Chapter 6
Balancing Assets against Liabilities and Equity
In This Chapter
Defining assets, liabilities, and equity
Exploring the basics of balance sheets
Reviewing assets
Understanding liabilities
Examining equity
Picture a tightrope walker tentatively stepping along a tightrope. As if that isn’t challenging enough, imagine that the tightrope walker is carrying plates of equal weight on both sides of a wobbling rod. What would happen if one of those plates were heavier than the other? You don’t have to understand anything about physics to know it isn’t going to be a pretty sight.
Just as the tightrope walker must be in balance, so must a company’s financial position. If the assets aren’t equal to the claims against those assets, then that company’s financial position isn’t in balance, and everything topples over. In this chapter, I introduce you to the balance sheet, which gives the financial-report reader a snapshot of the company’s position at a certain point in time.
Understanding the Balance Equation
A company keeps track of its financial balance on a balance sheet, a summary of a company’s financial standing at a particular point in time. A company’s balance sheet contains the following items:
Assets: Anything the company owns, from cash to stock of products for sale, to the paper it prints the reports on.
Liabilities: Debts the company owes.
Equity: Money owed to the owners of the company, such as the cash they have put in as share capital plus the profits the company has retained.
The assets that a company owns are equal to the claims against that company, by creditors (liabilities) or owners (equity). The claims side must equal the assets side in order for the balance sheet to stay in balance. The parts always balance according to this formula:
Assets = Liabilities + Equity
As a company and its assets grow, its liabilities or equities grow in similar proportion. For example, whenever a company buys a major asset, such as a building, the company has to use another asset to pay for it, like cash in the bank, or use a combination of assets and liabilities (such as overdrafts or mortgages) or equity (owner’s money, perhaps obtained by selling more shares).
Introducing the Balance Sheet
Trying to read a balance sheet without having a grasp of its parts is a little like trying to translate a language you’ve never spoken – you may recognise the letters, but the words don’t mean much. Unlike a foreign language, however, a balance sheet is pretty easy to get a fix on as soon as you work out a few basics.
Digging into dates
The first things you should notice when looking at the financial statements are the dates at the top. You need to know on what date or during what period of time the financial statements are relevant. This information is particularly critical when you start comparing results among companies. You don’t want to compare the 2007 results of one company with the 2006 results of another company. Economic conditions are certainly different, and the comparison doesn’t give you an accurate view of how well the companies competed in similar economic conditions.
On a balance sheet, the date at the top is written after ‘as at’, meaning that the balance sheet reports a company’s financial status on that particular day. A balance sheet differs from other kinds of financial statements, such as the income statement or statement of cash flows, which show information for a period of time such as a year, a quarter, or a month. We discuss income statements in Chapter 7 and statements of cash flows in Chapter 8.
If a company’s balance sheet states ‘As at 31 December 2007’, the company is most likely operating on a calendar year. Not all companies end their business year at the end of the calendar year, however. Many companies operate on a fiscal year instead, which means the company picks a 12-month period that more accurately reflects its business cycles. For example, a number of retail companies end their fiscal year on 31 January. The best time of year for major retail sales is during the holiday season and post-holiday season, so stores close the books after those periods end. Many companies end their year at the same time as the end of the tax year – end of March or 5 April in the case of the UK.
To show you how economic conditions might make it very difficult to compare the balance sheets of two companies with two different fiscal years, we’ll use the terrorist attacks on 11 September 2001. If one company reports its fiscal year from 1 September to 31 August, and another company reports its fiscal year from 1 January to 31 December, the results could be very different. The company that reported from 1 September 2000 to 31 August 2001, would not have felt the impact of that devastating event. Its Christmas-season sales from October 2000 to December 2000 are likely to have been much different from those of the company that reported from 1 January 2001 to 31 December 2001, because those results would include sales after 11 September, when the world economy slowed considerably. The company’s balance sheet for 1 September 2001 to 31 August 2002, would show the full impact of the attacks on the company’s financial position.
Nailing down the numbers
As you start reading financial reports for large corporations, you see that they don’t use big numbers to show billion-pound results (1,000,000,000) or state the amount to the penny, such as 1,123,456,789.99. Imagine how difficult it would be to read such detailed financial statements!
