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Chapter 2 Balance Sheet
Chapter 2 Balance Sheet
FINANCIAL STATEMENT
ANALYSIS
Contents
CHAPTER 2
UNDERSTANDING
THE BALANCE SHEET
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Balance Sheet
Liabilities and
Assets
Equity
Current
liabilities
Current Assets
Non-current
Liabilities
Non-current
Assets Shareholders’
Equity
Balance Sheet
Assets Liabilities and Stockholders’ Equity
Current Assets Current Liabilities
• Cash and cash equivalents • Current liabilities
• Marketable securities • Non-current liabilities
• Accounts receivable
• Inventories
• Other current assets
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I. ASSETS
Economic resources are controlled by a company and expected
to provide probable economic benefit in the future
Assets can be recognized if
• There is economic benefit
• Assets have expense or value of asset can be realizably
determined
Assets are classified into two groups
• Current assets: Cash and cash equivalents, short-term
financial investment, account receivables, inventory,
other current assets
• Non current assets: long term receivable, fixed assets,
property, long term financial investment, other non
current assets
Current assets
Current assets include cash and other assets that will be
converted into cash or used up within one year or the firm’s
operating cycle, whichever is greater. Current assets include:
1. Cash and cash equivalents are short-term, highly liquid
investments that are readily convertible to cash and near
enough to maturity that interest rate risk is insignificant.
Cash and cash equivalent are reported on the balance sheet
at amortized cost and fair value.
2. Marketable securities are financial assets that are traded in
a public market and whose value can be readily
determined.
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Current assets
3. Account receivable are financial assets that represent amounts
owed to the firm by customers for goods or services sold on
credit. Accounts receivable are reported at net realized value,
which based on estimated bad debt expense.
• Bad debt expense increase the allowance for doubtful
accounts, a contra-asset account.
• A contra-asset account is used to reduce the value of its
controlling account.
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Current assets
4. Inventories are goods held for sale to customers or used in
manufacture of goods to be sold.
• Manufacturing firms separately report inventories of raw
materials, work-in-process and finished goods.
• The cost included in inventory include purchase cost,
conversion costs, and other costs necessary to bring the
inventory to its present location and condition.
• Costs that are exclude from inventory include abnormal
waste of material, labor, and overhead, storage costs (unless
they are necessary as a part of the production process),
administrative overhead, and selling costs.
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Non-current assets
1. Property, plant, and equipment (PP&E) are tangible
assets used in the production of goods and services.
• PP&E includes land and buildings, machinery and
equipment, furniture, and natural resources.
• Under IFRS, PP&E can be reported using the cost model
or the revaluation model.
• Under US.GAAP, only the cost model is allowed.
• Under the cost model, PP&E is reported at amortized cost
(historical cost minus accumulated depreciation,
amortization, depletion, impairment losses).
• Under the valuation model, PP&E is reported at fair value
less any accumulated depreciation.
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Non-current assets
2. Investment property includes assets that generate
rental income or capital appreciation.
• Under IFRS, investment property can either be
reported at amortized cost or fair value.
• Under the fair value model, any change in fair value
is recognized in the income statement.
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Non-current assets
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Non-current assets
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Example
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Example (continued)
The fair value of the plant and equipment was $120 million
more than its recorded book value. The fair value of all other
identifiable assets and liabilities were equal to their recorded
book values. Calculate the amount of goodwill Wood should
report on its consolidated balance sheet.
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Solution
Answer :
• Fair value of net asset = fair value of plant and equipment,
net- fair value of liabilities
= 80+880-400=560 million (USD)
• Goodwill = purchase price-fair value of net assets
=600-560=40 million USD
Notes:
• Firms can manipulate net income upward by allocating more
of the acquisition price to goodwill and less to the identifiable
assets
• Analyst should eliminate goodwill from balance sheet and
goodwill impairment charges from income statement
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Financial assets
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II. LIABILITIES
• Are obligations owned by entity from previous transactions that
are expected to result in an outflow of economic benefits in the
future.
• Amount has been received but not been recorded as revenue on the
income statement or will have to be returned.
• Amount has been recorded as expense on the income statement but
has not been paid yet.
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Current liabilities
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Current liabilities
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Non-current liabilities
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Non-current liabilities
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V. SHAREHOLDERS’ EQUITY
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V. SHAREHOLDERS’ EQUITY
Contributed capital
• Total amount paid in by the common and preferred
shareholders
• Par value is a legal value and has no relationship to fair
value
• Authorized shares are the number of shares that may be
sold under the firm’s articles of incorporation
• Issued shares are the number of shares that have
actually been sold to shareholders
• Outstanding shares is equal to the issued shares less
treasury shares
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• Inventories
• Capitalizing and expensing
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INVENTORIES
Weighted average Items sold are a mix Average cost of all Average cost of all
cost (US and IFRS) of purchases items item
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Example 1
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Inventories
FIFO LIFO
COGS
Ending inventory
Gross profit
Tax
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Example 2
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Example 3
• CAP Inc. and NOW Inc. start up with $1,000 cash and $1,000
common stock. Each year the companies receive total revenues
of $1,500 cash and pay cash expenses, excluding an equipment
purchase, of $500. At the beginning of operations, each
company spends $900 to purchase equipment. CAP estimates
the equipment will have a useful life of three years and an
estimated salvage value of $0 at the end of the three years.
NOW estimates a much shorter useful life and expenses the
equipment immediately. The companies have no other assets
and make no other assets purchases during the three years
period. Assume the companies pay no dividends, earn zero
interest on cash balances, have a tax rate of 30%, and use the
same accounting method for financial and tax purposes.
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Example 3
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Solution
CAP Inc. 1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash
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Solution
NOW Inc. 1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash
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Solution
Question 1
Neither company reports higher net income nor total cash flow
over the three years. The sum of net income over the three years
is identical ($1,470 total) whether the $900 is capitalized or
expensed.
The sum of the change in cash ($1,470 total) is identical under
either scenario. CAP Inc. reports higher cash from operation by
an amount of $900 because, under the capitalization scenario, the
$900 purchase is treated as an investing cash flow.
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Solution
0 1 2 3
Retained earning
Common stock
Total shareholders’ equity
ROE
Net profit margin
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Capitalizing Expensing
Total assets
Shareholders’ equity
Income variability
Net income (first year)
Net income (subsequent years)
Cash flow from operations
Cash flow from investing
Debt ratio & Debt to equity
Interest coverage (first year)
Interest coverage (subsequent years)
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