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short-term obligations. The quick ratio expresses the more liquid current assets (sometimes referred to as “quick assets”) in relation to current liabilities. It quantifies how many dollars (or whatever reporting currency) of quick assets the company has to pay to each dollar of current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity. The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets in the numerator. The quick ratio reflects the fact that certain current assets—such as prepaid expenses, some taxes, and employee-related prepayments—represent costs of the current period that have been paid in advance and cannot usually be converted back into cash. The quick ratio also reflects the fact that inventory might not be easily and quickly converted into cash and, furthermore, that a company would probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly. In situations where inventories are illiquid (as indicated, for example, by low inventory turnover ratios), the quick ratio may be a better indicator of liquidity than the current ratio. The cash ratio expresses cash and marketable securities in relation to current liabilities. It quantifies how many dollars (or whatever reporting currency) of cash and securities the company has to pay each dollar of current liabilities. The cash ratio normally represents a reliable measure of an entity’s liquidity in a crisis situation, but in a general market crisis, the fair value of marketable securities could decrease significantly as a result of market factors, in which case even this ratio might not provide reliable information. The cash ratio reflects that there can be a time lag involved even in turning receivables into cash. Caveat: Being more liquid or more solvent does not necessarily translate into “better.” At the extreme, the most liquid and most solvent company would hold only cash as an asset and be financed only with equity (i.e., no debt), but it could not be argued that would be “best.” A wide range of factors affects a company’s liquidity management and capital structure. Copyright © 2013 CFA Institute

Balance sheet Ratios: Solvency Ratios
Solvency ratios indicate financial risk and financial leverage and a company’s ability to meet its financial obligations over time. Ratio Calculation 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 LOS. Analyze balance sheets and statements of changes in equity. LOS. Calculate and interpret liquidity and solvency ratios. Pages 229–239 This slide shows an additional solvency ratio that is presented in a subsequent chapter in the text: debt to capital. For most of these ratios, the calculation is implicit in its name. Generally, the greater the debt in a company’s capital structure, the greater the financial risk and the less “solvent.” For this class of ratio, a higher ratio indicates weaker solvency. Of the ratios listed here, only the total debt (also known as debt to assets) can be found directly on the company’s financial statements. Ratio of long-term debt to equity: Measures the amount of long-term debt capital relative to equity capital. For example, a ratio of 1.0 would indicate equal amounts of long-term debt and equity. A higher ratio indicates a higher financial risk and thus weaker solvency. Ratio of debt to equity: Measures the amount of debt capital relative to equity capital. For example, a ratio of 1.0 would indicate equal amounts of debt and equity. Debt includes both short-term debt and long-term debt. A higher ratio indicates higher financial risk and thus weaker solvency. Total debt (also known as ratio of debt to assets): Measures the percentage of total assets financed with debt. For example, a debt-to-assets ratio of 0.40 or 40% indicates that 40% of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weaker solvency. Ratio of debt to capital: Measures the percentage of a company’s capital (debt plus equity) represented by debt. A higher ratio generally means higher financial risk and thus indicates weaker solvency. Financial leverage ratio: This ratio (often called simply the “leverage ratio”) measures the amount of total assets supported for each one money unit of equity. For example, a value of 3 for this ratio means that each €1 of equity supports €3 of total assets. The higher the financial leverage ratio, the more leveraged the company is in the sense of using debt and other liabilities to finance assets. This ratio is often defined in terms of average total assets and average total equity and plays an important role in the DuPont decomposition of return on equity that will be discussed in a later chapter. Copyright © 2013 CFA Institute

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

Chapter 5 Understanding Balance Sheets

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