At the top of a balance sheet or any other financial statement, you see a statement indicating that the numbers are in millions, thousands, or however the company decides to round the numbers. For example, if a billion-dollar company indicates that numbers are in millions, you see 1 billion represented as 1,000 and 35 million as 35. The 1,123,456,789.99 figure would be shown as 1,123.
Comparing formats
You are likely to come across two main formats for balance sheets, the UK format and the US format. We’ve compiled samples of each format using very simple numbers to give you an idea of what you can expect to see. Of course, real balance sheets have much larger and more complex numbers.
The UK format, the type of format you see most often, is a vertical presentation of the numbers, as Table 6–1 shows.
| Non-current assets | 200 |
| Current assets | 300 |
| Total assets | 500 |
| Current liabilities | 200 |
| Non-current liabilities | 100 |
| Total liabilities | 300 |
| Net assets | 200 |
| Equity | 200 |
In the UK, a balanced sheet shows net assets equal to equity.
The US format is normally a horizontal presentation of the numbers although they also use the vertical format. You can see it in Table 6–2.
| Current assets | $300 |
| Long-term assets | $150 |
| Other assets | $50 |
| Total assets | $500 |
| Current liabilities | $200 |
| Long term liabilities | $100 |
|---|---|
| Shareholders’ equity | $200 |
| Total liabilities/equity | $500 |
In the US format, a balanced sheet shows total assets equal to total liabilities plus equity.
The UK format is different from the US in that it may have two significant lines that don’t appear in the US format:
Net current assets: This line is the current assets the company has available to pay bills. You calculate net current assets by subtracting the current liabilities from the current assets.
Net assets: This line shows what is left for the company’s owners, or shareholders, after all liabilities have been subtracted from total assets.
(Keep in mind that Non-current assets in the UK are known as long-term assets plus Other assets in US balance sheets.)
| Fixed assets | 200 |
| Current assets | 300 |
| Current liabilities | 200 |
| Net current assets | 100 |
| Liabilities due beyond one year | 100 |
| Net assets | 200 |
| Equity | 200 |
Assessing Assets
Anything that the company owns is considered an asset. An asset can be something as basic as cash or as massive as a factory. A company must have assets in order to operate the business. The asset side of a balance sheet gives you a summary of what the company owns.
Non-current assets
Assets that the company plans to hold for use in the business rather than for sale are placed in the non-current assets section of the balance sheet. Non-current assets, described in the following sections, include intangible assets; land and buildings; capitalised leases; plant and equipment; furniture and fixtures; and investments. This section of the balance sheet shows you the assets that a company has to build its products and sell its goods.
Intangible assets
Any assets that aren’t physical, such as patents, copyrights, trademarks, and goodwill, are considered intangible assets. Patents, copyrights, and trademarks are actually registered with the appropriate government department, and the company holds exclusive rights to these items. If another company wants to use something that is patented, copyrighted, or trademarked, it must pay a fee to use those assets.
Patents give the companies the right to dominate the market for a particular product. For example, pharmaceutical companies can be the sole source for a drug that is still under patent. Copyrights also give companies exclusive rights for sale. Books that are copyrighted can be printed only by the publisher or individual who owns that copyright or by someone who has bought the rights from the copyright owner.
Goodwill is a different type of asset, reflecting things like the value of a company’s locations, customer base, or consumer loyalty. Companies essentially purchase goodwill when they buy another company for a price that’s higher than the value of a company’s tangible assets – its market value. The premium that’s paid for the company’s assets is kept in an account called goodwill shown on the balance sheet. Goodwill is dealt with in more detail in Chapter 10.
Property, plant, and equipment
Property: Any land and buildings the company own are included under this heading. Companies must depreciate (show that the asset is gradually being used up by deducting a portion of the value) the value of their buildings each year. The land portion of ownership isn’t depreciated because its value is not used up by the passage of time. Adopting a policy of revaluation is possible if the company wishes to do so. Revaluation might seem to be a good idea when the value goes up significantly from the purchase price. However, once the decision has been taken to revalue property then that valuation must be kept up-to-date – even if it falls.
If property is leased, then the value of the property is not usually included in the balance sheet. However, any amounts spent on improving a leasehold property are included and depreciated in the same way as other assets.
