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Chapter 5:
Understanding
Balance Sheets
FIN410 Lecture Materials by Bushra Ferdous Khan

Topics to be studied from this

chapter…
1. Current Assets
2. Current Liabilities
3. Non-current Assets
4. Non-current Liabilities
5. Components of Equity

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Topic 1

Current Assets

Current Assets
“Assets that are held primarily for the purpose of trading or that are expected to be sold,
used up, or otherwise realized in cash within one year or one operating cycle of the
business, whichever is greater, after the reporting period are classified as current
assets.”
“Only a few businesses have operating cycle longer than a year”. Example: real estate
developers, premium cheese makers. “Even though these types of companies often
hold inventories longer than one year, the inventory is classified as a current asset
because it is expected to be sold within an operating cycle.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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REAL Example of Longer than

One-Year Operating Cycle

Source: Annual Report 2019 of Eastern Housing Company

Current Assets
“Current assets are generally maintained for operating purposes,
and these assets include—in addition to cash—
 items expected to be converted into cash (e.g., trade receivables),
 used up (e.g., office supplies, prepaid expenses), or
 sold (e.g., inventories) in the current operating cycle.”

“Current assets provide information about the operating

activities and the operating capability of the entity.”

“Non-current assets represent the infrastructure from which the entity

operates and are not consumed or sold in the current period.
Investment in such assets are made from a strategic and longer
term perspective.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Current Assets
1. “Cash and Cash Equivalents: Cash equivalents are highly liquid,
short-term investments that are so close to maturity, the risk is
minimal that their value will change significantly with changes in
interest rates. Cash and cash equivalents are financial assets.
Demand deposits with banks and highly liquid investments with
original maturities of three months or less. Cash and cash
equivalents excludes amounts that are restricted in use for at
least 12 months.”

2. “Marketable Securities: Marketable securities are also financial

assets and include investments in debt or equity securities that
are traded in a public market, and whose value can be
determined from price information in a public market.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Current Assets
3. “Trade Receivables: Trade receivables, also referred to as accounts receivable,
are another type of financial asset. These are amounts owed to a company by its
customers for products and services already delivered. They are typically
reported at net realizable value, an approximation of fair value, based on
estimates of collectability. Several aspects of accounts receivable are usually
relevant to an analyst.”
 “First, the overall level of accounts receivable relative to sales is important
because a significant increase in accounts receivable relative to sales could
signal that the company is having problems collecting cash from its customers.”

 “A second relevant aspect of accounts receivable is the allowance for

doubtful accounts. The allowance for doubtful accounts reflects the
company’s estimate of the amount of receivables that will ultimately be
uncollectible. Additions to the allowance in a particular period are reflected as
bad debt expenses, and the balance of the allowance for doubtful accounts
reduces the gross receivables amount to a net amount that is an estimate of net
realizable value.”

 “Another relevant aspect of accounts receivable is the concentration of credit

risk.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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REAL Example for “the overall level of accounts receivable relative to

sales is important because a significant increase in accounts receivable
relative to sales could signal problems”…

Source: Holden Wilen, November 15 2019, Baltimore Business Journal [Read the case on Under Armour attached]

REAL Example for “allowance for doubtful accounts”…

Source: Annual Report 2018 of Heidelberg Cement Bangladesh Limited

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REAL Example for “concentration of credit”…

Source: Note 16 of Annual Report 2016 of ASM International. Link: [Link]

statements/consolidated-financial-statements/notes-to-the-consolidated-financial-statements/note-16-financial-instruments-and-financial-risk-management

Current Assets
4. Inventories: “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 measured at the lower of cost and net realizable value (NRV)
under IFRS. The cost of inventories comprises all costs of purchase, costs of
conversion, and other costs incurred in bringing the inventories to their present
location and condition. NRV is the estimated selling price less the estimated
costs of completion and costs necessary to complete the sale. NRV is applicable
for all inventories under IFRS.”

 “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. The loss in value
is reflected in the income statement. Under IFRS, if inventory that was written down
in a previous period subsequently increases in value, the amount of the original
write-down is reversed.”

