Level I - Financial Reporting and Analysis

Understanding Balance Sheets

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 Contents
1. Introduction
2. Components and Format of the Balance Sheet
3. Current Assets and Current Liabilities
4. Non-Current Assets
5. Non-Current Liabilities
6. Equity
7. Analysis of the Balance Sheet

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 1. Introduction
• IFRS: Statement of Financial Position versus U.S. GAAP: Balance
Sheet

• The balance sheet provides information on a company’s resources

(assets) and its sources of capital (liabilities and equity)

• The fundamental equation: A = L + E

• Different items of assets and liabilities may be measured

differently

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 2. Components and Format of the Balance Sheet
• Assets (A) are what the company owns. They are the resources controlled by the
company as a result of past events and from which future economics benefits are
expected to flow to the entity.

• Liabilities (L) are what company owes. They represent the 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 owner’s residual interest in the company’s assets after
deducting its liabilities. Also known as shareholders’ equity. The accounting
equation for determining equity is E = A – L.

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 Balance Sheet Components and Classification

• Balance sheet shows a company’s assets, liabilities and equity on a

particular date (end of reporting period)
 Measurement basis varies across items
 “Current value” is the value at the end of the reporting period
 Important elements of a company’s ability to generate future cash flows are not
shown on the balance sheet

• Current and Non-Current (Classified Balance Sheet) versus Liquidity-

Based Presentation

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 Classified Balance Sheet

Source: Principlesofaccounting.com www.ift.world 6

Liquidity-Based Presentation

Source: China Construction Bank

2009 Annual Report

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 3.1 Current Assets
Current Assets: Those assets held primarily for trading or expected to be sold, used up
or otherwise realized in cash within one year or in one operating business cycle.

• Cash and Cash Equivalents

 Cash equivalents are highly liquid, short-term investments that are so close to maturity, the risk
is minimal that their value will change significantly with changes in interest rates
 Cash equivalents are financial assets; reported at fair value or amortized cost
• Marketable Securities
 Also financial assets and include publically traded debt and equity instruments
• Trade Receivables (Accounts Receivables, A/R)
 Allowance for doubtful accounts (contra asset account)
• Inventories
• Other Current Assets (Prepaid expenses)

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 3.2 Current Liabilities
Current Liabilities: Those liabilities which are expected to be settled within one
year or in one operating business cycle.

• Accounts Payable or Trade Payables

• Notes Payable
• Income Taxes Payable
• Accrued Expenses
• Deferred Income (Deferred Revenue or Unearned Revenue)

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 4. Non-Current Assets
Non-Current Asset: All assets not classified as current. Also called long-term or long-
lived assets.

• Property, Plant and Equipment (PPE)

• Investment Property
• Intangible Assets
• Goodwill
• Financial Assets

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 PPE, Investment Property, Intangible Assets

• Property, Plant and Equipment (PPE)

 Tangible; expected to provide economic benefit over more than one fiscal period
 IFRS: report using cost model or revaluation model
 Cost model: historical cost less depreciation; also called amortized cost
 Land is not depreciated
• Investment Property
This material will be
 Property not used in regular operations of company
covered in detail in the
 Purely an IFRS concept reading on Long Lived
• Intangible Assets Assets; come back to the
curriculum examples after
 Identifiable non-monetary assets without physical substance you’ve done that
 IFRS: report using cost model or revaluation model reading.

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 Goodwill
Goodwill arises when one company is purchased by another company. If the
purchase price is greater than fair value at acquisition then goodwill is created in
the acquirers’ balance sheet. Goodwill is subject to impairment.

Example: Company A buys Company T for $100 million. Book value of Company
T’s assets and liabilities: $125 million and $75 million. Fair value of Company T’s
assets and liabilities: $160 million and $75 million. What is the goodwill?

Goodwill = 15 million

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 Financial Assets
Financial Assets: IFRS define a financial instrument as a contract that gives rise to a
financial asset of one company and a financial liability or equity instrument of another
entity. Measurement basis depends on how financial asset is categorized.

Category Treatment
Held-for-trading (HFT) Measured at fair value
Unrealized gains shown on Income Statement
Available-for-sale (AFS) Measured at fair value
Unrealized gains/losses shown in OCI
Held-to-maturity (HTM) Measured at cost or amortized cost
Unrealized gains not recorded anywhere

Realized gains shown on income Mark-to-market is the process whereby the value of a
statement for all categories financial instrument is adjusted to reflect current value
based on market prices

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 Financial Assets - Example
Company owners contribute 100,000 which is invested in a 20-year bond with a 5% coupon paid semi-
annually. After six months company receives the first coupon payment of 2,500. At this stage the
market price has increased to 102,000. Show the balance sheet and income statement treatment
under each of the following categorizations: HFT, AFS, HTM.
HFT AFS HTM
Balance Sheet
Cash
Cost of securities
Unrealized gains/losses

PIC
RE
OCI

Income Statement
Interest income
Unrealized gain

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 Solution
Company owners contribute 100,000 which is invested in a 20-year bond with a 5% coupon paid semi-
annually. After six months company receives the first coupon payment of 2,500. At this stage the
market price has increased to 102,000. Show the balance sheet and income statement treatment
under each of the following categorizations: HFT, AFS, HTM.
HFT AFS HTM
Balance Sheet
Cash 2,500 2,500 2,500
Cost of securities 100,000 100,000 100,000
Unrealized gains/losses 2,000 2,000

