CHAPTER 5

UNDERSTANDING BALANCE SHEETS

 OVERVIEW

• Balance sheet elements and format

• Accounting issues
- Current and noncurrent assets and liabilities
- Measurement bases of different assets and liabilities
• Components of shareholders’ equity
• Balance sheet analysis
• Liquidity and solvency

Copyright © 2013 CFA Institute 2

 BALANCE SHEET CONTENTS

• The balance sheet is also known as the statement of

financial position or statement of financial condition.
• The balance sheet discloses, at a specific point in time,
- what an entity owns (or controls),
- what it owes, and
- what the owners’ claims are.

Assets = Liabilities + Owners’ equity

Copyright © 2013 CFA Institute 3

 BALANCE SHEET ELEMENTS

• Assets (A): resources controlled by the company as a

result of past events and from which future economic
benefits are expected to flow to the entity.

• Liabilities (L): obligations of a company arising from past

events, the settlement of which is expected to result in an
outflow of economic benefits from the entity.

• Equity (E): represents the owners’ residual interest in the

company’s assets after deducting its liabilities.

Copyright © 2013 CFA Institute 4

 EQUITY
• The balance sheet provides important information about a
company’s financial condition.
• However, balance sheet amounts of equity (assets, net of
liabilities) should not be viewed as a measure of either the market
or intrinsic value of a company’s equity.
• Why?
- The balance sheet is a mixed model with respect to
measurement (some items at historical cost, some items at
current value).
- Even current value reflects a value that was current at the end
of the reporting period.
- Future cash flows, which affect value, are driven by items
excluded from the balance sheet (e.g., reputation, management
skills).
Copyright © 2013 CFA Institute 5
 BALANCE SHEET: EXAMPLE
COLGATE-PALMOLIVE COMPANY (ASSETS)

Colgate's Annual Report

Copyright © 2013 CFA Institute 6
 BALANCE SHEET: EXAMPLE
COLGATE-PALMOLIVE COMPANY (LIABILITIES)

Colgate's Annual Report

Copyright © 2013 CFA Institute 7
 BALANCE SHEET: EXAMPLE
COLGATE-PALMOLIVE COMPANY (EQUITY)

Colgate's Annual Report

Copyright © 2013 CFA Institute 8
 BALANCE SHEET FORMAT

• Liquidity
- For a company overall, its ability to pay for short-term
obligations
- For a particular asset or liability, its “nearness to cash”
• Balance sheet ordering according to liquidity
- Companies using U.S. GAAP (e.g., Colgate) order items
on the balance sheet from most liquid to least liquid.
- Companies using IFRS order balance sheet information
from least liquid to most liquid.

Copyright © 2013 CFA Institute 9

 BALANCE SHEET: EXAMPLE
HENKEL AG (ASSETS)

Henkel's Annual Report

Copyright © 2013 CFA Institute 10

 BALANCE SHEET: EXAMPLE
L’ORÉAL (ASSETS)

L’Oréal's Annual Report

Copyright © 2013 CFA Institute 11
 CURRENT AND NONCURRENT
ASSETS AND LIABILITIES
• Balance sheet must distinguish between and present separately
- current and noncurrent assets
- current and noncurrent liabilities
• Exception to the current and noncurrent classifications
requirement, under IFRS:
- Current and noncurrent classifications are not required if a
liquidity-based presentation provides reliable and more
relevant information.
- In a liquidity-based presentation, all assets and liabilities
presented in order of liquidity.
- Liquidity-based presentation are often used by banks.
• Classified balance sheet: Balance sheet with separately
classified current and noncurrent assets and liabilities.

Copyright © 2013 CFA Institute 12

 BALANCE SHEET: EXAMPLE
BARCLAYS PLC (ASSETS)

Barclays' Annual Report

Copyright © 2013 CFA Institute 13
 CURRENT AND NONCURRENT
ASSETS AND LIABILITIES
• Current assets: Assets 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.
• Noncurrent assets: Assets not classified as current. Also
known as long-term or long-lived assets.
• Current liabilities: Liabilities expected to be settled within
one year or within one operating cycle of the business.
• Noncurrent liabilities: All liabilities not classified as
current.
• Working capital: The excess of current assets over
current liabilities.
Copyright © 2013 CFA Institute 14
 MEASUREMENT BASES OF CURRENT ASSETS:
CASH AND CASH EQUIVALENTS
• Cash Equivalents: Highly liquid, short-term investments
that are so close to maturity that the risk of significant
change in value from changes in interest rates is minimal.
- Examples:
- demand deposits with banks
- highly liquid investments with original maturities of three
months or less (e.g., U.S. T- bills, commercial paper,
money market funds)
- For cash and cash equivalents, amortized cost and fair
value are likely to be immaterially different.

