Analysis of Assets

and Liabilities
GROUP 5 PRESENTATION
INVENTORIES AND VALUATION
● Inventory refers to the stock of materials and components that are used in the
manufacturing process to produce finished goods. These materials are typically in their
basic form and have not undergone any significant processing or transformation.
Examples of raw materials include wood, steel, plastic, chemicals, and textiles
● Raw materials inventory management is crucial for ensuring that production operations
run smoothly and that there are no interruptions due to shortages or stockouts.
● Work in progress (WIP) inventory represents goods that are in the process of being
manufactured but are not yet completed. These items are at various stages of
production, ranging from partially assembled products to components that are
undergoing processing on the production line.
● Managing WIP inventory effectively is essential for optimizing production efficiency and
minimizing cycle times
● Finished goods inventory comprises products that have completed the manufacturing
process and are ready to be sold to customers
Inventory Valuation
● Inventory valuation is the process of assigning a monetary value to the inventory held
by a business at a specific point in time
● There are three ways to determine inventory valuation:
○ FIFO:The cost of goods sold (COGS) is calculated based on the assumption that
the oldest inventory items are sold first. As a result, the cost assigned to COGS
reflects the cost of the earliest inventory purchases, while the ending inventory
reflects the cost of the most recent purchases.
○ LIFO (Last-In, First-Out) method: LIFO assumes that the most recently
acquired inventory items are sold first. Therefore, the cost of goods sold is based
on the latest inventory purchases, while the ending inventory represents the cost
of the oldest items in stock.
○ Weighted Average method: The weighted average method calculates the cost
of goods sold and ending inventory by averaging the costs of all inventory items
available for sale during the accounting period. This method considers both the
cost and quantity of inventory purchased
So what implications do these methods have
on Financial statements?

● FIFO tends to result in higher ending inventory values and lower COGS, leading to
higher reported profits and higher taxable income.
● LIFO often leads to lower ending inventory values and higher COGS, resulting in lower
reported profits and lower taxable income, especially during periods of rising prices.
● Weighted average method provides a compromise between FIFO and LIFO and may
result in intermediate values for ending inventory and COGS.
CAPITALIZATION
DECISION
● Capitalization refers to the process of recording certain expenditures as assets on the
balance sheet instead of recognizing them as expenses on the income statement. This
typically involves recognizing the cost of long-term assets, such as property, plant, and
equipment (PP&E), intangible assets, or investments, over their useful lives
● Capitalization is important because of the following reasons:
○ Accurate Asset Valuation: Capitalization ensures that expenditures that provide
future economic benefits are properly reflected on the balance sheet at their
historical cost
○ Matching Principle: By capitalizing certain costs and spreading their recognition
over multiple periods, financial statements adhere to the matching principle,
which aims to match expenses with the revenues they generate
○ Investor Confidence: Transparent and conservative capitalization policies can
enhance investor confidence and trust in financial reporting.
○ Regulatory Compliance: Compliance with reporting guidelines, mitigates the
risk of financial statement misrepresentation, and reduces the likelihood of
regulatory scrutiny or penalties.
Criteria for Capitalizing costs
● Capitalization is determined by the following criteria:
○ Materiality- Capitalization is typically reserved for significant expenditures that
materially impact the value of assets or future earnings
○ Future Economic Benefits- Costs should be capitalized if they are expected to
generate future economic benefits for the company beyond the current
accounting period.
○ Identifiability- Costs must be directly attributable to the acquisition, construction,
or enhancement of a specific asset.There should be a clear link between the
expenditure and the increase in the asset's future economic benefits.
○ Measurability:Costs must be reliably measurable in monetary terms.This
criterion ensures that the capitalized amount accurately reflects the economic
resources consumed or sacrificed to acquire or improve the asset.
○ Direct vs. Indirect Costs:Direct costs directly attributable to the acquisition,
construction, or improvement of an asset are typically capitalized.Indirect costs,
such as general overhead or administrative expenses, are usually expensed as
incurred unless they meet specific criteria for capitalization.
So what are examples of costs that are typically
capitalized
1. Development Costs:
● Costs incurred to develop or improve a product, process, or formula.
● Example: Research and development (R&D) expenses related to creating a new
drug or technology.
2. Software Costs:
● Costs associated with purchasing or developing software for internal use.
● Example: Costs incurred to customize and implement an enterprise resource
planning (ERP) system.
3. Property, Plant, and Equipment (PP&E):
● Costs related to acquiring, constructing, or improving tangible assets used in
operations.
● Examples: Land, buildings, machinery, equipment, and vehicles..
4. Construction Costs:
● Costs incurred during the construction or expansion of facilities or infrastructure.
● Examples: Labor, materials, permits, and overhead expenses directly attributable
to the construction project.
5. Start-up Costs:.
● Examples: Legal fees, incorporation costs, and initial advertising expenses
FIXED ASSET RE-
VALUATIONS
● Re-valuation of fixed assets involves periodically reassessing the carrying value of
tangible assets, such as property, plant, and equipment (PP&E), to reflect their current
fair market value. Instead of valuing fixed assets solely based on their historical cost (as
recorded at acquisition), re-valuation adjusts their carrying amount to align with their
current market value, which may have changed over time due to factors such as
inflation, changes in market conditions, or appreciation/depreciation in asset values.
● Assets may be revalued for the following reasons:
○ Market Value Fluctuations-Re-valuation may be necessary to reflect changes in
market conditions, such as fluctuations in real estate or equipment prices,
ensuring that asset values accurately reflect their current market worth.
○ Asset Appreciation- If fixed assets have appreciated in value over time due to
factors such as inflation, technological advancements, or increased demand, re-
valuation helps capture this appreciation and update asset values accordingly.
○ Asset Impairment:-Revaluation may be prompted by indicators of impairment,
such as declines in asset performance, changes in economic conditions, or shifts
in market demand, to ensure that asset values are not overstated on the balance
sheet.
○ Investment Decisions:-Companies may re-value fixed assets when considering
strategic investments, acquisitions, or divestitures to accurately assess the value
of assets involved in transactions and make informed decisions
Impact of revaluation on the balance sheets
and financial ratios

