Ch 2.

The Balance Sheet

 Contents
1. Purposes of the Balance Sheet
2. Limitations of the Balance Sheet
3. Balance Sheet Formats
4. Content of the Balance Sheet
5. Balance Sheet Analysis
 Competencies
1. Explain the purposes of the Balance Sheet
2. Identify the limitations of the Balance Sheet
3. Define the various elements of assets,
liabilities, and owners’ equity as presented on
the balance sheet.
4. Explain the use of footnotes in balance sheets
5. Interpret balance sheets using horizontal and
vertical analysis as well as base-year
comparisons.
 Financial Statements
1. Balance sheet
2. Income statements
3. Statement of Cash flows
4. Statement of Retained earnings
 Balance Sheet
• Statement of the financial position

• At the end of each accounting

period

• “Snapshot” at a point in time

Purposes of the Balance Sheet
• Reflects the accounting equation
• Reveals assets, liabilities, and owner’s equity
(net worth)
• Shows a company’s :
• Financial flexibility (e.g., liquidity, solvency)
 Balance Sheet

• Assets, which are those items owned by

the business
• Liabilities, which are the amounts the
business owes to others
• Owners’ equity, which is the residual
claims owners have on their assets, or the
amount left over in a business after
subtracting its liabilities from its assets.
 Balance Sheet
Assets = Liabilities + Owner’s
Equity

Liabilities
Assets +
Owner’s Equity
Balance Sheet
Why a Balance Sheet Balances –
Dr. Dopson’s Stuff Theory

• Dr. Dopson’s Stuff Theory is simple. For

all the stuff (assets) you have in your life,
you got it from either:
• Borrowing money that you have to repay such
as through credit cards or loans (liabilities) or
• Acquiring the stuff through others such as your
parents, siblings, or friends (investors’ equity)
or paying for the stuff yourself through money
you earned (retained earnings equity)
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 Relationship between balance
sheet and income statement
• Assets used to generate revenue and cash flow
• For a hospitality business this is land, building
and equipment
• Liabilities are related to expenses
• Accrued wages and accounts payable
• Retained earnings will increase with net income,
less any dividends declared
• This is the link to the income statement
Limitations of the Balance Sheet
• NO CURRENT VALUES (cost principle)
• Historical cost based: doesn’t reflect current values of
some assets (e.g., property & equipment)

Hilton Hotels Corp.

-Market value of its assets: $4.03 billion

-Book value on the balance sheet: $1.89 billion

Limitations of the Balance Sheet

• Missing “assets”: (e.g.) no HR asset

Limitations of the Balance Sheet
• Time
• Static nature: reflect the financial position for only a
moment

• Not exact
• Subjective nature: by judgments and estimates
Components of the Balance Sheet

• The balance sheet is subdivided into

components under the broad headings of
• Assets,
• Liabilities,
• Owners’ Equity.
• These subclassifications have been created by
accountants to make information more easily
accessible to readers of the balance sheet and
to allow for more rapid identification of
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specific types of information for decision
making.
Major Contents of the Balance Sheet
Assets Liabilities and Equity
• Current assets • Current liabilities
• Long-term liabilities
• Noncurrent assets
• Owner’s equity
• Other assets
 Current Assets
• Current Assets are those which may reasonably be
expected to be sold or turned into cash within one year.
• Current assets, typically listed on the balance sheet in
order of their liquidity, include:
• Cash
• Marketable securities (short-term investments)
• Accounts receivable (net receivables)
• Inventories
• Prepaid expenses: (e.g.) prepaid insurance, prepaid rent,
prepaid interest etc.
• Liquidity is defined as the ease in which current assets
can be converted to cash in a short period of time (less
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than 12 months).
 Current Assets
• For purposes of preparing a balance sheet,
• the term cash refers to the cash held in cash banks,
money held in checking or savings accounts, electronic
fund transfers from payment card companies, and
certificates of deposit (CDs).
• Marketable securities include those investments such
as stocks and bonds that can readily be bought sold and
thus are easily converted to cash.
• These are stocks and bonds the business purchases
from other companies. These are not to be confused
with a company’s stocks that are listed on its balance
sheet as owners’ equity. 20
 Current Assets
• Accounts receivable represent the amount of money
owed to a business by others (such as customers).
• Net receivables (the term net means that something has
been subtracted out) are those monies owed to the
business after subtracting any amounts that may not be
collectable (doubtful accounts).
• In the hospitality industry, inventories will include the
value of food, beverages and supplies used by a restaurant,
as well as sheets, towels and the in-room replacement
items (hangers, blow dryers, coffee makers and the like)
used by a hotel.
• Prepaid expenses are best understood as items that
21 will
be used within a year’s time, but which must be completely
paid for at the time of purchase.
 Noncurrent Assets
• Noncurrent Receivables
• Long Term Investments
• Property & Equipment
• Relates to Tangible Assets
• Land is not depreciated (land is unique)
• Construction In Progress - All labor, materials & other
expenses of construction - not depreciated
• Leasehold Improvements - renovations & remodeling
expenses on leased space
• China, Glassware, Linen, Uniforms
 Other Assets
• Generally are Intangible items; as a result, they are
amortized over time
• Goodwill - excess of purchase price over net book value
of a business
• Deferred franchise fees
• Preopening expenses
• Organization costs
• Operating equipment (linens, glasses, etc.)
 Current Liabilities
• Payables within one year resulting from
acquisitions of goods and services
• Amounts received in advance of services (e.g.)
advance deposit
• Current maturities of long-term debt
• Dividends payable, income taxes payable,
Notes payable, Accounts payable, Accrued
expenses, Advance deposits, Income taxes
payable, Deferred income taxes
 Long-term Liabilities
• To be paid beyond the next 12 months