Copyright © 2013 CFA Institute 15

 MEASUREMENT BASES OF CASH AND CASH
EQUIVALENTS: EXAMPLE DISCLOSURES
“Cash Equivalents. Highly liquid investments with remaining stated maturities
of three months or less when purchased are considered cash equivalents and
recorded at cost.”
• Procter & Gamble (2011), annual report

“Cash and cash equivalents. Cash and cash equivalents consist of cash in
bank accounts, units of cash unit trusts and liquid short-term investments with a
negligible risk of changes in value and a maturity date of less than three months
at the date of acquisition. . . . Units of cash unit trusts are considered to be
assets available for sale. As such, they are valued in the balance sheet at their
market value at the closing date. Any related unrealized gains are accounted for
in Finance costs, net in the income statement. The carrying amount of bank
deposits is a reasonable approximation of their fair value.”
• L’Oréal (2011), annual report

Copyright © 2013 CFA Institute 16

 MEASUREMENT BASES OF CURRENT ASSETS:
TRADE RECEIVABLES
• Trade receivables: Amounts owed to a company by its
customers for products and services already delivered.
- Also referred to as accounts receivable.
- Typically reported at net realizable value, an
approximation of fair value, based on estimates of
collectability.
• Aspects of accounts receivable often relevant to an
analyst:
- overall level of accounts receivable relative to sales,
- allowance for doubtful accounts, and
- concentration of credit risk.

Copyright © 2013 CFA Institute 17

 MEASUREMENT BASES OF RECEIVABLES:
L’ORÉAL EXAMPLE

Based on the note below, what percentage of its receivables

did L’Oréal estimate will be uncollectible?

Answer:
• For 2011, €46.2 divided by €3,042.3 = 1.52%.
• For 2010, €48.1 divided by €2,733.4 = 1.76%.
• For 2009, €50.2 divided by €2,493.5 = 2.01%.

Copyright © 2013 CFA Institute 18

EXAMPLE: TRADE RECEIVABLE
• Wilson Corporation uses an income statement approach to
estimate credit losses. Its gross Accounts. Receivable of
$5,000,000 at the beginning of the period had a net realizable
value of $4,925,000. During the period, the company wrote off
actual accounts receivable of $100,000 and collected $7,835,000
from credit customers. Credit sales for the year amounted to
$9,000,000. Of its credit sales, 1 percent was estimated to
eventually be uncollectible. Determine the net realizable value of
the company’s trade receivable at the end of the period.
Formula:
Account Receivable
Less: Allowances for doubtful accounts
Equals to Net realizable Value of Receivable

Copyright © 2012 CFA Institute 19

SOLUTION
Computations:
Accounts Receivable (beginning balance) $ 5,000,000
Add: Credit sales for the period 9,000,000
Less: Accounts receivable written-off (100,000)
Accounts receivable collected (7,835,000)
Total Accounts Receivable $ 6,065,000

Allowance for doubtful accounts (beginning balance*) $ 75,000

Add: estimated uncollectible ($9 million x 1%) 90,000
Less: Accounts receivable written-off (100,000)
Total Allowance for doubtful accounts $ 65,000

* $5,000,000 - $4,925,000 = $75,000 beginning balance in the Allowance for

doubtful account.

A/R net realizable value ($6,065,000 - $65,000) $ 6,000,000

Copyright © 2012 CFA Institute 20

 MEASUREMENT BASIS OF CURRENT
ASSETS: INVENTORY
Inventory Cost Flow

Beginning Ending
Inventory Goods
Inventory
Available
Goods for
Sale Cost of
Purchased
Goods Sold

Balance Sheet Income Statement

Copyright © 2013 CFA Institute 21

 MEASUREMENT BASES OF CURRENT ASSETS:
INVENTORY
U.S. GAAP IFRS
• Lower of cost or market (LCM): • Lower of cost or net realizable
- Market defined as replacement value (LCNRV):
cost with a floor (Net realizable - NRV defined as estimated
value, or NRV, less normal selling price less estimated
profit margin) and a ceiling costs of completion and sale.
(NRV).
- NRV defined as estimated
selling price less estimated
costs of completion and sale.
• Reversals of prior write-downs
• Reversals of prior write-downs are can be made and recognized in
NOT allowed. income.
• Does not permit LIFO.
• Permits last in, first out (LIFO).

