CHAPTER 4
Understanding Balance Sheets

Learning Outcomes

After completing this chapter, you will be able to do the following:

• 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 non-current assets and current and non-current liabilities;
• describe different types of assets and liabilities and the measurement bases of each;
• describe the components of shareholders’ equity;
• convert balance sheets to common-size balance sheets and interpret common-size balance sheets;
• calculate and interpret liquidity and solvency ratios.

Summary Overview

The balance sheet (also referred to as the statement of financial position) discloses what an entity owns (assets) and what it owes (liabilities) at a specific point in time. Equity is the owners’ residual interest in the assets of a company, net of its liabilities. The amount of equity is increased by income earned during the year, or by the issuance of new equity. The amount of equity is decreased by losses, by dividend payments, or by share repurchases.

An understanding of the balance sheet enables an analyst to evaluate the liquidity, solvency, and overall financial position of a company.

• The balance sheet distinguishes between current and non-current assets, and between current and non-current liabilities unless a presentation based on liquidity provides more relevant and reliable information.
• The concept of liquidity relates to a company’s ability to pay for its near-term operating needs. With respect to a company overall, liquidity refers to the availability of cash to pay those near-term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.”
• Some assets and liabilities are measured on the basis of fair value, and some are measured at historical cost. Notes to financial statements provide information that is helpful in assessing the comparability of measurement bases across companies.
• Assets expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as current assets. Assets not expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as non-current assets.
• Liabilities expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as current liabilities. Liabilities not expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as non-current liabilities.
• Trade receivables, also referred to as accounts receivable, are amounts owed to a company by its customers for products and services already delivered. Receivables are reported net of the allowance for doubtful accounts.
• Inventories are physical products that will eventually be sold to the company’s customers, either in their current form (finished goods) or as inputs into a process to manufacture a final product (raw materials and work-in-process). Inventories are reported at the lower of cost or net realizable value. If the net realizable value of a company’s inventory falls below its carrying amount, the company must write down the value of the inventory and record an expense.
• Inventory cost is based on specific identification or estimated using the first-in, first-out or weighted average cost methods. Some accounting standards (including US GAAP but not IFRS) also allow last-in, first-out as an additional inventory valuation method.
• Accounts payable, also called trade payables, are amounts that a business owes its vendors for purchases of goods and services.
• Deferred revenue (also known as unearned revenue) arises when a company receives payment in advance of delivery of the goods and services associated with the payment received.
• Property, plant, and equipment (PPE) are tangible assets that are used in company operations and expected to be used over more than one fiscal period. Examples of tangible assets include land, buildings, equipment, machinery, furniture, and natural resources such as mineral and petroleum resources.
• IFRS provide companies with the choice to report PPE using either a historical cost model or a revaluation model. US GAAP permit only the historical cost model for reporting PPE.
• Depreciation is the process of recognizing the cost of a long-lived asset over its useful life. (Land is not depreciated.)
• Under IFRS, property used to earn rental income or capital appreciation is considered to be an investment property. IFRS provide companies with the choice to report an investment property using either a historical cost model or a fair value model.
• Intangible assets refer to identifiable non-monetary assets without physical substance. Examples include patents, licenses, and trademarks. For each intangible asset, a company assesses whether the useful life is finite or indefinite.
• 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, it is tested for impairment at least annually.
• For internally generated intangible assets, IFRS require that costs incurred during the research phase must be expensed. Costs incurred in the development stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project.
• The most common intangible asset that is not a separately identifiable asset is goodwill, which arises in business combinations. Goodwill is not amortized; instead it is tested for impairment at least annually.
• Financial instruments are contracts that give rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. In general, there are two basic alternative ways that financial instruments are measured: fair value or amortized cost. For financial instruments measured at fair value, there are two basic alternatives in how net changes in fair value are recognized: as profit or loss on the income statement, or as other comprehensive income (loss), which bypasses the income statement.
• Typical long-term financial liabilities include loans (i.e., borrowings from banks) and notes or bonds payable (i.e., fixed-income securities issued to investors). Liabilities such as bonds issued by a company are usually reported at amortized cost on the balance sheet.
• Deferred tax liabilities arise from temporary timing differences between a company’s income as reported for tax purposes and income as reported for financial statement purposes.
• Six potential components that comprise the owners’ equity section of the balance sheet include: contributed capital, preferred shares, treasury shares, retained earnings, accumulated other comprehensive income, and non-controlling interest.
• The statement of changes in equity reflects information about the increases or decreases in each component of a company’s equity over a period.
• Vertical common-size analysis of the balance sheet involves stating each balance sheet item as a percentage of total assets.
• Balance sheet ratios include liquidity ratios (measuring the company’s ability to meet its short-term obligations) and solvency ratios (measuring the company’s ability to meet long-term and other obligations).

