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2021 Curriculum CFA Program Level I Financial Reporting and Analysis

Understanding Balance Sheets

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Introduction

The balance sheet provides information on a company’s resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company’s ability to pay for its near-term operating needs, meet future debt obligations, and make distributions to owners. The basic equation underlying the balance sheet is Assets = Liabilities + Equity.

Analysts should be aware that different types of assets and liabilities may be measured differently. For example, some items are measured at historical cost or a variation thereof and others at fair value. An understanding of the measurement issues will facilitate analysis. The balance sheet measurement issues are, of course, closely linked to the revenue and expense recognition issues affecting the income statement. Throughout this reading, we describe and illustrate some of the linkages between the measurement issues affecting the balance sheet and the revenue and expense recognition issues affecting the income statement.

This reading is organized as follows: In Section 2, we describe and give examples of the elements and formats of balance sheets. Section 3 discusses current assets and current liabilities. Section 4 focuses on assets, and Section 5 focuses on liabilities. Section 6 describes the components of equity and illustrates the statement of changes in shareholders’ equity. Section 7 introduces balance sheet analysis. A summary of the key points and practice problems in the CFA Institute multiple-choice format conclude the reading.

Learning Outcomes

The member should be able to:

  1. describe the elements of the balance sheet: assets, liabilities, and equity;

  2. describe uses and limitations of the balance sheet in financial analysis;

  3. describe alternative formats of balance sheet presentation;

  4. distinguish between current and non-current assets and current and non-current liabilities;

  5. describe different types of assets and liabilities and the measurement bases of each;

  6. describe the components of shareholders’ equity;

  7. convert balance sheets to common-size balance sheets and interpret common-size balance sheets;

  8. calculate and interpret liquidity and solvency ratios.

Summary

The balance sheet (also referred to as the statement of financial position) discloses what an entity owns (assets) and what it owes (liabilities) at a specific point in time. Equity is the owners’ residual interest in the assets of a company, net of its liabilities. The amount of equity is increased by income earned during the year, or by the issuance of new equity. The amount of equity is decreased by losses, by dividend payments, or by share repurchases.

An understanding of the balance sheet enables an analyst to evaluate the liquidity, solvency, and overall financial position of a company.

  • The balance sheet distinguishes between current and non-current assets and between current and non-current liabilities unless a presentation based on liquidity provides more relevant and reliable information.

  • The concept of liquidity relates to a company’s ability to pay for its near-term operating needs. With respect to a company overall, liquidity refers to the availability of cash to pay those near-term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.”

  • Some assets and liabilities are measured on the basis of fair value and some are measured at historical cost. Notes to financial statements provide information that is helpful in assessing the comparability of measurement bases across companies.

  • Assets expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as current assets. Assets not expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as non-current assets.

  • Liabilities expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as current liabilities. Liabilities not expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as non-current liabilities.

  • Trade receivables, also referred to as accounts receivable, are amounts owed to a company by its customers for products and services already delivered. Receivables are reported net of the allowance for doubtful accounts.

  • Inventories are physical products that will eventually be sold to the company’s customers, either in their current form (finished goods) or as inputs into a process to manufacture a final product (raw materials and work-in-process). Inventories are reported at the lower of cost or net realizable value. If the net realizable value of a company’s inventory falls below its carrying amount, the company must write down the value of the inventory and record an expense.

  • Inventory cost is based on specific identification or estimated using the first-in, first-out or weighted average cost methods. Some accounting standards (including US GAAP but not IFRS) also allow last-in, first-out as an additional inventory valuation method.

  • Accounts payable, also called trade payables, are amounts that a business owes its vendors for purchases of goods and services.

  • Deferred revenue (also known as unearned revenue) arises when a company receives payment in advance of delivery of the goods and services associated with the payment received.

  • Property, plant, and equipment (PPE) are tangible assets that are used in company operations and expected to be used over more than one fiscal period. Examples of tangible assets include land, buildings, equipment, machinery, furniture, and natural resources such as mineral and petroleum resources.

  • IFRS provide companies with the choice to report PPE using either a historical cost model or a revaluation model. US GAAP permit only the historical cost model for reporting PPE.

  • Depreciation is the process of recognizing the cost of a long-lived asset over its useful life. (Land is not depreciated.)

  • Under IFRS, property used to earn rental income or capital appreciation is considered to be an investment property. IFRS provide companies with the choice to report an investment property using either a historical cost model or a fair value model.

  • Intangible assets refer to identifiable non-monetary assets without physical substance. Examples include patents, licenses, and trademarks. For each intangible asset, a company assesses whether the useful life is finite or indefinite.

  • An intangible asset with a finite useful life is amortised on a systematic basis over the best estimate of its useful life, with the amortisation method and useful-life estimate reviewed at least annually. Impairment principles for an intangible asset with a finite useful life are the same as for PPE.

  • An intangible asset with an indefinite useful life is not amortised. Instead, it is tested for impairment at least annually.

  • For internally generated intangible assets, IFRS require that costs incurred during the research phase must be expensed. Costs incurred in the development stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project.

  • The most common intangible asset that is not a separately identifiable asset is goodwill, which arises in business combinations. Goodwill is not amortised; instead it is tested for impairment at least annually.

  • Financial instruments are contracts that give rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. In general, there are two basic alternative ways that financial instruments are measured: fair value or amortised cost. For financial instruments measured at fair value, there are two basic alternatives in how net changes in fair value are recognized: as profit or loss on the income statement, or as other comprehensive income (loss) which bypasses the income statement.

  • Typical long-term financial liabilities include loans (i.e., borrowings from banks) and notes or bonds payable (i.e., fixed-income securities issued to investors). Liabilities such as bonds issued by a company are usually reported at amortised cost on the balance sheet.

  • Deferred tax liabilities arise from temporary timing differences between a company’s income as reported for tax purposes and income as reported for financial statement purposes.

  • Six potential components that comprise the owners’ equity section of the balance sheet include: contributed capital, preferred shares, treasury shares, retained earnings, accumulated other comprehensive income, and non-controlling interest.

  • The statement of changes in equity reflects information about the increases or decreases in each component of a company’s equity over a period.

  • Vertical common-size analysis of the balance sheet involves stating each balance sheet item as a percentage of total assets.

  • Balance sheet ratios include liquidity ratios (measuring the company’s ability to meet its short-term obligations) and solvency ratios (measuring the company’s ability to meet long-term and other obligations).