Copyright © 2013 CFA Institute 22

Copyright © 2012 CFA Institute 23
SOLUTION

To write down the inventory of 28 units of WordCrafter to the lower-of-

cost-and-net-realizable-value:

Cost $9,400

Net realizable value/FMV 7,000

Reduction in carrying amount of ending

$2,400
inventory

Copyright © 2012 CFA Institute 24

Copyright © 2012 CFA Institute 25
SOLUTION
58%
Cost ratio during July ($522,000/$900,000)

$348,000
Estimated cost of goods sold ($600,000*58%)

Estimated ending inventory (at cost):

$522,000
Cost of goods available for sale during July

348,000
Less: Estimated cost of goods sold (above)

$174,000
Estimated ending inventory

Copyright © 2012 CFA Institute 26

 MEASUREMENT BASES OF NONCURRENT ASSETS:
PROPERTY, PLANT, AND EQUIPMENT

• Property, plant, and equipment (PP&E): Tangible assets that are

used in company operations over more than one fiscal period.

• Under the cost model, PP&E is reported at historical cost less any
accumulated depreciation and less any impairment losses.
- Depreciation: Systematic allocation of cost over an asset’s useful
life.
- Land is not depreciated.
- Impairment losses reflect an unanticipated decline in value.
- Reversals of impairment losses are permitted under IFRS but not
under U.S. GAAP.
• Under the revaluation model, PP&E is reported at fair value at the
date of revaluation less any subsequent accumulated depreciation.
- The revaluation model is NOT permitted under U.S. GAAP.

Copyright © 2013 CFA Institute 27

 MEASUREMENT BASES OF NONCURRENT ASSETS:
PROPERTY, PLANT, AND EQUIPMENT

U.S. GAAP IFRS

• Permit only the cost model for • Permit either cost model or
reporting PP&E. revaluation model.
- Can use different models for
different classes of assets.
- Must apply same model to all
assets within a particular class.

• Reversals of prior impairment • Reversals of impairment losses

losses are NOT allowed. are permitted.

Copyright © 2013 CFA Institute 28

 MEASUREMENT BASES OF NONCURRENT
ASSETS: INTANGIBLE ASSETS
• Intangible assets: Identifiable nonmonetary assets without physical
substance (e.g., patents, licenses, trademarks).
• Goodwill, which arises in business combinations and is not a
separately identifiable asset, is covered separately in IFRS.
• Measurement models for intangible assets:
- IFRS allow either a cost model or a revaluation model for intangible
assets.
- U.S. GAAP allow only the cost model.
• Measurement of intangible assets subsequent to acquisition:
- Intangible asset with finite useful life: Amortize over useful life and
assess for impairment when indicated.
- Intangible asset with indefinite useful life: Do not amortize, but
assess for impairment (annually under IFRS; only after qualitative
assessment under U.S. GAAP).

Copyright © 2013 CFA Institute 29

 MEASUREMENT BASES OF NONCURRENT
ASSETS: GOODWILL
Goodwill
- Arises when a company acquires another company for a
price in excess of fair market value of net identifiable
assets acquired.
- Is equal to purchase price of business minus fair market
value of net assets acquired.
- Represents value of all favorable attributes that relate to
a business enterprise.
- Is recorded only when there is an exchange transaction
that involves the purchase of an entire business.
- Is not amortized, but must be assessed for impairment.
• Accounting goodwill does not equal economic goodwill.

Copyright © 2013 CFA Institute 30

FINANCIAL ASSETS

Trading Securities Held to Maturity

Available for sale
(short term gains) (long term plan)
• Unrealized gain • Unrealized gain • Unrealized gain
is included in is deferred as a is not reflected
income part of other in either the B.S
statement comprehensive or IS
• Reflected in RE income within
O.E

Type IFRS U.S. GAAP

Trading Securities Fair value → P&L Fair value → P&L

Available-for-Sale Fair value → OCI Fair value → OCI

Held-to-Maturity Amortized cost Amortized cost

Copyright © 2012 CFA Institute 31

Copyright © 2012 CFA Institute 32
FINANCIAL ASSETS
1. Trading Securities
• Purpose: Bought to sell soon (short-term profits).
• Value Changes: Recorded in Profit and Loss (affects income statement right away).
• Measurement: At fair market value (updated daily).
• Example:
A company buys $10,000 of Apple stock, expecting to sell it in a week to make a
quick profit.

