Reading 26 LOS's

Question 1

LOS 26a: Describe the elements of the balance sheet: assets, liabilities, and equity

Answer 1

Assets are resources under a company’s control as a result of past transactions that are expected to generate future economic benefits for the company

Liabilities are a company’s obligations from previous transactions that are expected to result in outflows of economic benefits in the future

ASsets and liabilities should only be recognized on the financial statements if it is probable that the future economic benefits associated with them will flow in or out of the entity, and that the item’s cost or value can be measured with realiability

Equity represents the residual claim of shareholders on a company’s assets after deducating all liabilities. Equity can be created as a result of operating activities and financing activities

Question 2

LOS 26b: Describe the uses and limitations of the balance sheet in financial analysis

Answer 2

The balance sheet provides useful information regarding a comapany’s financial positions to both investors and lenders. However, balance sheet information should be interpretted carefully.

• Under current accounting standards, measurement bases of different assets and liabilities may vary considerably. For example historical cost vs current value
• The value of items reported on the balance sheet reflects their value at the end of the reporting period, which may not necessarily remain current at a later date
• the balance sheet does not include qualitative factors that have an important impact on the company’s future cash -generating abilitiy and therefore, its overall value

Question 3

LOS 26c: Describe alternative formats of balance sheet presentation

Answer 3

Balance sheets may be presented in the following formats:

• Report Format - Assets, liabilities, and equity are presented in a single column. This is the most commonly used
• Account Format- ASsets are presented on the left hand side of the balance sheet with liabilities and equity on the right
• Classified Balance Sheet- Different types of assets and liablities are grouped into sub categories to give more effective overview of the company’s financial position
• Liquidit-Based Presentation- IFRS allows the preparation of a balance sheet using a liquidity-based presentation, if such a format provides more reliable and relevant information. All assets and liabilities are presented in order of liquidity

Question 4

LOS 26d: Distinguish between current and non-current assets and current and non-current liabilities

Answer 4

Both IFRS and US GAAP require that assets and liabilities be grouped seperately into their current and non-current positions, which makes it easier for analysts to examine the company’s liquidity position as of the balance sheet date

Current Assets - these are liquid assets that are likely to be converted into cash or realized within one year or one operating cycle

Non-current assets (long-term or long-life assets) These are less liquid assets and are not expected to be converted into cash within one year or within one operating cycle

Current Liabliites- These are obligations that are likely to be settled within one year or one-operating cycle, whichever is longer

Non-current Liabilities - These liabilities are not expected to be settled within a year or within one operating cycle.

Working Capital - The difference between current assets and current liabilities is known as working capital. Working capital is necessary for the smooth functioning of a firm’s daily operations

Question 5

LOS 26e: Describe different types of assets and the measurement bases of each

Answer 5

Current Assets

1) Cash and cash equivalents

Cash equivalents are highly liquid securities that usually mature in less than 90 days. Since they are financial assets, they may be measured at amortized cost or fair value

• Amortized cost equals historical cost adjusted for amort and impairment
• IFRS states fair value as the amount the asset can be exchanged for in an arm’s length transaction. US GAAP states it based on exit price - price received to sell the asset

2)Marketable Securities

Investments in debt and equity securities that are traded on public markets. Their balance sheet values are based on market price

3) Trade Receivables

Represent amounts owed to the company by customers to whom sales have been made. These amounts are usually reported at net realizable value.

• The relation between accounts receivable and sales is important. A significant increase may imply that the company is having problems collecting from customers
• The more diversified the customer base, the lower the credit risk of accounts receivable

4) Inventories

These are physical stocks held by the company in the form of finished goods, work-in progress, or raw materials

• Under IFRS, inventory is reported at the lower of cost and net realizable value (NRV- calculated as selling price minus selling costs, while cost is determined by the cost flow assumption)
• Under US GAAP, inventory is reported as the lower of cost and market ( Market value equals the current replacement cost of inventory, which must lie between NRV minus the normaly profit margin and NRV.