• Notes, mortgages, bonds, leases, and deferred

income taxes etc.

• Long-term debt
 Owner’s Equity
• Capital Stock: Mostly, common stock
• Additional paid-in capital: Payments for capital stock in
excess of the stated value of the capital stock.
For example, assume that a company issues 1 million shares with
a par value of $50 per share. When the shares are purchased by
investors, however, they pay $70 per share-a premium of $20 over par
value.
** $50 million ($50 X 1 million shares) is for capital stock
** $20 million ($20 X 1 million shares) is for additional paid-in-capital.
• Retained earnings: Earnings but not distributed as
dividends
• Treasury stock: Property’s own capital stock
 Retained Earnings
• Retained Earnings = Cumulative Net
Income that has NOT been distributed as
dividends (ignoring adjustments); Net
Losses reduce Retained Earnings

• Sole Proprietorships and Partnerships do

NOT have retained earnings!!! All of their
income is paid out to partners.
Liquidity Ratios & Working
Capital
• Current Ratio = Current Assets
Current Liabilities
• Quick Ratio= Cash + M.S + Acct.
Receivables
Current Liabilities
• Working Capital
= Current Assets - Current Liabilities
 Balance Sheet Analysis
• After the balance sheet has been prepared, managerial
accountants use a variety of methods to analyze the
information it contains.

• Three of the most common types of analysis are:

• Horizontal (comparative) analysis
• Vertical (common-size) analysis
• Ratio analysis -> Chapter 5
 Horizontal Analysis
• A horizontal analysis of a balance sheet requires at least two
different sets of data. Because of this “comparison” approach
the horizontal analysis technique is also called a comparative
analysis.
• Managers who use horizontal analysis to evaluate the balance
sheet may be concerned with comparisons such as their:
• Current period results vs. prior period results
• Current period results vs. budgeted (planned) results
• Current period results vs. the results of similar business
units
• Current period results vs. industry averages
Figure 4.9 Horizontal (Comparative) Balance Sheet Analysis

Blue Lagoon Water Park Resort

Balance Sheets
December 31, 2009 and 2010

2009 2010 $ Change % Change

Assets

Current Assets
Cash 2,370,800 2,314,750 (56,050) (2.4)
Marketable Securities 4,109,600 3,309,600 (800,000) (19.5)
Net Receivables 1,655,300 1,053,950 (601,350) (36.3)
Inventories 897,200 1,497,200 600,000 66.9
Total Current Assets 9,032,900 8,175,500 (857,400) (9.5)

Investments 4,223,500 5,023,500 800,000 18.9

Property and Equipment
Land 7,712,550 7,712,550 0 0.0
Building 22,290,500 22,290,500 0 0.0
Furnishings and Equipment 5,063,655 7,289,000 2,225,345 43.9
Less Accumulated Depreciation 3,408,900 4,668,900 1,260,000 37.0
Net Property and Equipment 31,657,805 32,623,150 965,345 3.0
Other Assets 588,800 669,800 81,000 13.8
Total Assets 45,503,005 46,491,950 988,945 2.2