● Balance Sheet Impact;

○ Asset Values: Re-valuation adjusts the carrying values of fixed assets on the
balance sheet to reflect their current fair market value. If the re-valuation results
in an increase in asset values, the total assets on the balance sheet will increase.
Conversely, if the re-valuation leads to a decrease in asset values, total assets
will decrease
○ Equity: Any surplus or deficit resulting from the re-valuation is recorded in equity.
A surplus increases shareholders' equity, while a deficit decreases it. This
adjustment directly impacts the company's net worth.
● Financial ratios impact:
○ Return on Assets (ROA): ROA measures how efficiently a company utilizes its
assets to generate profits. Re-valuation can impact ROA by altering the asset
base. An increase in asset values due to revaluation may result in a higher ROA,
as profits are spread over a larger asset base.
○ Return on Equity (ROE): ROE measures the return generated on shareholders'
equity. Re-valuation affects ROE by changing the equity value. A surplus from re-
valuation increases equity, potentially boosting ROE, while a deficit decreases
equity, potentially reducing ROE.
○ Debt-to-Equity Ratio: Re-valuation influences the debt-to-equity ratio by altering
the equity value. A surplus from re-valuation increases equity, lowering the debt-
to-equity ratio as a company's debt remains constant relative to its equity.
Conversely, a deficit decreases equity, raising the debt-to-equity ratio.
○ Asset Turnover Ratio: Re-valuation indirectly impacts the asset turnover ratio,
which measures a company's efficiency in generating sales from its assets. An
increase in asset values may result in a lower asset turnover ratio if sales remain
constant, as the assets' carrying amount is highe
INTANGIBLE
ASSETS:GOODWIL
L, BRANDS
● Intangible assets are non-physical assets that lack a physical form but have economic
value and provide future benefits to the company. These assets are identifiable,
meaning they can be separated from the company and sold or transferred
independently
● Goodwill represents the excess of the purchase price of a business over the fair value
of its identifiable net assets acquired in a business combination.
● It arises from factors such as the company's reputation, customer relationships, brand
recognition, intellectual property, and strategic advantages
● Brands are specific intangible assets that represent the value associated with a
company's recognized product or service names, logos, symbols, or trademarks.
● Brands contribute to customer loyalty, brand recognition, and market differentiation,
leading to competitive advantages and enhanced profitability
How is Goodwill Generated and recorded in
Financial statements