 “When inventory is sold, the cost of that inventory is reported as an expense,

“cost of goods sold.” Accounting standards allow different valuation methods for
determining the amounts that are included in cost of goods sold on the income
statement and thus the amounts that are reported in inventory on the balance sheet.
IFRS allows only the first-in, first-out (FIFO), weighted average cost, and specific
identification methods.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Hypothetical Example for Inventory Measurement

ABC Corporation manufactures formal shirts. It has 1000 unsold units of shirts
laying in its inventory at the end of 2018. Manufacturing cost of these 1000
pieces of shirts is calculated to be BDT 50,000 which includes direct material
costs (including shipping expense to bring the fabric to ABC Corporation’s
factory), and conversion costs (which include all labor and manufacturing
overhead costs).
At the end of 2018, the shirts will be reported at their carrying value of
BDT 50,000 in ABC’s balance sheet.

Now imagine, a year has passed since the shirts have been manufactured. The
design is out of fashion and ABC estimates that there is no way the shirts can
be sold for BDT 50,000 or more. ABC estimates that the maximum revenue
that can be earned by selling these shirts is BDT 20,000. Additionally, to
facilitate the sale, a sales commission of BDT 4,000 would have to be paid.
The Net Realizable Value of the shirts is now BDT 20,000 – BDT 4,000 =
BDT 16,000

Hypothetical Example for Inventory Measurement (Continued)

Since IFRS requires that “Inventories are measured at the lower of cost
and net realizable value (NRV)”..
At the end of 2019 the shirts will be reported at BDT 16,000 in ABC’s
balance sheet.
Additionally, in 2019’s income statement a loss in inventory value of BDT 50,000 –
BDT 16,000 = BDT 34,000 will be recognized.

Now imagine in 2020 Shahrukh Khan is spotted wearing a shirt of the same
design in an award ceremony. This increases demand for the shirt in the
market. IFRS would allow reversing the write-down since “Under IFRS, if
inventory that was written down in a previous period subsequently
increases in value, the amount of the original write-down is reversed.”
Thus in 2020 the shirts can again be reported in balance sheet at BDT
50,000.

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Topic 2

Current Liabilities

Current Liabilities
“Current liabilities are liabilities that are expected to be settled within
one year or within one operating cycle of the business, whichever
is greater, after the reporting period are classified as current
liabilities.”

“IFRS specify that some current liabilities, such as trade

payables and some accruals for employee and other operating
costs, are part of the working capital used in the entity’s normal
operating cycle. Such operating items are classified as current
liabilities even if they will be settled more than one year after the
balance sheet date.”

“All other liabilities are classified as non-current liabilities.”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Current Liabilities
1. “Trade payables, also called accounts payable, are amounts that a company owes its
vendors for purchases of goods and services.”

2. “Financial liabilities that are due within one year or the operating cycle, whichever is
longer, appear in the current liability section of the balance sheet.”

3. “In addition, any portions of long-term liabilities that are due within one year (i.e., the
current portion of long-term liabilities) are also shown in the current liability section of the
balance sheet.”

4. “Accrued expenses (also called accrued expenses payable, accrued liabilities, and
other non-financial liabilities) are expenses that have been recognized on company’s
income statement but not yet been paid as of the balance sheet date.”

5. “Deferred income (also called deferred revenue or unearned revenue) arises when a
company receives payment in advance of delivery of the goods and services associated
with the payment.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Topic 3

Non-current Assets

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Non-current Assets
1. “Property, plant, and equipment (PPE) are tangible assets that are used in company
operations and expected to be used (provide economic benefits) over more than one fiscal
period. IFRS permits companies to report PPE using either a cost model or a revaluation
model.”
“Under the cost model, PPE is carried at amortized cost (historical cost less any
accumulated depreciation or accumulated depletion, and less any impairment
losses).
Historical cost generally consists of an asset’s purchase price, plus its delivery cost, and any other
additional costs incurred to make the asset operable (such as costs to install a machine).
Depreciation and depletion refer to the process of allocating (recognizing as an expense) the cost of
a long-lived asset over its useful life. Land is not depreciated.
Impairment losses reflect an unanticipated decline in value. Impairment occurs when the
asset’s recoverable amount is less than its carrying amount, with terms defined as follows
under IFRS:
■ Recoverable amount: The higher of an asset’s fair value less cost to sell, and its value in use.
■Fair value less cost to sell: The amount obtainable in a sale of the asset in an arms-length transaction
between knowledgeable willing parties, less the costs of the sale.
■ Value in use: The present value of the future cash flows expected to be derived from the asset.