Liabilities and Owners’ Equity

Current Liabilities
Accounts Payable 2,038,100 1,438,100 (600,000) (29.4)
Notes Payable 2,104,255 1,319,900 (784,355) (37.3)
Other Current Liabilities 1,814,600 1,264,600 (550,000) (30.3)
Total Current Liabilities 5,956,955 4,022,600 (1,934,355) (32.5)

Long-Term Liabilities
Long-Term Debt 13,821,750 14,577,400 755,650 5.5
Total Liabilities 19,778,705 18,600,000 (1,178,705) (6.0)

Owners’ Equity
Common Stock 2,925,000 3,000,000 75,000 2.6
Paid in Capital 17,850,100 18,775,100 925,000 5.2
Retained Earnings 4,949,200 6,116,850 1,167,650 23.6
Total Owners’ Equity 25,724,300 27,891,950 2,167,650 8.4

Total Liabilities and Owners’

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Equity 45,503,005 46,491,950 988,945 2.2
 Determining Variance
• The dollar change or variance shows changes from previously
experienced levels, and will give you an indication of whether
your numbers are improving, declining, or staying the same.
• All dollar variances and percentage variances on the balance
sheet can be calculated in the same way.
• The dollar differences between identical categories listed on
two different balance sheets is easy to compute and is always
the numerator in any percentage change (variation)
calculation.
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gofigure!

To calculate the variance in cash, you would use the following formula:

Cash This Year – Cash Last Year = Variance

or

$2,314,750 - $2,370,800 = ($56,050)

Effective managers are also interested in computing the percentage variance, or

percentage change, from one time period to the next. Thus, the cash percentage
variance is determined as follows:

(Cash This Year – Cash Last Year)

Cash Last Year = Percentage Variance

or

($2,314,750 - $2,370,800)
$2,370,800 = (2.4%)
(gofigure! continued)

Of course, an alternative and shorter formula for computing the percentage

variance is as follows:

Variance
Cash Last Year = Percentage Variance

or

($56,050)
$2,370,800 = (2.4%)

Another way to compute the percentage variance is to use a math shortcut, as

follows:

Cash This Year

Cash Last Year –1 = Percentage Variance

or

$2,314,750
$2,370,800 – 1 = (2.4%)
 Vertical Analysis
• When using vertical analysis on a balance sheet, the business’s Total
Assets take on a value of 100%. Total Liabilities and Owners’ Equity also
take a value of 100%.
• When utilizing vertical analysis, individual asset categories are expressed
as a percentage (fraction) of Total Assets. Individual liability and owner’s
equity classifications are expressed as a percentage of Total Liabilities
and Owner’s Equity.
• Each percentage computed is a percent of a “common” number, which is
why this type analysis is sometimes referred to as common-size analysis.
• Vertical analysis of the balance sheet may be used to compare a unit’s
percentages with industry averages, other units in a corporation, or
percentages from prior periods.
Figure 4.8 Vertical (Common Size) Balance Sheet Analysis

Blue Lagoon Water Park Resort

Balance Sheet
December 31, 2010
$ %
Assets

Current Assets
Cash 2,314,750 5.0
Marketable Securities 3,309,600 7.1
Net Receivables 1,053,950 2.3
Inventories 1,497,200 3.2
Total Current Assets 8,175,500 17.6

Investments 5,023,500 10.8

Property and Equipment
Land 7,712,550 16.6
Building 22,290,500 47.9
Furnishings and Equipment 7,289,000 15.7
Less Accumulated Depreciation 4,668,900 10.0
Net Property and Equipment 32,623,150 70.2
Other Assets 669,800 1.4
Total Assets 46,491,950 100.0

Liabilities and Owners’ Equity

Current Liabilities
Accounts Payable 1,438,100 3.1
Notes Payable 1,319,900 2.8
Other Current Liabilities 1,264,600 2.7
Total Current Liabilities 4,022,600 8.6

Long-Term Liabilities
Long-Term Debt 14,577,400 31.4
Total Liabilities 18,600,000 40.0

Owners’ Equity
Common Stock 3,000,000 6.4
Paid in Capital 18,775,100 40.4
Retained Earnings 6,116,850 13.2
Total Owners’ Equity 27,891,950 60.0

Total Liabilities and Owners’ Equity 46,491,950 100.0

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