Inventory costs should include direct materials, direct labor, and overheads. It should not include:

• Selling costs
• Administrative overheads
• Storage costs incurred after production is complete
• Abnormal amounts of wasted material, labor and overheads

5) Other Current Assets

Items that are not material enough to be reported as a seperate line item on the balance sheet are aggregated into a single amount and reported as “ other current assets”

Prepaid Expenses are normal operating expenses that have been paid in advance, so they are recognized as assets on the balance sheet. Over time, they are expensed on the income statement and the value of the asset is reduced

Deferred tax assets (DTA)- usually arise when a company’s taxes payable exceed its income tax expense

Non-Current Assets

1) Property, Plant, and equipment (PP&E)

These are long-term assets that have physical substance. Examples are land, plant, machinery, equipment, and any natural resources owned by the company

Under IFRS, PP&E may be valued using either the cost model or the revaluation model. US GAAP only allows the cost model

2) Investment property

IFRS defines investment property as property that is owned for rental income and/or capital appreciation. Under IFRS, investment property may be valued using the cost model or the fair value model. US GAAP does not include a specific definition for investment property

3) Intangible Assets

These are identifiable, non-monetary assets that lack physical substance. Under IFRS, they may be reported using either the cost or revaluation model. US GAAP only allows the cost model

• Intangible assets with finite useful lives are amortized systematically over their lives and may also be impaired depending on circumstances
• Intangible assets with indefinite lives are not amortized, but are tested for impairment at least annually.

Indentifiable intangible assets can be aquired singly and are usually related to rights and priviledges that accrue to their owners over a finite period. Under IFRS, these may only be recognized if it is probable that future economic benefits will flow to the company and the cost of the asset can be measured reliably. Under IFRS and US GAAP the costs related to the following are usually expensed:

• Start-up and training costs
• Adminstrative and overhead
• Advertising and promotion
• Relocation and reorganization

Acquired intangible assets may be reported as separately identifiable intangibles if:

• They arise from contractual rights or other legal rights
• Can be seperated and sold

Goodwill is the excess of the amount paid to acquire a business over the fair value of its net assets. This may happen because:

• certain items of value (reputation, brand) are not recognized in a company’s financial statements
• The target company may have incurred research and development expenditures that may have not been recognized on the balance sheet, but do hold value
• The acquisition may improve the aquirer’s position against a competitor of there may be possible synergies

_Accounting Goodwill -_is based on accounting standards and is only reported for acquisitions when the purchase price exceeds the fair value of the aquired’s net assets

Economic Goodwill- Which is not reflected on the balance sheet, is based on a company’s performance and its future prospects. Analysts are more concerned with this value, as it contributes to the value of the firm and should be reflected in stock price

Under US GAAP and IFRS accounting goodwill resulting from acquisitions is capitalized. Further it is not amortized but tested for impairment annually

Goodwill can significantly affect the comparability of financial statements of companies

4) Financial Assets

Under IFRS a financial istrument is defined as a contract that gives rise to a financial asset for one entity and a financial liablity or equity for another entity.

Mark-To Market is a process of adjusting the values of trading assets and liablities to reflect their current market values. These adjustments are usually made on a daily basis

Marketable investments can be classified under the following categories:

• Available for sale securities- these are debt or equity securities that are neither expected to be sold soone, or held to maturity. They may be sold to address the liquidity needs of the company. Dividend income, interest income, and realized gains and losses are reported on the income statement The “available for sale” classification no longer appears in IFRS, but they still permit certain equity investments to be measured at fair value with unrealized gains and losses reported in other comprehensive income as part of shareholder’s equity.
• Held to Maturity Securities- These are debt securities that are purchased with the intent of holding them till maturity. These are carried at amortized cost. Only interest income and realized gains and losses are reported, and they are reported on the income statement
• Trading Securities- These are debt and equity securities that are aquired with the intent of earning trading profits over the near term. These securities are measured at fair market value on the balance sheet. Dividend income, interest income, realized gains and losses, and unrealized gains and losses are all reported on the income statement

Question 6

LOS 26e: Describe different types of liabilities and the measurement bases of each