When an asset is considered impaired, the company recognizes the impairment loss in
the income statement in the period the impairment is identified. Reversals of impairment
losses are permitted under IFRS.”
“Under the revaluation model, the reported and carrying value for PPE is the fair
value at the date of revaluation less any subsequent accumulated depreciation.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Non-current Assets
2. “Investment Property: Some property is not used in the production
of goods or services or for administrative purposes. Instead, it is used to
earn rental income or capital appreciation (or both). Under IFRS,
such property is considered to be investment property.”

 “IFRS provides companies with the choice to report investment

property using either a cost model or a fair value model. In general,
a company must apply its chosen model (cost or fair value) to all of its
investment property.”

 “The cost model for investment property is identical to the cost model for
PPE: In other words, investment property is carried at cost less any accumulated
depreciation and any accumulated impairment losses.”

 “Under the fair value model, investment property is carried at its fair value.
When a company uses the fair value model to measure the value of its
investment property, any gain or loss arising from a change in the fair value
of the investment property is recognized in profit and loss, i.e., on the
income statement, in the period in which it arises.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Non-current Assets
3. “Intangible Assets: Intangible assets are identifiable non-monetary assets
without physical substance. An identifiable asset can be acquired singly (can be
separated from the entity) or is the result of specific contractual or legal rights or
privileges. Examples include patents, licenses, and trademarks.”

“IFRS allows companies to report intangible assets using either a cost model or a
revaluation model. The revaluation model can only be selected when there is
an active market for an intangible asset. These measurement models are
essentially the same as described for PPE.”

“For each intangible asset, a company assesses whether the useful life of the asset
is finite or indefinite. Amortization and impairment principles apply as follows:
■An intangible asset with a finite useful life is amortized on a systematic basis over the
best estimate of its useful life, with the amortization method and useful life estimate reviewed at
least annually.

■An intangible asset with an indefinite useful life is not amortized. Instead, at least
annually, the reasonableness of assuming an indefinite useful life for the asset is reviewed
and the asset is tested for impairment.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Continued discussion on Intangible Assets

“Intangible assets are recognized in the balance sheet when they are procured/
acquired.”
“Under both, IFRS and US GAAP, internally created intangible assets are expensed.”
“IFRS provides that for internally created intangible assets, the company must separately
identify the research phase and the development phase.”
“The research phase includes activities that seek new knowledge or products. IFRS require
that costs to internally generate intangible assets during the research phase must be
expensed on the income statement.”
“The development phase occurs after the research phase and includes design or testing of
prototypes and models. 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.”
“US GAAP prohibits the capitalization as an asset of most costs of internally developed
intangibles and research and development. All such costs usually must be expensed.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Non-current Assets
4. Goodwill: “When one company acquires another, the purchase price is allocated to all the
identifiable assets (tangible and intangible) and liabilities acquired, based on fair value. If the
purchase price is greater than the acquirer’s interest in the fair value of the identifiable assets and
liabilities acquired, the excess amount is recognized as an asset, described as goodwill.”
“Analysts should distinguish between accounting goodwill and economic goodwill. Economic
goodwill is based on the economic performance of the entity, whereas accounting goodwill is
based on accounting standards and is reported only in the case of acquisitions. Economic
goodwill is important to analysts and investors, and it is not necessarily reflected on the balance
sheet. Instead, economic goodwill is reflected in the stock price (at least in theory).”
“Under both IFRS and US GAAP, accounting goodwill arising from acquisitions is capitalized.
Goodwill is not amortized but is tested for impairment annually. If goodwill is deemed to be
impaired, an impairment loss is charged against income in the current period. An impairment loss
reduces current earnings. An impairment loss also reduces total assets, so some performance
measures, such as return on assets (net income divided by average total assets), may actually
increase in future periods. An impairment loss is a non-cash item.”
“The recognition and impairment of goodwill can significantly affect the comparability of
financial statements between companies. Therefore, analysts often adjust the companies’ financial
statements by removing the impact of goodwill. Such adjustments include:
 excluding goodwill from balance sheet data used to compute financial ratios, and
 excluding goodwill impairment losses from income data used to examine operating trends.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Non-current Assets
5. Financial Assets: “Financial assets include a company’s investments in
stocks issued by another company or its investments in the notes, bonds, or other
fixed-income instruments issued by another company (or issued by a governmental
entity).”
“In general, there are two basic alternative ways that financial instruments are
measured subsequent to initial acquisition: fair value or amortized cost.”
“Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly market transaction.”
“Amortized cost of a financial asset (or liability) is the amount at which it was
initially recognized, minus any principal repayments, plus any amortization of
discount or minus any amortization of premium, and minus any reduction for
impairment.” Amount at which the financial asset was initially recognized
– Any principal repayment
+ Any amortization of discount OR – Any amortization of premium
-Any reduction for impairment
=Amortized cost
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Continued discussion on Financial Assets

