UNDERSTANDING THE BALANCE SHEET
LOS 33.d: Compare and contrast current and noncurrent assets and
Current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater. The operating cycle is the time it takes to produce or purchase inventory, sell the product, and collect the cash. Current assers are usually presented in the order of their liquidity, with cash being rhe most liquid. Current assers reveal informarion about the operating activities of the firm.
Current liabilities are obligarions that will be satisfied within one year or one
operating cycle, whichever is greater. More specifically, a liability that meets any of the following criteria is considered current:
•
•
•
Settlement is expected during the normal operating cycle.
Settlement is expected within one year.
There is not an unconditional rightto defer settlement for more than one year.
Current assets minus current liabilities equals working capital. Not enough working capital may indicate liquidity problems. Too much working capital may be an indication of inefficient use of assets.
Noncurrent assets do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle. Noncurrent assets provide information about the firm's investing activities, which form the foundation upon which the firm operates.
Noncurrent liabilities do not meet the criteria of current liabilities. Noncurrent liabilities provide information about the firm's long-term financing activities.
International Financial Reporting Standards (IFRS) requires the current/ noncurrent' format unless a liquidity-based presentation is more relevant, as in the banking industry.
If a firm has a controlling interest in a subsidiary that is not 1000'0 owned, the parent reports a minority (nonconrrolling) interest in its consolidated bahnce sheer. The minority interest is the pro-rata share of the subsidiary's net assets (equity) not owned by the parent company.
Under IFRS, the minority interest is reported in the equity section of the consolidated balance sheer. Under U.S. GAAP, the minority interest can be reported in the liabilities section, the equity section, or the "mezzanine secrion" of the balance sneer. The mezzanine section is located between liabilities and equity.
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Srud,' Session 8
Cross-Reference to CFA Institute Assigned Reading #33 - Undcrsl;ll\ding rhe Balance Sheet
LOS 33.e: Explain the measurement bases (e.g.. historical cost and fair value) of assets and liabilities, inCluding current assets, current liabilities.
tangible assets, and intangible assets.
Under currelH accoulHing standards. the balance sheet conrains a mixture of hisrorical costs and fair values. In addition. sometimes replacemenr cost and the present value of future cash flows are used ro measure assets and liabilities.
Historical cost is the value that was exchanged at the acquisition date. Hisrorical cost is verifiable aRd objective; however. its rele\"Jnce ro investment analysis declines over time as prices change.
Fair value is the amount at which an asset can be bought or sold, or a liability can be incurred or setrled, between knowledgeable. willing panies in an arm's-length transaction. Fair value is subjective to a significant extent.
Because of this mixture of measurement bases, the balance sheet value of rotal assets should not be interpreted as the value of the firm. Analysts must adjust the balance sheet ro better assess a firm's investment potential or creditwonhiness.
Specific assets and their related liabilities are not usually offset (netted) on the balance sheet. For example, if a firm purchases manufacturing equipment for $3 million that is subject ro a loan of $2 million, the asset and liability are shown separately on the balance sheet rather than reponing a net asset value of $1 million.
The financial statement footnotes should include the following information about the measurement of the firm's assets and liabilities:
• Basis for measurement.
. , Carrying value of inventory bycategor~'.
•... AmOUnt of inventory carried at fair value less COStSto sell.
Write-downs and reversals, with a discussion of the circumstances that ledto them.
Inventories pledged as collateral for liabilities.
• Inventories recognized as an expense.
Curren t Assets
Current assets include cash and other assets that wilJ be convened into cash or used up within one year or the firm's operating cycle, whichever is greater. Some of the more common current assets include the following:
• Cash and cash equivalents (liquid low-risk securities with maturities less than 90 days).
• Accounts receivable (trade receivables)-amoullts expected to be colJected from the sale of goods and services. Receivables are typically reported net of an alJowance for bad debt (net receivables). This is not considered offsetting because of the nature of the allowance.