Problems

1. Resources controlled by a company as a result of past events are:
   1. equity.
   2. assets.
   3. liabilities.
2. Equity equals:
   1. Assets − Liabilities.
   2. Liabilities − Assets.
   3. Assets + Liabilities.
3. Distinguishing between current and non-current items on the balance sheet and presenting a subtotal for current assets and liabilities is referred to as:
   1. a classified balance sheet.
   2. an unclassified balance sheet.
   3. a liquidity-based balance sheet.
4. Shareholders’ equity reported on the balance sheet is most likely to differ from the market value of shareholders’ equity because:
   1. historical cost basis is used for all assets and liabilities.
   2. some factors that affect the generation of future cash flows are excluded.
   3. shareholders’ equity reported on the balance sheet is updated continuously.
5. The information provided by a balance sheet item is limited because of uncertainty regarding:
   1. measurement of its cost or value with reliability.
   2. the change in current value following the end of the reporting period.
   3. the probability that any future economic benefit will flow to or from the entity.
6. Which of the following is most likely classified as a current liability?
   1. Payment received for a product due to be delivered at least one year after the balance sheet date.
   2. Payments for merchandise due at least one year after the balance sheet date but still within a normal operating cycle.
   3. Payment on debt due in six months for which the company has the unconditional right to defer settlement for at least one year after the balance sheet date.
7. The most likely company to use a liquidity-based balance sheet presentation is a:
   1. bank.
   2. computer manufacturer holding inventories.
   3. software company with trade receivables and payables.
8. All of the following are current assets except:
   1. cash.
   2. goodwill.
   3. inventories.
9. The most likely costs included in both the cost of inventory and property, plant, and equipment are:
   1. selling costs.
   2. storage costs.
   3. delivery costs.
10. Debt due within one year is considered:
    1. current.
    2. preferred.
    3. convertible.
11. Money received from customers for products to be delivered in the future is recorded as:
    1. revenue and an asset.
    2. an asset and a liability.
    3. revenue and a liability.
12. An example of a contra asset account is:
    1. depreciation expense.
    2. sales returns and allowances.
    3. allowance for doubtful accounts.
13. The carrying value of inventories reflects:
    1. their historical cost.
    2. their current value.
    3. the lower of historical cost or net realizable value.
14. When a company pays its rent in advance, its balance sheet will reflect a reduction in:
    1. assets and liabilities.
    2. assets and shareholders’ equity.
    3. one category of assets and an increase in another.
15. Accrued expenses (accrued liabilities) are:
    1. expenses that have been paid.
    2. created when another liability is reduced.
    3. expenses that have been reported on the income statement but not yet paid.
16. The initial measurement of goodwill is most likely affected by:
    1. an acquisition’s purchase price.
    2. the acquired company’s book value.
    3. the fair value of the acquirer’s assets and liabilities.
17. Defining total asset turnover as revenue divided by average total assets, all else equal, impairment write-downs of long-lived assets owned by a company will most likely result in an increase for that company in:
    1. the debt-to-equity ratio but not the total asset turnover.
    2. the total asset turnover but not the debt-to-equity ratio.
    3. both the debt-to-equity ratio and the total asset turnover.
18. A company has total liabilities of £35 million and total stockholders’ equity of £55 million. Total liabilities are represented on a vertical common-size balance sheet by a percentage closest to:
    1. 35%.
    2. 39%.
    3. 64%.
19. For financial assets classified as trading securities, how are unrealized gains and losses reflected in shareholders’ equity?
    1. They are not recognized.
    2. They flow through income into retained earnings.
    3. They are a component of accumulated other comprehensive income.
20. For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity?
    1. They are not recognized.
    2. They flow through retained earnings.
    3. They are a component of accumulated other comprehensive income.
21. For financial assets classified as held to maturity, how are unrealized gains and losses reflected in shareholders’ equity?
    1. They are not recognized.
    2. They flow through retained earnings.
    3. They are a component of accumulated other comprehensive income.
22. The non-controlling (minority) interest in consolidated subsidiaries is presented on the balance sheet:
    1. as a long-term liability.
    2. separately, but as a part of shareholders’ equity.
    3. as a mezzanine item between liabilities and shareholders’ equity.
23. The item “retained earnings” is a component of:
    1. assets.
    2. liabilities.
    3. shareholders’ equity.
24. When a company buys shares of its own stock to be held in treasury, it records a reduction in:
    1. both assets and liabilities.
    2. both assets and shareholders’ equity.
    3. assets and an increase in shareholders’ equity.
25. Which of the following would an analyst most likely be able to determine from a common-size analysis of a company’s balance sheet over several periods?
    1. An increase or decrease in sales.
    2. An increase or decrease in financial leverage.
    3. A more efficient or less efficient use of assets.
26. An investor concerned whether a company can meet its near-term obligations is most likely to calculate the:
    1. current ratio.
    2. return on total capital.
    3. financial leverage ratio.
27. The most stringent test of a company’s liquidity is its:
    1. cash ratio.
    2. quick ratio.
    3. current ratio.
28. An investor worried about a company’s long-term solvency would most likely examine its:
    1. current ratio.
    2. return on equity.
    3. debt-to-equity ratio.
29. Using the information presented in Exhibit 4, the quick ratio for SAP Group at 31 December 2017 is closest to:
    1. 1.00.
    2. 1.07.
    3. 1.17.
30. Using the information presented in Exhibit 14, the financial leverage ratio for SAP Group at December 31, 2017 is closest to:
    1. 1.50.
    2. 1.66.
    3. 2.00.