Property that is not used in the business but is kept for its potential to earn rental income or for capital gain is known as investment property. Under International Accounting Standards (IAS) 40, investment property can be included in the balance sheet at cost less depreciation or fair value.
Strangely, small companies have less choice on this matter than listed companies. The only permitted treatment under UK GAAP is to include investment properties at open market value.
Sometimes you see an indication that a company holds hidden assets – they’re hidden from your view when you read the financial reports because you have no idea what the true market value of the buildings and land might be. For example, an office building that was purchased for £390,000 and held for 20 years without being revalued may have a market value of £1 million if it were sold today but has been depreciated to £190,000 or left at its original purchase price over the past 20 years.
Plant and equipment: Companies track and summarise all machinery and equipment used in their facilities or by their employees under the sub-heading plant and equipment. These assets depreciate just like buildings but for shorter periods of time, depending on the company’s estimate of their useful life. IT equipment may be included in this category or may be shown as a separate class of assets in the notes to the accounts.
Furniture and fittings: Some companies have a separate class for furniture and fittings or fixtures and fittings, whereas others group these items in plant and equipment. You’re more likely to find furniture and fixture line items in major retail chains that hold significant furniture and fixture assets in their retail outlets than you are to find the line item on balance sheets for manufacturing companies that don’t have retail outlets.
Capitalised leases
If a company acquires an asset, such as a machine, under a lease agreement where that agreement covers most of the asset’s life, then the asset will be included in plant and equipment. The same method of accounting is used for a hire purchase agreement that contains an option to purchase the asset at some point in the future. You can find more details about the leases in the notes to the financial statements.
Accumulated depreciation
In an important note to the accounts you can find out the cost of the non-current assets, their depreciation charge this year and the accumulated depreciation since the asset was obtained. We explain depreciation in greater detail in Chapter 4.
The note shows each non-current category, such as property, plant, and equipment separately so that you can get some idea which of the asset types are oldest by recognising how much depreciation has been charged against it.
Investments in associates and joint ventures
A subsidiary is an entity that is controlled by another entity. A company will prepare consolidated accounts to include all of its subsidiaries. (We talk more about consolidation in Chapter 10.)
Investments in associates are included in the balance sheet under the heading of non-current assets. An associate is an entity over which the company has significant influence but which does not fall into the definition of a subsidiary or a joint venture. It is presumed (unless the presumption can clearly be demonstrated to be false) that significant influence exists if the company holds, directly or indirectly, 20 per cent or more of the voting rights in the associate.
If a company controls less than 20 per cent of another entity’s voting rights then it is presumed that there is no significant influence – unless, again, this presumption can be clearly demonstrated to be false. Such an investment is included within non-current assets or current assets depending on the intentions of the investing company, (see the section ‘Current asset investments’ later in this chapter). Long before a company reaches even the 20 per cent mark, you usually find discussion of the company’s buying habits in the financial press or in analyst reports. Talk of a possible merger or acquisition often begins when a company reaches the 20 per cent mark.
You usually don’t find more than a line item in the balance sheet that shows the total of all associates. More detail is mentioned in the notes to the financial statements.
A joint venture is an entity which is under the joint control of two or more other parties. Joint ventures are accounted for by proportional consolidation (see Chapter 10) or by the same method as associates.
Current assets
Anything that a company owns that it can convert to cash in less than a year is a current asset. Without these funds, the company would not be able to pay its bills and would have to close its doors. Cash, of course, is an important component of this part of the balance sheet, but there are other assets that will be used during the year to pay the bills.
Inventory (also known as stock)
Any products held by the company ready for sale are considered stock. The term stock has always been used in the UK but the correct name is now inventory in accordance with IAS 1. We will use the terms interchangeably as is very common in UK business. The stock on the balance sheet is normally valued at the cost to the company, not at the price the company hopes to sell the product at. However, if an item of stock has lost value so that the company will suffer a loss on sale, then that item is valued at net realisable value which is selling price less any expenditure necessary to bring the item to a saleable condition.