• Inventories-items held for sale or used in [he manufacturing of goods [0be sold.
Manufacturing firms separately report inventories of raw materials, work-in- process, and finished goods.
Study Session 8 Cross-Reference co CFA Institute Assigned Reading #33 - Understanding the Balance Sheet Marketable se~urjtics-debtor equity securities that are traded in a public market
(e.g., Treasury securities, certain equity securities, and mutual funds).
Other current assets incl uding prepaid expenses.
Inventory is reported at the lower of COSt or net realizable value. Net realizable value is the selling price of the inventory less the estimated cost of completion and disposal costs. For a manufacturer, inventory COSt includes direct materials, direct labor, and overhead. Inventory cost excludes the following:
Abnormal amounts of wasted materials, labor, and overhead.
• Storage costs beyond the produc:tion process.
• Administrative overhead.
• Disposal (selling) costs.
As discussed in the topic review on understanding the income statement;the cost flow assumption (i.e., FIFO, LIFO, average cost, or specific identification) affects the carrying (book) value of the inventory.
Standard costing and the retail method are used by some firms to measure inventory.
Standard costing, often used by manufacturing firms, involves assigning
predetermined costs to goods produced. Firms that use the retail method measure inventory at retail prices and then subtract gross profit in order to reflect cost.
Prepaid expenses are operating COSts that have been paid in advance. As the COSts are actually incurred, an expense is recognized in the income statement and prepaid expenses (an asset) decrease. For example, if a firm makes an annual rent payment of
$400,000 at the beginning of the year, an asset (cash) decreases and another asset (prepaid rent) increases by the amount of the pavment. At the end of three months, one-q uarrer of the prepaid rent has been used. At this point, the firm may recognize
$100,000 of rent expense in its income statement and reduce assets (prepaid rent) by
$100,000 to $300,000.
CurrentLiabilities
Current liabilities are obligations that will be satisfied within one year or operating cycle, whichever is greater.
Accounts payable (trade payables) are amounts owed to suppliers for goods or services purchased on credit.
Notes payable are obligations in the form of promissory nares owed to creditors. Notes payable can also be included in noncurrenr liabilities, if their mJturities are greater than one 'lear.
The current ponion of long-term debt is the pt'incipal portion of debt due within one year or the firm's operating cycle. whichever is grearetã.
Ta.xes payable are currenr r;lxes th;\t h;l\'c been recognized in rhe income statement bilt have not yer been ~)aidã.
Accrued liabilities (accrued expenses) He expenses rhat have been recognized in the income srarement but .\[~. nor vcr COIHLlcru;dhã due. Accrued expenses resulr fwm rhe
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StUll\- SeSSi(ln ~
Cross-ReI'cc'rence to CFA Institute Assi~nedReading #33 - Und'erstanding the Balance Shelãt
;lccrual mcrilOd of ;\CCOUIHing. under which expenscs are recogni7-t~das incurred. For example.consiclcr a lirlll that is relluired to make annual ycar-end interest payments of S;100.000 on an outslanding bank loan. At the end of March. the firm would recognize onc-quancr ($2"i,()()(l) of the IotaIinterest expense in its' income statement and an accrued liability would be increased lwthe same amount. even though the liability is not actual'" due unril the end of rhe vear., .
Unearned revenue (unearned income) is cash collected in advance of providing goods and senãices. For example. a magazine publisher receives subscription paymenrs in advance of delivery. \Vhen payment is received. both assets (cash) and liabilities (unearned revenue) increase bv the same amounr. As the magazines are delivered, the publisher recognizes revenue in the income statemenr and the liability is reduced.
Tangible Assets
Long-term assets with physical substance are known as tangible assets. Tangible assets, such as plan t. eq uipmenr, and natural resources, are reported on the balance sheet at historical COSt less accumulated depreciation or depletion. Historical COSt includes the original cost of the asset plus all costS necessary to get the asset ready for use (e.g., freight and instaJlation).