https://youtu.be/yq9qjCmUfS4?si=e3d8qpOw3UA_IqI4
DEBT
● Debt refers to financial obligations or liabilities that a company owes to external parties,
such as creditors, lenders, or bondholders, typically arising from borrowing funds to
finance operations, investments, or capital expenditures
● Debt can take various forms, including loans, bonds, mortgages, or lines of credit. It is
recorded on the balance sheet as a liability and represents funds that the company
must repay over time, along with any associated interest payments.
● Significance in Financial Analysis:
❏ Debt levels are crucial indicators of a company's financial health, risk profile, and
ability to meet its financial obligations.
❏ Financial analysts assess a company's debt levels, debt structure, and debt
repayment capacity to evaluate its solvency, creditworthiness, and financial
stability.
❏ Debt metrics such as debt-to-equity ratio, interest coverage ratio, and debt
service coverage ratio are commonly used in financial analysis to assess a
company's leverage, liquidity, and ability to service its debt.
Types of loans and their Characteristics
Type of loan Characteristics

Bank Loans ● Terms and conditions vary depending on the lender and the
borrower's creditworthiness
● Repayment terms may include fixed or variable interest rates,
amortization schedules, and collateral requirements
● Bank loans may be secured or unsecured, with secured loans
requiring collateral to secure repayment.

Bonds ● Bonds have fixed maturity dates, typically ranging from a few years
to several decades.
● Bondholders receive periodic interest payments (coupon
payments) until maturity, at which point the principal amount is
repaid
● Bonds may be classified based on issuer (corporate bonds,
government bonds), maturity (short-term, long-term), or interest
payment structure (fixed-rate, floating-rate).
Reporting of Debt

● When it comes to reporting of debt in financial statements and their implications are as
follows:
○ Financial statements:Debt is reported on the balance sheet as a liability under
the current liabilities or long-term liabilities section, depending on the maturity of
the debt short-term debt due within one year is classified as current liabilities,
while long-term debt due beyond one year is classified as non-current liabilities.
○ Implications for Solvency analysis: High levels of debt relative to equity or
assets may indicate increased financial risk and leverage, potentially affecting a
company's ability to meet its debt obligations
LEASES & OFF
BALANCE SHEET
FINANCING
● Lease Agreements: A lease agreement is a contract between a lessor (owner) and a
lessee (user) that allows the lessee to use an asset (such as equipment, property, or
machinery) owned by the lessor for a specified period of time in exchange for periodic
payments. The terms of the lease, including the duration, payment amount, and
conditions for termination, are outlined in the agreement.
● There are different types of leases, including operating leases and finance leases, each
with its own accounting and financial implications.
● Off-Balance Sheet Financing: Off-balance sheet financing refers to a financing
arrangement in which a company obtains funds without reporting the transaction as a
liability on its balance sheet. This allows the company to keep the debt off its balance
sheet, which can make its financial position appear stronger than it actually is
● Leases are of two types:
○ Operating Lease: In an operating lease, the lessor (owner of the asset) allows
the lessee (user) to use the asset for a specified period of time without
transferring ownership rights
○ Finance Lease (Capital Lease): In a finance lease, the lessee effectively
assumes the risks and rewards of ownership of the leased asset, even though
legal ownership remains with the lessor.
BALANCE SHEET
DISCLOSURE
● Balance sheet disclosure is important for the following reasons:
○ Transparency: Balance sheet disclosure ensures transparency by providing
detailed information about a company's assets, liabilities, and equity. This allows
stakeholders to understand the composition and value of the company's
resources and obligations
○ Decision Making: Investors and creditors rely on balance sheet disclosure to
assess a company's financial health and performance. By understanding the
nature and extent of a company's assets and liabilities, stakeholders can
evaluate its ability to generate future cash flows, meet its financial obligations,
and sustain operations
○ Risk Assessment: Balance sheet disclosure helps stakeholders identify and
evaluate risks associated with a company's financial position. For example,
disclosures about contingent liabilities or off-balance sheet arrangements enable
investors and creditors to assess potential future obligations and risks that may
impact the company's financial stability.
Common disclosures required for assets and liabilities include:
● Significant Accounting Policies: Companies disclose their accounting policies
related to the recognition, measurement, and presentation of assets and
liabilities. This includes information about depreciation methods, inventory
valuation, impairment assessments, and other key accounting principles.
● Contingent Liabilities: Contingent liabilities are potential obligations that may
arise from past events, depending on future outcomes. Companies disclose
contingent liabilities in the footnotes to the balance sheet, providing details about
the nature of the obligations, their potential impact on the company's financial
position, and the likelihood of occurrence.
● Off-Balance Sheet Arrangements: Companies disclose significant off-balance
sheet arrangements, such as operating leases, contingent assets, and contingent
liabilities, that may impact their financial position and performance. These
disclosures provide stakeholders with a comprehensive view of the company's
financial obligations and risks.
Reserves and
Provisions
https://youtu.be/vDg8wsSsNV0?si=RA3ksWgsg4HRJKn-
Examples and Impact on Financial
Statements