Companies can pick any of four different methods to calculate the cost of their stock (depending on their business and location), and the method they choose can significantly impact the bottom line. The four methods of costing coincide with the way that the company keeps track of stock. The following are the different stock-costing systems:
First in, first out (FIFO): This system assumes that the oldest goods are sold first. This system is used when the company is concerned about spoilage or obsolescence. Food stores use FIFO because items that sit on the shelves too long spoil. Computer firms use it because products become quickly outdated, and they need to sell the older products first. Assuming that older goods cost less than newer goods, FIFO makes the bottom line look better, because the lowest cost is assigned to the goods sold, increasing the net profit from sales. FIFO is the system most commonly used in the UK.
Last in, first out (LIFO): This system assumes that the newest stock is sold first. Companies with products that don’t spoil or become obsolete can use this system. The bottom line can be significantly affected if the cost of goods to be sold is continually rising. The most expensive goods that come in last are assumed to be the first sold. LIFO increases the cost of goods sold, which in turn lowers the net profit from sales and decreases a company’s tax liability because its profits are lower after the higher costs are subtracted. Hardware stores that sell hammers, nails, screws, and other items that have been the same for years and won’t spoil are good candidates for LIFO. We have included LIFO because it is a term you will still hear, but companies cannot use LIFO under International Accounting Standards. LIFO continues to be used in the United States.
Average costing: This system reflects the cost of stock most accurately and gives the company a good view of the cost trends for its stock. As a company receives each new shipment of stock, it calculates an average cost for each product by adding in the new stock. If a company is frequently faced with stock prices that go up and down, average costing can help level out the peaks and valleys of stock costs through the year. Because the price of petrol rises and falls almost every day, petrol stations usually use this type of system.
Specific identification: This system is a system that tracks the actual cost of each individual piece of stock. Companies that sell big-ticket items or those with differing accessories or upgrades (such as cars) commonly use this system. Each car that comes into the showroom has a different set of features, so the price of each car differs.
Trade and other receivables also known as Accounts receivable or Debtors
Any company that allows its customers to buy on credit has an accounts receivable line on its balance sheet. Accounts receivable is a collection of individual customer accounts listing money that customers owe the company for products or services they’ve already received.
A company must carefully monitor not only whether the customer pays, but also how quickly they pay. If a customer makes payments later and later, the company must determine whether to allow the late-paying customer gets additional credit or whether it should block further purchases. Although the sales may look good, a non-paying customer hurts the company because they’re taking out – and failing to pay for – stock that another customer could’ve bought. Too many non-paying or late-paying customers can severely hurt a company’s cash-flow position, which means the company may not have the cash it needs to pay the bills.
Comparing a company’s accounts receivable line over a number of years gives you a very good idea of how well the company is doing in collecting late-paying customers’ accounts. Although you may see a company report very positive sales numbers and a major increase in sales, if the accounts-receivable number is rising more rapidly in proportion, the company may be having trouble collecting the money on these accounts. We show you how to analyse accounts receivable in Chapter 16.
Current asset investments
Securities that are bought by a company primarily as a place to hold assets until the company decides how to use the money for its operations or growth are included in current assets. A company must report these assets at their fair value based on the market value of the share or bond on the day the company prepares its financial report. This means that the company must report any unrealised losses or gains – changes in the value of a holding that has not yet been sold – on current asset investments on the company’s balance sheet to show the impact of those gains or losses on the company’s earnings.
Cash
For companies, cash is basically the same thing you carry around in your pocket or keep in your current and savings accounts. Keeping track of money is a lot more complex for companies, however, because they usually keep it in many different locations. Every multimillion corporation has numerous locations, and every location needs cash in the appropriate currency.
Even in a centralised accounting system, in which all bills are paid in the same place and all money is collected and put in the bank at the same time, a company keeps cash in more than one location. Keeping most of the money in the bank and having a little cash on hand for incidental expenses doesn’t work for most companies.
For example, retail outlets or banks need to keep cash in every cash register or under the control of every cashier to be able to transact business with their customers. Yet the company must have a way of tracking its cash and knowing exactly how much it has at the end of every day (and sometimes several times during the day for high-volume businesses). Anyone handling cash for a company must count out his cash drawer before leaving for the day and show that the amount of cash matches up with the figure that the day’s transactions indicate should be there.
If a company has a number of locations, each location is likely to need a bank in which it can deposit receipts and get cash as needed. So a large corporation is going to have a maze of bank accounts, cash registers, petty cash, and other places where cash is kept daily. At the end of every day, each company location calculates the cash total and reports it to the centralised accounting area.