PIC PIC 100,000 PIC 100,000

PIC 100,000 RE up by 2,500
RE RE up by 2,500
RE up by 4,500
OCI OCI up by 2,000

Income Statement 2,500 2,500 2,500

Interest income 2,000
Unrealized gain

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 Summary of how financial assets are classified and measured

Measured at Fair Value Measured at Cost or Amortised Cost

Financial assets held for trading For unquoted equity instruments where the fair value
is not reliably measureable, cost may serve as a proxy
(estimate for fair value)

Available-for-sale financial assets Held-to-maturity investments (investments in bonds

issued by another company, intended to be held to
maturity)

Derivatives whether stand-alone or embedded in Loans to and receivables from another company
non-derivative instruments

Non-derivative instruments (including financial

assets with fair value exposures hedged by
derivatives)

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 5. Non-Current Liabilities
Non-current liability: all liabilities not classified as current

• Long-term Financial Liabilities

 Loans, notes, bonds payable

• Deferred Tax Liabilities

 Result from temporary timing difference between a company’s income as reported for tax
purposes (taxable income) and income as reported for financial statement purposes (reported
income)

This material will be covered

in detail in the readings on
income taxes and non-
current liabilities.

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 6. Equity
Equity is the owner’s residual claim on a company’s
assets after subtracting its liabilities. Components of
equity:
1. Capital contributed by owners (common stock, issued
capital); may have a par (stated) value; disclose
number of shares authorized, issued and outstanding
2. Treasury shares
3. Retained earnings
4. Accumulated other comprehensive income
5. Noncontrolling interest (minority interest)
6. Preferred shares: classified as equity or financial
liabilities depending on characteristics

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 Equity Components – Simple Illustration
At start of Year 1 owners contribute 100. Among other assets, the company purchases financial
assets categorized as AFS worth 10. During Year 1 the net income is 20 which is retained. Value of
financial assets goes up to 12. During Year 2 there is a treasury stock operation worth 30. Net
income is 40, which retained. Financial assets goes up to 15. Show the relevant equity
components at the end of Year 1 and Year 2.

Component End of Year 1 End of Year 2

Issued Capital
Treasury Stock
Accumulated Retained Earnings
Accumulated Other Comprehensive
Income

Total Equity

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 Solution
At start of Year 1 owners contribute 100. Among other assets, the company purchases financial
assets categorized as AFS worth 10. During Year 1 the net income is 20 which is retained. Value of
financial assets goes up to 12. During Year 2 there is a treasury stock operation worth 30. Net
income is 40, which retained. Financial assets goes up to 15. Show the relevant equity
components at the end of Year 1 and Year 2.

Component End of Year 1 End of Year 2

Issued Capital 100 100

Treasury Stock (30)

Accumulated Retained Earnings 20 60

Accumulated Other Comprehensive 2 5

Income

Total Equity 122 135

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 Statement of Changes in Equity
The statement of changes in equity presents information about the increases or decreases in a
company’s equity over a period. IFRS requires the following information in the statement of
changes in equity:
 Total comprehensive income for the period;
 The effects of any accounting changes that have been retrospectively applied to previous
periods;
 Capital transactions with owners and distributions to owners; and
 Reconciliation of the carrying amounts of each component of equity at the beginning and end
of the year.

U.S. GAAP requirement is for companies to provide an analysis of changes in each component of
equity as shown in the balance sheet.

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Excerpt from Apple Inc.’s Consolidated Changes in Shareholders Equity

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 7. Analysis of the Balance Sheet
• Balance sheet analysis can help us evaluate a company’s liquidity and solvency
• Analysis tools: Common-Size Analysis and Balance Sheet Ratios
• Common-Size Analysis: All balance sheet items are expressed as a % of total assets

Time Series Analysis Cross Sectional Analysis

Source: Principlesofaccounting.com
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 Liquidity Ratios
Liquidity ratios tell us about a company’s ability to meet current liabilities

Liquidity Ratios Calculation

Current Current assets ÷ Current liabilities

Quick (acid test) (Cash + Marketable securities + Receivables) ÷ Current liabilities

Cash (Cash + Marketable securities) ÷ Current liabilities

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 Solvency Ratios
Solvency ratios help us evaluate a company’s:
1. ability to meet long-term and other liabilities
2. financial risk and leverage

Solvency Ratios Calculation

Long-term debt-to-equity Total long-term debt ÷ Total equity

Debt-to-equity Total debt ÷ Total equity

Total debt-to-assets Total debt ÷ Total assets

Financial leverage Total assets ÷ Total equity

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 General Remarks about Ratio Analysis

• Ratio analysis requires judgment; for example, current ratio is only a

rough measure of liquidity

• Ratios are sensitive to end of period financing and operating decisions

• Need to evaluate ratios in the context of a company’s industry

More on this in the reading

on financial analysis
techniques.

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 Summary
• Current and Non-Current Assets
 Valuation based on categorization of financial assets

• Current and Non-Current Liabilities

• Components of Shareholder’s Equity

• Analysis of the Balance Sheet

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 Conclusion
• Read summary

• Review learning objectives

• Examples

• Practice problems: good but not enough

• Practice questions from other sources

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