Balance Sheet | Statement of Financial Position

This lectures cover CPA questions covering classified balance sheet and its component such as current assets, non current assets, short term liabilities, long term liabilities and owner’s equity.

Balance Sheet | Statement of Financial Position

The balance sheet, sometimes referred to as the statement of financial position, reports the assets, liabilities, and stockholders’ equity of a business enterprise at a specific date. This financial statement provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and the owners’ equity in net resources. It therefore helps in predicting the amounts, timing, and uncertainty of future cash flows.

Usefulness of the Balance Sheet

By reporting information on assets, liabilities, and stockholders’ equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a company’s risk and future cash flows. In this regard, analysts use the balance sheet to assess a company’s liquidity, solvency, and financial flexibility.

Liquidity describes “the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid.” Creditors are interested in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities. These ratios indicate whether a company, like Amazon.com, will have the resources to pay its current and maturing obligations. Similarly, stockholders assess liquidity to evaluate the possibility of future cash dividends or the buyback of shares. In general, the greater Amazon’s liquidity, the lower its risk of failure.

Solvency refers to the ability of a company to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency than a similar company with a low level of long-term debt. Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments).

Liquidity and solvency affect a company’s financial flexibility, which measures the “ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.” For example, a company may become so loaded with debt—so financially inflexible—that it has little or no sources of cash to finance expansion or to pay off maturing debt. A company with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater an enterprise’s financial flexibility, the lower its risk of failure.

Limitations of the Balance Sheet

Some of the major limitations of the balance sheet are:

  • 1.Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value. For example, Georgia-Pacific owns timber and other assets that may appreciate in value after purchase. Yet, Georgia-Pacific reports any increase only if and when it sells the assets.
  • 2.Companies use judgments and estimates to determine many of the items reported in the balance sheet. For example, in its balance sheet, Dell estimates the amount of receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty.
  • The balance sheet necessarily omits many items that are of financial value but that a company cannot record objectively. For example, the knowledge and skill of Intel employees in developing new computer chips are arguably the company’s most significant assets. However, because Intel cannot reliably measure the value of its employees and other intangible assets (such as customer base, research superiority, and reputation), it does not recognize these items in the balance sheet. Similarly, many liabilities are reported in an “off-balance-sheet” manner, if at all.

Classification in the Balance Sheet

Balance sheet accounts are classified. That is, balance sheets group together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The FASB has often noted that the parts and subsections of financial statements can be more informative than the whole. Therefore, the FASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also makes it easier for users to evaluate the company’s liquidity, financial flexibility, profitability, and risk.

To classify items in financial statements, companies group those items with similar characteristics and separate items with different characteristics. For example, companies should report separately:

  • 1.Assets that differ in their type or expected function in the company’s central operations or other activities. For example, IBM reports merchandise inventories separately from property, plant, and equipment.
  • 2.Assets and liabilities with different implications for the company’s financial flexibility. For example, a company that uses assets in its operations, like Walgreens, should report those assets separately from assets held for investment and assets subject to restrictions, such as leased equipment.
  • 3.Assets and liabilities with different general liquidity characteristics. For example, Boeing Company reports cash separately from inventories.
  • 1.ASSETS. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
  • 2.LIABILITIES. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
  • 3.EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

Current Assets

Current assets are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies). The cycle operates from cash through inventory, production, receivables, and back to cash. When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period.

Cash.

Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution). Cash equivalentsare short-term highly liquid investments that will mature within three months or less. Most companies use the caption “Cash and cash equivalents,” and they indicate that this amount approximates fair value.

Short-Term Investments.

 All equity securities are recorded at fair value with changes reported in net income (unless accounted for under the equity method or if it is not practicable to determine fair value). Companies group investments in debt securities into three separate portfolios for valuation and reporting purposes:

  • Held-to-maturity: Debt securities that a company has the positive intent and ability to hold to maturity.
  • Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences.
  • Available-for-sale: Debt securities not classified as held-to-maturity or trading securities.

Receivables.

A company should clearly identify any expected loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables used as collateral. Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of property, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year.

Inventories.

To present inventories properly, a company discloses the basis of valuation (e.g., lower-of-cost-or-net realizable value or lower-of-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO).

Prepaid Expenses.

A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer. As we discussed earlier, these items are current assets because if they had not already been paid, they would require the use of cash during the next year or the operating cycle. A company reports prepaid expenses at the amount of the unexpired or unconsumed cost.

A common example is the prepayment for an insurance policy. A company classifies it as a prepaid expense because the payment precedes the receipt of the benefit of coverage. Other common prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies

Noncurrent Assets

Noncurrent assets are those not meeting the definition of current assets. They include a variety of items, as we discuss in the following sections.

Long-Term Investments.

Long-term investments, often referred to simply as investments, normally consist of one of four types:

  • 1.Investments in securities, such as bonds, common stock, or long-term notes.
  • 2.Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
  • 3.Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance.
  • 4.Investments in nonconsolidated subsidiaries or affiliated companies.
  • Property, Plant, and Equipment.
  • Property, plant, and equipment are tangible long-lived assets used in the regular operations of the business. These assets consist of physical property such as land, buildings, machinery, furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets.

Intangible Assets.

Intangible assets lack physical substance and are not financial instruments (for the definition of a financial instrument). They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off (amortizes) limited-life intangible assets over their useful lives. It periodically assesses indefinite-life intangibles (such as goodwill) for impairment. Intangibles can represent significant economic resources, yet financial analysts often ignore them, because valuation is difficult.

Owners’ Equity

The owners’ equity (stockholders’ equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of capital stock agreements and the various restrictions on stockholders’ equity imposed by state corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts:

  • 1.CAPITAL STOCK. The par or stated value of the shares issued.
  • 2.ADDITIONAL PAID-IN CAPITAL. The excess of amounts paid in over the par or stated value.
  • 3.RETAINED EARNINGS. The corporation’s undistributed earnings.
  • 4.ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items.
  • 5.TREASURY STOCK. Generally, the cost of shares repurchased.
  • 6.NONCONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not wholly owned by the reporting company.