Information Included in the Balance Sheet

Three assumptions and a measurement concept underlie the definitions of financial statement elements

Assumptions

• Separate Entity Assumption: each business’s activities must be account for separately from the personal activities of the owners, all other person, and other entities. This means, for example, that, when an owner purchases property for personal use, the property is not an asset of the business

• Going Concern Assumption (continuity assumption): it is assumed that the business will continue operating into the foreseeable future, long enough to meet its contractual commitments and plans. This means, for example, that if there was a high likelihood of bankruptcy, then its assets should be valued and reported on the balance sheet as if the company were to be liquidated (that is, discontinued, with all of its assets sold and all debts paid)

• Monetary Unit Assumption: the financial statements are reported using the national monetary unit (e.g., dollars in the United States), without any adjustment for change sin purchasing power (e.g., inflation)

Measurement Concept

• Historical Cost: the balance sheet elements are initially recorded at their costs

Elements of the Balance Sheet: Assets

• economic resources owned or controlled by the company, they have measurable value and are expected to benefit the company by producing cash inflows or reducing cash outflows in the future

• Assets are listed in the balance sheet in order of liquidity, which means how fast they can be turned into cash

Assets are grouped as current or long-term assets

• Current Assets: are resources the company will use or turn into cash with one year

• Long-Term (or noncurrent) assets: are to be used or turned into cash after a year

Current Assets

Current Assets:

• hold for <1 year

• Generally used for daily operating purposes and provide information about operating activates (e.g. large amount of trade receivable indicate usually credit sales)

Common current assets:

• Cash

• Inventories: always regarded current assets regardless of the time needed to sell or produce it

• Accounts receivable/trade receivables

• Prepaid expense

Cash and Inventory

• Cash: most liquid asset, a good indicator of a company’s health

• Inventories: physical products that will eventually be sold to the company’s customers: represent a significant asset on B/S as merchandising and manufacturing companies generate revenues & profits through the sale of inventories

Circulating Nature of Current Assets

• Inventories could either be sold cash or in credit. It it’s sold on credit, it will first become trade receivables, and when customer make the payment, trade receivables will be converted into cash, which then can be used to purchase more inventories (a new cycle beings again).

Accounts Receivables

• Trade receivables (accounts receivables): it represents amounts owed to a company by its customers for products/services sold on credit

• For analysis:

  • Level of accounts receivable: large amount of receivables relative to revenues may indicate problems collecting cash from customers

  • Concentration of credit risk: whether the receivables are diverse in terms of customer base or concentrated on limited number of customers: high concentration usually indicates high risk

Non-Current (Long-term) Assets

Non-current Assets:

• Hold for <1 year

• represent infrastructure from which the entity operates and used from a strategic and long-term perspective

Common non-current assets:

• Property, plant and equipment (PPE)

  • land

  • buildings

  • equipment and machinery

  • motor vehicles

• Intangible assets

• Goodwill

Tangible and Intangible Assets

Non-current assets (long-term/long-lived assets) could be either tangible or intangible

• Tangible Assets: with physical form (can be touched) usually referred to as property, plant and equipment (PP&E) or fixed assets: include land, buildings, furniture, machinery, and equipment

• Intangible Assets: lack physical form and confer specific rights on their owner examples include: patents, licenses, trademarks

Side note: The footnotes will disclose how much of the account receivables are owed by customers

Goodwill

• when one company acquires another company and is willing to pay more than its net fair value of the target company, because some items which are not recognized on B/S may also have value, such as reputation, trained employees and good relationship with customers and suppliers.

• It can only be recognized on the balance sheet during an acquisition when it is quantifiable

• Goodwill is also a good way to overstate assets

Assets: Requirements for Inclusion on the Bank Sheet

NOTE: not ALL resources exploited by a business will be assets for accounting purpose

To be regarded as an asset for inclusion on the balance sheet, it must meet the following requirements:

1. It is probable that the future economic benefits will flow to the entity

2. The economic resources must be under the control of the business (e.g., legal ownership, contractual agreement)

3. The asset has a cost or value that can be measured reliably in monetary terms

Not all assets will be included in the balance sheet: employers< management skills

Elements of the Balance Sheet: Liabilities

Liabilities: Obligations resulting from a past transaction, they are expected to be settled in the future by transferring assets or providing services

• Entities that a a company owns are called creditors

• Listed in order of maturity (how soon an obligation is to be paid) and grouped by current and noncurrent (long-term)

  • Current Liabilities will need to be paid or settled within one year

  • Noncurrent Liabilities have due dates beyond one year

Current & Non Current Liabilities

Current Liabilities: to be settled within 1 year

Common Current Liabilities accounts:

• Trade Payables

• Short-term loans

• Bank Overdraft

• Accrued Expense

Non-Current Liabilities: long-term />1 year

Common type:

• Long-term borrowings

• Notes payable

Trade Payables

• Trade payables (accounts payable): amounts a company owes its vendors for purchase of goods/services in case of credit purchase

• Trade credit allows a company to pay the supplier at a later schedule date

• For analysis:

  • Trade credit: could be seen as an interest-free financing, as it allows firms to pay the trade payables at later date without paying interest.