Managing cash is one of the hardest jobs because cash can so easily disappear if proper internal controls aren’t in place. Internal controls for monitoring cash are usually among the strictest in any company. If this subject interests you, you can find out more about it in any basic accounting book, such as Understanding Business Accounting For Dummies by John A Tracy and Colin Barrow (Wiley).
Other types of current asset
The rule is that an asset is current if it is the intention of the company to convert it into cash within 12 months and that there is a good likelihood that they will be able to do so. You may, for example, see Taxation receivable in current assets if the company is likely to recover tax in cash during the next year, or in non-current assets if not.
Looking at Liabilities
Companies must spend money in order to conduct their day-to-day operations. Whenever a company makes a commitment to spend that money on credit, whether it be short-term using a credit card or long-term using a mortgage, those commitments become debts or liabilities.
Current liabilities
Current liabilities are any obligations that a company must pay during the next 12 months. These include short-term borrowings, the current portion of long-term debt, accounts payable, and accrued liabilities. If the company can’t pay these bills, it could go out of business or go into bankruptcy.
Trade and other payables: Companies list money they owe to others for products, services, supplies, and other short-term needs (invoices due in less than 12 months) in accounts payable. They record payments due to suppliers, contractors, and other companies they do business with.
Accrued liabilities: Liabilities that are accrued but aren’t yet paid at the time a company prepares the balance sheet are called accrued liabilities and are included in trade and other payables. For example, companies include royalties, advertising, payroll, management incentives, or employee taxes that aren’t yet paid in this line item. Sometimes a company breaks down items like income taxes payable individually without using a catch-all line item called accrued liabilities. When you look in the notes, you see more detail about the types of company financial obligations included and the total of each type of liability.
Short-term borrowings:
Short-term borrowings are usually credit facilities the company takes to manage cash flow and will include bank overdrafts. When a company borrows this way, it isn’t much different from when you use a credit card or personal loan to pay bills until your next pay day. As you know, these types of loans usually carry the highest interest-rate charges, so if a company can’t repay them quickly, it converts the debt to something longer term with lower interest rates.
This type of liability should be a relatively low number on the balance sheet compared with other liabilities. If the number isn’t low, it could be a sign of trouble, indicating that the company is having difficulty securing long-term debt or meeting its cash obligations.
Current portion of long-term borrowings: Payments due on long-term debt during the coming financial year are shown in this line of the balance sheet. Any portion of the debt that’s owed beyond the current 12 months is reflected in the long-term liabilities section. There are many ways for a company to borrow money and these are detailed in the notes to the accounts.
Current tax payable: This tax, probably corporation tax, relates to the profits of the year being reported and will be paid during the next 12 months.
Provisions: Most balance sheets have an element of these liabilities that will probably have to be paid. Provisions may be short-term or long-term depending on their timing.
Net current assets
This line shows the difference between current assets and current liabilities. If this figure is positive and the difference is large it shows that the company will have no short-term trouble in meeting its financial commitments. However, what figure represents a comfortable net current assets figure depends on the industry.
Non-current liabilities
Any money the company must pay out more than 12 months in the future is considered a long-term liability. Long-term liabilities won’t throw a company into bankruptcy, but if they become too large, the company could have trouble paying its bills in the future.
Long-term borrowings: The items under this heading include bank loans and other long term borrowings such as debentures or mortgages. In a recent change to accounting principles, preference shares may also be included in liabilities. The detail of the nature and timing of long- term borrowings is in the notes to the accounts.
Post employee benefit obligations: There are two types of pension scheme – defined contribution and defined benefit. Companies with a defined contribution scheme pay the correct amount into each employee’s scheme each year. As such, the company has no future obligation and there will be no reference to pension schemes in the balance sheet.
In a defined benefit scheme, the employer commits to paying a future pension based on length of service and salary during service. Amounts will be paid into the pension scheme throughout the employees’ working lives but, in the event that the amounts put aside are insufficient, the company remains liable to make up the difference. It is the actuary’s best estimate of the shortfall that shows in the balance sheet. Clearly, this estimate is highly subjective and, in the event of a downturn in the stock market, can be a very large figure. In the event that the actuary assesses a surplus in the scheme then that will be included in the balance sheet as an asset.