Questions 31 through 34 refer to Exhibit 1.

Exhibit 1 Common-Size Balance Sheets for Company A, Company B, and Sector Average

			Company A	Company B	Sector Average
ASSETS			00	00	00
	Current assets		00	00	00
		Cash and cash equivalents00	500	500	700
		Marketable securities00	500	000	200
		Accounts receivable, net00	500	1500	1200
		Inventories00	1500	2000	1600
		Prepaid expenses00	01500	01500	01100
	Total current assets		3500	5500	4800
		Property, plant, and equipment, net00	4000	3500	3700
		Goodwill00	2500	000	800
		Other assets00	10000	01000	0700
Total assets			10000	10000	10000
		00	00	00	00
LIABILITIES AND SHAREHOLDERS’ EQUITY			00	00	00
	Current liabilities		00	00	00
		Accounts payable00	1000	1000	1000
		Short-term debt00	2500	1000	1500
		Accrued expenses00	01000	01500	01300
	Total current liabilities		3500	2500	2800
		Long-term debt00	4500	2000	2800
		Other non-current liabilities00	01000	011000	01700
	Total liabilities		8000	5500	6300
		Total shareholders’ equity00	02000	04500	03700
Total liabilities and shareholders’ equity			10000	10000	10000

31. Based on Exhibit 1, which statement is most likely correct?
    1. Company A has below-average liquidity risk.
    2. Company B has above-average solvency risk.
    3. Company A has made one or more acquisitions.
32. The quick ratio for Company A is closest to:
    1. 0.43.
    2. 0.57.
    3. 1.00.
33. Based on Exhibit 1, the financial leverage ratio for Company B is closest to:
    1. 0.55.
    2. 1.22.
    3. 2.22.
34. Based on Exhibit 1, which ratio indicates lower liquidity risk for Company A compared with Company B?
    1. Cash ratio.
    2. Quick ratio.
    3. Current ratio.