  • Trend in overall levels of trade payables relative to purchase: significant changes in accounts payable relative to purchases could signal changes in company’s credit relationship with suppliers

Accrued Expense

Accrued expense (accrued liabilities): expenses that have been recognized on a company’s income statement but not yet been paid as of the balance sheet date

Par example:

• Wage Expense: wages owed to employees who worked during the period will be paid in next period

• Interest Expense: interest are always paid in the future

• Utilities expense for water, gas, and electricity: organization receive utility bills after using utility services, the services will be paid next period

Elements of the Balance Sheet: Stockholders’ Equity

Stockholders’ Equity: represents the residual interest in the assets of the entity after subtracting liabilities. It is a combination of the financing provided by the owners and by business operations

Financing Provided by Owners is referred to as contributed capital

• Owners invest in the business by providing cash and sometimes other assets, receiving in exchange shares of stock as evidence of ownership

• Use the accounts Common Stock and Additional Paid-In Capital to represent the amount investors paid when they purchased the stock from the company

Financing Provided by Operations is referred to as earned capital or retained earnings

• The portion of profits reinvested in the business is called Retained Earnings

• Losses and dividends decrease the Retained Earnings Accounts

Unrecorded but Valuable Assets

Many very valuable intangible assets, such as trademarks, patents, and copyrights are not reported on the balance sheet.

Intangible assets not reported include:

• assets developed inside a company (not purchased)

• assets developed over time through research, development, and advertising (not purchased)

• for example, Coca-Cola does not report the value of its patented Coke formula

Accounts

• Organizations use account, a standardized format, to accumulate the dollar effect of transactions

• Each company establishes a chart of accounts, a list of all accounts titles to facilitate transaction recordings

• Typical accounts: cash, accounts receivables, inventory, revenue, cost of goods sold, depreciation expense

Typical Account Titles

Transactions

How Transactions Affect Accounts?

Every business transaction will affect accounts and financial statements

For example:

• if the firm sells more products in the accounting period, revenue will increase in income statement: if the sales are made in cash, then cash account will also increase in balance sheet

• If the firm buy a building for production, PP&E account will increase in balance sheet, and if the payment is by cash and paid immediately, then cash account will decrease in balance sheet

Principle of Transaction Analysis

There are two principles when analyzing how transaction affect accounts:

1. Dual aspect convention: every transaction affects at least two accounts. Correctly identifying those accounts and the direction of the effect (whether an increase or decrease) is critical!

2. Accounting equation will ALWAYS hold “balance“ after each transaction

Assets = Equity + Liabilities

Dual Aspect Convention

Every transaction will affect at least two different accounts on the accounting equation. Because every transaction involved an exchange by which the business entity both receives something and gives up something return.

Analyzing Transactions

Steps to follow in analyzing investing and financing transactions

Step 1: Ask → What was received?

• Identify the account(s) affected

• Classify the account(s) by type of element

  • Asset (A). / Liability (L). / Stockholders’ Equity (SE).

• Determine the direction and amount of the effect(s):

  • The account increased (+)/decreased (-)

Step 2: Ask → What was given?

• Repeat - Identify, Classify and Determine Effect

Step 3: Verify → Is the accounting equation in balance? (Does A = L + SE?)

Answers to Practice in Slides

(1) Accounts Receivable - CA

 (2) Retained Earnings - SE

 (3) Accrued Expenses Payable - CL

 (4) Prepaid Expenses - CA

 (5) Common Stock - SE

 (6) Long-Term Investments - NCA

 (7) Plant, Property, and Equipment - NCA

(8) Accounts Payable - CL

(9) Short-Term Investments - CA

(10) Long-Term Debt - NCL

(11) Inventories - CA

(12) Additional Paid-in Capital - SE

(13) Current Lease Obligations - CL

(14) Operating Lease Right-of-Use Assets - NCA (just because)

(15) Treasury Stock - SE