Answer 6

Current Liabilities

1) Trade payables (accounts payable) These are amounts owed by the business to its suppliers for purchases on credit. Analysts are usually interested in examining the trend in the levels of trade payables relative to purchases to gain insight into the company’s relationship with its suppliers

2) Notes payable These financial liabliities are borrowings from creditors that are documented by a loan agreement. Depending on the repayment date, notes payable may also be included in non-current liabilities

3) Current Portion of Long-term Liabilities- These represent portions of long-term debt obligations that are expected to be paid within a year of the balance sheet date or within one operating cycle, whichever is greater

4) Income Taxes payable these are taxes that have not actually been paid

5) Accrued Liabilities these are expenses that have been recognized on the income statement but have still not been paid for as of the balance sheet date

6) Unearned Revenue (deferred revenue or deferred income) This arises when a company receives cash in advance for goods and servies that are still to be delivered

Non-Current Liabilities

1) Long-term financial liabilities these may either be measured at fair value or amortized costs

2) Deferred Tax liabilities These usually arise when a company’s income tax expense exceeds taxes payable. These unpaid taxes will be paid in future periods

Question 7

LOS 26f: Describe the componenets of shareholder’s equity

Answer 7

US GAAP and IFRS define equity as the owners’ residual claim on the assets of an entity after deducting all liabilities. Various components are below:

• Capital contributed by owners (common stock or issued capital): Owners contribute capital to an entity by investing in common shares. These shares have par values that are required to be listed seperately in owners’ equity. Also required are the number of authorized, issued, and outstanding shares for each class of stock issued by the company. Issued shares are the total number of shares that have been sold to shareholders. Outstanding shares equal the number of shares that were issued less the number of shares repurchased (treasury stock).
• Preferred Shares- Preferred shareholders receive dividends and have priority over ordinary shareholders in the event of liquidation. They may be calssified as equity or financial liabilities depending on their characteristics
• treasury Shares - these are shares that have been bought back by the company. Share repurchases result in a deduction from owners equity and less shares outstanding. They receive no dividends and have no voting rights. They may be reissued at a later date, but no gain or loss is recognized when they are reissued
• Retained Earnings- these are the cumulative earnings of the firm over the years that have not been distributed to shareholders as dividends
• Accumulated other comprehensive income this represents cumulative other comprehensive income
• Non-controlling interest ( minority interest) - This is the minority shareholders’ pro rata share of the net assets of a subsidiary that is not wholly owned by the company

Statement of Changes in Owner’s Equity

This statement presents the effects of all transactions that increase or decrease a company’s equity over the period. Under IFRS that following information should be included in the statement of changes in equity:

• Total comprehensive income for the period
• The efffects of any accounting changes that have been retrospectively applied to previous periods
• Capital transations with owners and distributions to owners
• Reconcilitation of the carrying amounts of each component of equity at the beginning and end of the year

Under US GAAP companies are required to provide an analysis of changes in each component of stockholders’ equity that is shown in the balance sheet

Question 8

LOS 26g: Convert balance sheets to common-size balance sheets and interpret common-size balance sheets

LOS 26h: Calculate and interpret liquidity and solvency ratios

Answer 8

Common-Size Balance Sheets

A veritcal common-size balanace sheet expresses each balance sheet item as a percentage of total assets. This allows an analyst to perform historical analysis and cross-sectional analysis across firms within the same industry

Balance Sheet ratios

Liquidity ratios- measure a company’s ability to settle short-term obligations. The higher a company’s liquidity ratios, the greater the likelihood that the company will be able to meet its short-term obligations

• Current ratio = current assets / current liabilities
• Quick ratio (acid test) = cash+marketable securities + receivables / current liabilities
• Cash ratio = cash + marketable securities / current liabilities

Solvency Ratios measures a company’s ability to settle long-term obligations. High solvency ratios, are undesirable and indicate that the company is highly leveraged and risky

• Long term debt to equity ratio = total long term debt / total equity
• debt to equity ratio = total debt / total equity
• total debt ratio = total debt / total assets
• financial leverage ratio = total assets / total equity