CHAPTER 4
Understanding Balance Sheets

Solutions

1. B is correct. Assets are resources controlled by a company as a result of past events.
2. A is correct. Assets = Liabilities + Equity and, therefore, Assets − Liabilities = Equity.
3. A is correct. A classified balance sheet is one that classifies assets and liabilities as current or non-current and provides a subtotal for current assets and current liabilities. A liquidity-based balance sheet broadly presents assets and liabilities in order of liquidity.
4. B is correct. The balance sheet omits important aspects of a company’s ability to generate future cash flows, such as its reputation and management skills. The balance sheet measures some assets and liabilities based on historical cost and measures others based on current value. Market value of shareholders’ equity is updated continuously. Shareholders’ equity reported on the balance sheet is updated for reporting purposes and represents the value that was current at the end of the reporting period.
5. B is correct. Balance sheet information is as of a specific point in time, and items measured at current value reflect the value that was current at the end of the reporting period. For all financial statement items, an item should be recognized in the financial statements only 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.
6. B is correct. Payments due within one operating cycle of the business, even if they will be settled more than one year after the balance sheet date, are classified as current liabilities. Payment received in advance of the delivery of a good or service creates an obligation or liability. If the obligation is to be fulfilled at least one year after the balance sheet date, it is recorded as a non-current liability, such as deferred revenue or deferred income. Payments that the company has the unconditional right to defer for at least one year after the balance sheet may be classified as non-current liabilities.
7. A is correct. A liquidity-based presentation, rather than a current/non-current presentation, may be used by such entities as banks if broadly presenting assets and liabilities in order of liquidity is reliable and more relevant.
8. B is correct. Goodwill is a long-term asset, and the others are all current assets.
9. C is correct. Both the cost of inventory and property, plant, and equipment include delivery costs, or costs incurred in bringing them to the location for use or resale.
10. A is correct. Current liabilities are those liabilities, including debt, due within one year. Preferred refers to a class of stock. Convertible refers to a feature of bonds (or preferred stock) allowing the holder to convert the instrument into common stock.
11. B is correct. The cash received from customers represents an asset. The obligation to provide a product in the future is a liability called “unearned income” or “unearned revenue.” As the product is delivered, revenue will be recognized, and the liability will be reduced.
12. C is correct. A contra asset account is netted against (i.e., reduces) the balance of an asset account. The allowance for doubtful accounts reduces the balance of accounts receivable. Accumulated depreciation, not depreciation expense, is a contra asset account. Sales returns and allowances create a contra account that reduce sales, not an asset.
13. C is correct. Under IFRS, inventories are carried at historical cost, unless net realizable value of the inventory is less. Under US GAAP, inventories are carried at the lower of cost or market.
14. C is correct. Paying rent in advance will reduce cash and increase prepaid expenses, both of which are assets.
15. C is correct. Accrued liabilities are expenses that have been reported on a company’s income statement but have not yet been paid.
16. A is correct. Initially, goodwill is measured as the difference between the purchase price paid for an acquisition and the fair value of the acquired, not acquiring, company’s net assets (identifiable assets less liabilities).
17. C is correct. Impairment write-downs reduce equity in the denominator of the debt-to-
    equity ratio but do not affect debt, so the debt-to-equity ratio is expected to increase. Impairment write-downs reduce total assets but do not affect revenue. Thus, total asset turnover is expected to increase.
18. B is correct. Vertical common-size analysis involves stating each balance sheet item as a percentage of total assets. Total assets are the sum of total liabilities (£35 million) and total stockholders’ equity (£55 million), or £90 million. Total liabilities are shown on a vertical common-size balance sheet as (£35 million/£90 million) ≍ 39%.
19. B is correct. For financial assets classified as trading securities, unrealized gains and losses are reported on the income statement and flow to shareholders’ equity as part of retained earnings.
20. C is correct. For financial assets classified as available for sale, unrealized gains and losses are not recorded on the income statement and instead are part of other comprehensive income. Accumulated other comprehensive income is a component of shareholders’ equity.
21. A is correct. Financial assets classified as held to maturity are measured at amortized cost. Gains and losses are recognized only when realized.
22. B is correct. The non-controlling interest in consolidated subsidiaries is shown separately as part of shareholders’ equity.
23. C is correct. The item “retained earnings” is a component of shareholders’ equity.
24. B is correct. Share repurchases reduce the company’s cash (an asset). Shareholders’ equity is reduced because there are fewer shares outstanding and treasury stock is an offset to owners’ equity.
25. B is correct. Common-size analysis (as presented in the chapter) provides information about composition of the balance sheet and changes over time. As a result, it can provide information about an increase or decrease in a company’s financial leverage.
26. A is correct. The current ratio provides a comparison of assets that can be turned into cash relatively quickly and liabilities that must be paid within one year. The other ratios are more suited to longer-term concerns.
27. A is correct. The cash ratio determines how much of a company’s near-term obligations can be settled with existing amounts of cash and marketable securities.
28. C is correct. The debt-to-equity ratio, a solvency ratio, is an indicator of financial risk.
29. B is correct. The quick ratio ([Cash + Marketable securities + Receivables] ÷ Current liabilities) is 1.07 ([= €4,011 + €990 + €5,899] ÷ €10,210). As noted in the text, the largest components of the current financial assets are loans and other financial receivables. Thus, financial assets are included in the quick ratio but not the cash ratio.
30. B is correct. The financial leverage ratio (Total assets ÷ Total equity) is 1.66 (= €42,497 ÷ €25,540).
31. C is correct. The presence of goodwill on Company A’s balance sheet signifies that it has made one or more acquisitions in the past. The current, cash, and quick ratios are lower for Company A than for the sector average. These lower liquidity ratios imply above-average liquidity risk. The total debt, long-term debt-to-equity, debt-to-equity, and financial leverage ratios are lower for Company B than for the sector average. These lower solvency ratios imply below-average solvency risk.

    Current ratio is (35/35) = 1.00 for Company A, versus (48/28) = 1.71 for the sector average.

    Cash ratio is (5 + 5)/35 = 0.29 for Company A, versus (7 + 2)/28 = 0.32 for the sector average.

    Quick ratio is (5 + 5 + 5)/35 = 0.43 for Company A, versus (7 + 2 + 12)/28 = 0.75 for the sector average.

    Total debt ratio is (55/100) = 0.55 for Company B, versus (63/100) = 0.63 for the sector average.

    Long-term debt-to-equity ratio is (20/45) = 0.44 for Company B, versus (28/37) = 0.76 for the sector average.

    Debt-to-equity ratio is (55/45) = 1.22 for Company B, versus (63/37) = 1.70 for the sector average.

    Financial leverage ratio is (100/45) = 2.22 for Company B, versus (100/37) = 2.70 for the sector average.

32. A is correct. The quick ratio is defined as (Cash and cash equivalents + Marketable securities + receivables) ÷ Current liabilities. For Company A, this calculation is (5 + 5 + 5)/35 = 0.43.
33. C is correct. The financial leverage ratio is defined as Total assets ÷ Total equity. For Company B, total assets are 100, and total equity is 45; hence, the financial leverage ratio is 100/45 = 2.22.
34. A is correct. The cash ratio is defined as (Cash + Marketable securities)/Current liabilities. Company A’s cash ratio, (5 + 5)/35 = 0.29, is higher than (5 + 0)/25 = 0.20 for Company B.