Measurement of Financial Assets Under IFRS
Measurement Alternatives

Fair Value Amortized Cost

Used under two scenarios Used under one scenario only

Financial assets are measured Financial assets are measured

at fair value through profit or at fair value through other Held-to-maturity
loss – comprehensive income –
Held-for-trading Held-for-sale
Used for trading debt securities
The asset’s cash flows occur
Used when business model’s objective
acquired with the intent of selling it involves both collecting contractual cash on specified dates and
rather than holding it to collect the flows and selling the financial assets. consist solely of principal
interest and principal payments.
and interest, and if the
Used for both debt and equity investment. business model is to hold the
Used for equity investments for which (Remember usage for equity investment
the company irrevocably elects this requires irrevocable election at the time asset to maturity.
measurement method at acquisition of purchase)

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Continued discussion on Financial Assets

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Continued discussion on Financial Assets

Held-to-maturity thus
unrealized gains does not
impact assets, owner’s
equity, or net income

When held-for-trading the

coupon payment is part of
net income thus shown as
retained earnings

After impact on net

profit the income
statement will also
show Other
Comprehensive
Income from
Unrealized Gains of
2,000,000
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Topic 4

Non-current Liabilities

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Non-current Liabilities
1. Long-term Financial Liabilities: “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 loans payable and bonds payable are usually reported a
amortized cost on the balance sheet. At maturity, the amortized cost of the
bond (carrying amount) will be equal to the face value of the bond.”

 “In certain cases, liabilities such as bonds issued by a company are

reported at fair value. Those cases include financial liabilities held for
trading, derivatives that are a liability to the company, and some non-
derivative instruments such as those which are hedged by derivatives.”

2. “Deferred Tax Liabilities: Deferred tax liability is a tax that is

assessed or is due for the current period but has not yet been paid. The
deferral comes from the difference in timing between when the tax is
accrued and when the tax is paid.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Topic 5

Components of Equity

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Components of Equity
1 “Capital contributed by owners (or common stock, or issued capital).
The amount contributed to the company by owners.”
2 Preferred shares. “Classified as equity or financial liabilities based upon
their characteristics rather than legal form. For example, perpetual, non-
redeemable preferred shares are classified as equity. In contrast,
preferred shares with mandatory redemption at a fixed amount at a
future date are classified as financial liabilities.”
3 “Treasury shares (or treasury stock or own shares repurchased).
Shares in the company that have been repurchased by the company and
are held as treasury shares, rather than being cancelled.”
 “A repurchase of previously issued shares reduces shareholders’ equity by
the amount of the cost of repurchasing the shares and reduces the number
of total shares outstanding.”
 “Treasury shares are non-voting and do not receive any dividends
declared by the company.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Components of Equity
4 Retained earnings. “The cumulative amount of earnings recognized in the
company’s income statements which have not been paid to the owners of the
company as dividends.”

5 Accumulated other comprehensive income (or other reserves). “The

cumulative amount of other comprehensive income or loss. The term
comprehensive income includes both a) net income, which is recognized on
the income statement and is reflected in retained earnings, and b) other
comprehensive income which is not recognized as part of net income and is
reflected in accumulated other comprehensive income.”

6 Noncontrolling interest (or minority interest). “The equity interests of

minority shareholders in the subsidiary companies that have been
consolidated by the parent (controlling) company but that are not wholly
owned by the parent company.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Practice ALL Examples from this chapter. From Example 1 to Example 8.

Additionally, practice the MCQs on topics discussed in class that appear at

the chapter end.

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