● Reserves: An example of a reserve is a general reserve for future contingencies. When

a company sets aside a portion of its profits as a general reserve, it does not impact the
income statement directly. However, it reduces the amount of distributable profits and
increases equity on the balance sheet, thereby enhancing financial stability.
● Provisions: A common example of a provision is a warranty provision. When a
company sells products with warranties, it recognizes a provision for future warranty
expenses based on historical warranty claims and estimates of future claims. This
provision is recognized as a liability on the balance sheet, reducing profits on the
income statement and increasing liabilities. As actual warranty expenses are incurred,
the provision is adjusted accordingly, impacting both the income statement and the
balance sheet.
CONTINGENT
LIABILITIES
● Contingent liabilities are potential obligations that may arise from past events,

depending on the occurrence or non-occurrence of uncertain future events.

● Types of Contingent Liabilities and Their Potential Impact:

○ Lawsuits: Legal claims against a company represent contingent liabilities. The
outcome of lawsuits may result in settlements or judgments against the company.
The potential impact on financial statements includes recognizing a liability if the
likelihood of an unfavorable outcome is probable and the amount can be
reasonably estimated
○ Warranties: Warranties provided by a company on its products represent
contingent liabilities. The company may incur expenses to honor warranties if the
products are defective or fail to meet performance standards. The potential
impact on financial statements includes recognizing a liability for estimated
warranty costs based on historical experience and warranty claim rates.
○ Guarantees: Guarantees provided by a company for third-party obligations
represent contingent liabilities. If the guaranteed party defaults on its obligations,
the company may be required to fulfill the guarantee. The potential impact on
financial statements includes recognizing a liability for the estimated fair value of
the guarantee, which is often based on the likelihood of default and the expected
loss amount.
DISCLOSURE REQUIREMENT FOR CONTINGENT LIABILITIES AND THEIR
IMPLICATIONS TO STAKEHOLDERS

● Accounting standards, such as Generally Accepted Accounting Principles (GAAP) and

International Financial Reporting Standards (IFRS), require companies to disclose
material contingent liabilities in the footnotes to the financial statements.
● The disclosure includes information about the nature of the contingent liabilities, the
potential impact on the company's financial position and performance, and any
mitigating factors or uncertainties.
● Stakeholders, such as investors, creditors, and analysts, rely on the disclosure of
contingent liabilities to assess the potential risks and uncertainties facing the company.
● The presence of significant contingent liabilities may affect stakeholders' perceptions of
the company's financial health, risk profile, and future prospects, influencing investment
decisions, credit ratings, and stock prices.