Land is also a tangible asset that is reported at historical cost. However, land is not depreciated.
Tangible assets not used in the operations of the firm should be classified as investmenr assets.
Intangible Assets
Intangible assets are long-term assets that lack physical substance:Financial securities are not considered inrangible assets. The value of an identifiable intangible assetis based on the rights or privileges conveyed to its owner over a finite period. Accordingly, the COSt of an idenrifiable inrangible asset is amortized over its useful life. Examples of identifiable inrangibles include patenrs, trademarks, and copyrights. Note, however, that the value of inrernaJly produced intangible assets may not be recorded on the balance sheer.
An inrangible asset that is unidentifiablecannot be purchased separately and may have an infll1ite life. Intangible assets with infinite lives are not amortized, but are tested for impairmenr at least annuaJly. The best example of an unidenrifiable inrangible asset is goodwill.
Inrangibje assets that are purchased are reported on the balance sheet at historical cost less accumulated amortization. Except for certain legal COStS, inrangible assets that are created imernaJly. incl tiding research and developmenr COStS, are expensed as incurred under U.S, GAAP. Under IFRS, a firm must idenrify the research stage and the developmenr stage. Accordingly, the firm must expense costs during the research stage but can capitalize COStS during the deveJopmenr stage.
Page 90 ©2008Schweser
S[UJy Session R Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet All of the foUowing should be expensed as incurred:
Start-up and training costs.
Administrative overhead.
Advertising and promotion.
Relocation and reorganization costs.
Termination costs.
Some analysts completely eliminate intangible assets, particularly unidenri.Fiable inrangibles, for analytical purposes. Analysts should, however, consider the valuetothe firm of each intangible asset before making any adjustmenrs. . Goodwill is the excess of purchase price over the fair value of the identifiable assets and liabilities acquired in a business acq uisition. Let's look at an example of calculating goodwill.
. . .. equ'al to
thlelI'recol,cfed\!)b(~k1fallues,. :t,ja1l:uIatetfi:e'amount ofgood'Will Wood sn.()wdreport~
:~,~-".
©2008 Schwcscr Page 91
Srud,'Session 8
Cross-Reference to CFA Institure Assigned Reading #33 - Understanding rhe Balance Sheet
,Curte.n:t;ass~isi '. <
ã;Pla.nialid~4'ufp~~~t>net
Liabilities
Fair.v.:iluerifnet,aSseis
~ãti(:,--. ,~,'":::':",.:":':',.", -."v;ii:: ':-'/.:.:" ,:'.-"'ãã:~::\;:\~i:i;'::,~::,::',-::',>,'~.
;~:~~,~h';f;~-<"..,\~\;;-.":'-\}:''';',' ".,:'..:. ,::'::::".-:,.; =00
Book,.lIalue (millions)
$80 880
560
600 ruilll
40
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Accounting goodwill should not be confused with economic goodwill. Economic'ã
goodwill derives from the expected future performance of the firm, while accounting goodwill is the result of past acquisitions.
Goodwill is created in a purchase acquisition. Internally generated goodwill is expensed as incurred. Goodwill is not amortized but must be tested for impairment at least annually. If impaired, goodwill is reduced and a loss is recognized in the income statement. The impairment loss does not affect cash flow, As long as goodwill is not impaired, it can remain on the balance sheet indefinitely.
Since goodwill is not amortized, firms can manipulate net income upward by allocating more of the acquisition pricetogoodwill and less tothe identifiable assets. The result is less depreciation and amortization expense, resulting in higher net income.
When computing ratios, analysts should eliminate goodwill from the balance sheet and goodwill impairment charges from the income statement for comparability. Also, analysts should evaluate future acquisitions in terms of the price paid relative tothe earning power of the acquired assets.
©2008Schwcscr
Study Session 8 Cross-Reference to CPA Institute Assigned Reading #33 - Understanding the Balance Sheet