2. Available-for-Sale (AFS) Securities

• Purpose: Not meant to sell right away, but also not held to maturity.
• Value Changes: Recorded in OCI (not in profit immediately).
• Measurement: At fair market value.
• Example:
A company buys $50,000 in government bonds and might sell them in a few months if
it needs cash, but isn’t planning to hold them forever.

Copyright © 2012 CFA Institute 33

FINANCIAL ASSETS
2. Held-to-Maturity (HTM) Securities
• Purpose: Held until they mature (long-term plan).
• Value Changes: Not updated to market value; kept at cost and amortized.
• Measurement: At amortized cost.
• Example:
A company buys $100,000 in 10-year bonds and plans to hold them until they
are fully paid back in 10 years.

Copyright © 2012 CFA Institute 34

 MEASUREMENT BASES OF FINANCIAL ASSETS

Changes in Value through

Profit and Loss
Trading Securities (stocks and
bonds)
Measured at Fair
Value

Changes in Value through OCI

Financial
Assets IFRS: Designated Equity
Investments
Measured at U.S. GAAP: Available-for-Sale
Amortized Cost: Debt or Equity
- Held-to-Maturity
- Debt Instruments

Copyright © 2013 CFA Institute 35

 COMMON TYPES OF CURRENT LIABILITIES

• Trade payables, also known as accounts payable: Amounts that a

company owes its vendors for purchases of goods and services—in
other words, the unpaid amounts of the company’s purchases on credit
as of the balance sheet date.
• Notes payable: Financial liabilities owed by a company to creditors,
including trade creditors and banks, through a formal loan agreement.
• Accrued expenses (also called “accrued expenses payable,” “accrued
liabilities,” and other “nonfinancial liabilities”) are expenses that have
been recognized on a company’s income statement but that have not
yet been paid as of the balance sheet date.
• Deferred income (also called “deferred revenue” and “unearned
revenue”) arises when a company receives payment in advance of
delivery of the goods and services associated with the payment.

Copyright © 2013 CFA Institute 36

COMMON TYPES OF NONCURRENT LIABILITIES
• Long-term financial liabilities: Include loans (i.e., borrowings
from banks) and notes or bonds payable (i.e., fixed-income
securities issued to investors).
• Usually reported at amortized cost on the balance sheet.
• In certain cases, liabilities, such as bonds, issued by a
company are reported at fair value.

• Deferred tax liabilities: Amount of income taxes payable in

future periods with respect of taxable temporary differences.
• Result from temporary timing differences between a
company’s income as reported for tax purposes (taxable
income) and income as reported for financial statement
purposes (reported income).

Copyright © 2013 CFA Institute 37

DEFERRED TAX LABILITY
• A Deferred Tax Liability happens when a company’s accounting income
(used for financial reporting) is higher than its taxable income (used for tax
purposes)
• Example:
- A company buys equipment costing $10,000.
- It uses straight-line depreciation for accounting (financial statements):
- $2,000 per year for 5 years.
- But for tax, it uses accelerated depreciation:
- $4,000 in Year 1.
• Due to method’s difference accounting depreciation is $2000 and tax
depreciation is $4000—that means accounting profit is higher by $2000
• If Tax Rate = 30%
• Temporary difference = $2,000
• Tax on that = 30% × $2,000 = $600 is the DTL
Copyright © 2012 CFA Institute 38
 COMPONENTS OF SHAREHOLDERS’ EQUITY

• Capital contributed by owners (or common stock or share

capital)
• Preferred shares
• Treasury shares (or treasury stock)
• Retained earnings
• Accumulated other comprehensive income (or other
reserves, items recognized directly in equity)
• Non-controlling interest (or minority interest)

Copyright © 2013 CFA Institute 39

NON-CONTROLLING INTEREST: EXAMPLE
• Non-Controlling Interest (NCI) is the portion of a subsidiary’s equity that is not
owned by the parent company.
• “In other words, if a parent company owns less than 100% of another company,
the part it does not own is called the NCI.”
• Parent Co. owns 80% of Subsidiary Co. That means 20% is Non-Controlling
Interest (NCI).
• Subsidiary’s Net Income = $50,000, Subsidiary’s Net Assets = $200,000
• Since NCI owns 20%, they are entitled to:
NCI share of profit=20%×50,000=10,000.
- This $10,000 does not go to the parent — it's shown separately on the
income statement.
• Let’s say at acquisition, the NCI’s share of the subsidiary’s net assets was:
NCI share of equity=20%×200,000=40,000.​
- This $40,000 is shown in the equity section of the consolidated balance
sheet under Non-Controlling Interest.
Copyright © 2012 CFA Institute 40
 BALANCE SHEET: EXAMPLE
L’ORÉAL (EQUITY AND LIABILITIES)