Deferred tax liabilities: Deferred tax is a device used by accountants to reflect the fact that tax is calculated not on the profits in the income statement but on profits adjusted for tax purposes. This calculation is explained further in Chapter 7.
In Appendix A, you can see that both Tesco and Marks and Spencer give the financial report reader little detail of these liabilities on the balance sheet. Instead, you must dig through the notes and managers’ commentary to find the detail of the liabilities.
Navigating the Equity Maze
The final piece of the balancing equation is equity. All companies are owned by somebody, and the claims that these owners have against the assets owned by the company are called equity. In a non-corporate entity, the equity owners are individuals or partners. In a corporation, the equity owners are shareholders.
Share capital
A share represents a portion of ownership in a company. Each share has a nominal value of say 25 pence or £1 but normally shares in public companies are sold to investors at a higher price than the nominal value. The difference between the nominal value and the selling price is known as a premium. The amount recorded in the balance sheet as share capital is the number of shares issued multiplied by the nominal value of the share. This price isn’t affected by the current market value of the share. Any increase or decrease in a share’s value after its initial offering to the public isn’t reflected in the accounts. The market gains or losses are actually taken by the shareholders and not the company when shares are bought and sold on the market.
Some companies issue two types of shares: ordinary and preference.
Ordinary (or equity) shareholders
These shareholders own a portion of the company and have a vote on issues taken to the shareholders. If the board decides to pay dividends (a certain portion per share paid to ordinary shareholders from profits), ordinary shareholders get their portion of those dividends after the preference shareholders have been paid in full.
Preference shareholders
These shareholders own stock that’s actually somewhere in-between ordinary shares and a bond (a long-term liability to be paid back over a number of years).
Preference shares come in all shapes and sizes. Thirty years ago, most preference shares were a permanent part of the company’s capital. A fixed dividend was payable each year (subject to the approval of the directors) and the term ‘preference’ referred to the fact that the dividend on the preference shares would be paid before any dividend on ordinary shares. Similarly, if the company was wound up, preference shareholders would receive their capital before the ordinary shareholders.
These days, preference shares may well be convertible and/or redeemable. If they are redeemable, the company has the right or obligation to buy the shares back. The date of redemption may be fixed or it may be at the option of the shareholder or the company. The redemption amount may be par or at a premium.
If the shares are convertible, they can be converted into equity shares. Again, the date of conversion may or may not be fixed and the right to enforce conversion may belong to the shareholder or the company.
Legally, preference shares are a type of share (and subject to the requirements of the Companies Act) but sometimes they have characteristics that make them more like bonds. In a recent change to accounting principles, the directors of the company must decide whether the preference shares issued by the company should be classified with equity or liabilities. This will depend on whether the rights of the preference shareholders give the company an obligation to make payments which it can’t avoid.
Preference shares have become the financial instrument of choice for venture capitalists since they permit great flexibility in the arrangements between the company and the provider of funds. By juggling the percentage dividend and the premium on redemption, the venture capitalist can obtain the required return over a period of time but the repayments can be spread to suit the needs of the company. The right to convert will then kick in if the company fails to meet its obligations at any stage and this then gives the venture capitalist a stake in the equity – or even control of the company.
Share premium account
If a growing company decides to raise capital by selling more shares it will issue them at a price somewhere near the current market value not at its nominal value. This line in the balance sheet shows the difference between the two. So if a share with nominal value of 25p is trading at £1.50 pence on the market and the company issues new shares at say, £1.20, then 25 pence is added to Issued capital and 95 pence into the share premium account.
Other reserves
The most common balance that you will see under this heading is the Revaluation Reserve. If a property is revalued, then the assets in the balance sheet will go up. To keep the balance, equity must also be increased. If the property had been sold, then a profit would be realised and this would be shown in the income statement and would affect retained earnings. Since the property has only been revalued, the profit is unrealised and therefore the increase in equity is shown in the revaluation reserve.
Retained earnings
Each year, a company makes a choice to pay out its net profit to its shareholders or to retain all or some of it for reinvesting in the company. Any profit not paid to shareholders over the years is accumulated in an account called retained earnings.
Capital
If you don’t see this line item on the balance sheet of a partnership, it is likely that the owners didn’t invest their own capital to get started, or they already took out their initial capital when the company began to earn money.
Drawing