L'Oréal Annual Report

Copyright © 2013 CFA Institute 41
 ANALYSIS OF BALANCE SHEETS

• Liquidity
- A company’s ability to meet its short-term financial commitments.
- Assessment focus: The company’s ability to convert assets to
cash and to pay for operating needs.
• Solvency
- A company’s ability to meet its financial obligations over the
longer term.
- Assessment focus: The company’s financial structure and its
ability to pay long-term financing obligations.
• Analytical Tools
- Common-size analysis.
- Balance sheet ratios.

Copyright © 2013 CFA Institute 42

 COMMON-SIZE BALANCE SHEETS

($ thousands) A B C
ASSETS
Cash, cash equivalents, marketable securities 1,900 200 3,300
Accounts receivable 500 1,050 1,500
Inventory 100 950 300
Total current assets 2,500 2,200 5,100
Property, plant, and equipment, net 750 750 4,650
Goodwill 0 300 0
Total assets 3,250 3,250 9,750
LIABILITIES AND EQUITY
Accounts payable 0 2,500 600
Total current liabilities 0 2,500 600
Long-term bonds payable 10 10 9,000
Total liabilities 10 2,510 9,600
Total shareholders’ equity 3,240 740 150
Total liabilities and shareholders’ equity 3,250 3,250 9,750

Copyright © 2013 CFA Institute 43

 COMMON-SIZE BALANCE SHEETS

(percent of total assets) A B C

ASSETS
Cash, cash equivalents, marketable securities 58.46% 6.15% 33.85%
Accounts receivable 15.38% 32.31% 15.38%
Inventory 3.08% 29.23% 3.08%
Total current assets 76.92% 67.69% 52.31%
Property, plant, and equipment, net 23.08% 23.08% 47.69%
Goodwill 0.00% 9.23% 0.00%
Total assets 100.00% 100.00% 100.00%
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable 0.00% 76.92% 6.15%
Total current liabilities 0.00% 76.92% 6.15%
Long-term bonds payable 0.31% 0.31% 92.31%
Total liabilities 0.31% 77.23% 98.46%
Total shareholders’ equity 99.69% 22.77% 1.54%
Total liabilities and shareholders’ equity 100.00% 100.00% 100.00%

Copyright © 2013 CFA Institute 44

 COMMON-SIZE BALANCE SHEETS

(percent of total assets) A B C

ASSETS
Cash, cash equivalents, marketable securities 58% 6% 34%
Accounts receivable 15% 32% 15%
Inventory 3% 29% 3%
Total current assets 77% 68% 52%
Property, plant, and equipment, net 23% 23% 48%
Goodwill 0% 9% 0%
Total assets 100% 100% 100%
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable 0% 77% 6%
Total current liabilities 0% 77% 6%
Long-term bonds payable 0% 0% 92%
Total liabilities 0% 77% 98%
Total shareholders’ equity 100% 23% 2%
Total liabilities and shareholders’ equity 100% 100% 100%

Copyright © 2013 CFA Institute 45

 BALANCE SHEET RATIOS: LIQUIDITY RATIOS

Liquidity ratios indicate a company’s ability to meet

current liabilities.

Ratio Calculation
Current Current assets /Current liabilities
Quick (acid test) (Cash + Marketable securities + Receivables) /
Current liabilities

Cash (Cash + Marketable securities) /

Current liabilities

Copyright © 2013 CFA Institute 46

 BALANCE SHEET RATIOS: SOLVENCY RATIOS

Solvency ratios indicate financial risk and financial leverage and

a company’s ability to meet its financial obligations over time.

Ratio Calculation
Long-term debt to equity Total long-term debt  Total equity
Debt to equity Total debt  Total equity
Total debt (also known as Total debt  Total assets
debt to assets)
Debt to capital Total debt  (Total debt + Total equity)
Financial leverage Total assets  Total equity

Copyright © 2013 CFA Institute 47

 SUMMARY

• Balance Sheet: what an entity owns (or controls), what it

owes, and what the owners’ claims are at a specific point in
time.
• Balance sheets usually present current and noncurrent
assets and liabilities.
• Accounting issues relate primarily to measurement
(historical cost versus fair value).
• Tools for balance sheet analysis include common-size
analysis and balance sheet ratios.
• Balance sheet ratios indicate liquidity and solvency.

Copyright © 2013 CFA Institute 48