Balance Sheet Terms. HAME513: Understanding Financial Statements Cornell School of Hotel Administration

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1 Balance Sheet Terms This is a printer- friendly version of the content included in the "Balance Sheet Line by Line" activities. You may want to print this page for future reference. Assets Assets are used by the company to generate revenue and otherwise facilitate the business's operations. There are physical assets like buildings and delivery trucks, and intangible assets like goodwill and patents. The balance sheet breaks down these assets in two ways: first, by short- term and long- term assets, and then by types of assets, such as cash, accounts receivable, and net fixed assets. Current Assets This item generally includes all assets that will be used by the company within 12 months. The most common current asset accounts found in a company's balance sheet are: cash and cash equivalents, accounts receivable, inventories, and other current assets. Cash and Cash Equivalents Cash: Cash includes money on deposit in the company's checking account. Retail and service firms with stores that deal with the public also have bills and coins in the tills of their stores' cash registers, and most firms keep a petty cash fund. Cash equivalents (also known as marketable securities): In the United States, corporations do not earn any interest on money held in checking accounts. Companies will therefore move all funds not immediately necessary for transactions out of non- interest- earning checking accounts and into interest- earning investments. Because these funds may be needed on short notice, it is essential that the securities be readily marketable and subject to minimal price fluctuation. In addition, these investments typically mature in 90 days or less, which minimizes their loss potential. Examples of these short- term marketable securities include certificates of deposit (CDs), short- term US Treasury bills, and money market mutual funds. The generally accepted accounting practice is to show the value of these marketable securities on the books of the company at purchase cost or current market value, whichever is lower. Astrobucks had $99,677,000 of cash and cash equivalents at the end of Year One and $200,907,000 at the end of Year Two. This increase of $101,230,000 represents a significant increase in the amount of cash and cash equivalents held by Astrobucks, and is a reflection both of the increase in the number of operating units of Astrobucks as well as the increased level of same- store sales at existing Astrobucks stores. 1

2 Accounts Receivable, Net It would be straightforward if sales were booked onto the income statement at the time the sales occurred. However, companies usually do not receive cash when they make a sale. Instead, they will offer trade credit or an account receivable (A/R) to their customer and allow the customer to pay later. This creates an accrual account for the selling company, and as we'll see later, this also creates an account payable (A/P) for the company buying the goods and services. In most cases, companies request that full payment be made within 30 days, although there are some companies that allow for longer payment due dates, depending on the industry and the credit period allowed by competing companies. Also, the customer may take longer to pay than the company originally allowed. The accounts receivable account represents the amount due from customers for services provided and booked as sales but not yet collected. A company like Astrobucks recognizes accounts receivable not from its customers buying coffee, but from its franchisees that owe money to Astrobucks from franchise fees and from corporate accounts that purchase their coffee. This amount is shown on the balance sheet net of an allowance for uncollectible accounts. Experience shows that some customers fail to pay their bills, either because of financial difficulties or some catastrophe, such as a hurricane or a flood befalling their business. The dollar amount that a company deducts from its accounts receivable each year for this allowance depends upon its historical experience with its clients and the age and amount of each account that is owed to the company. The amount due from Astrobucks' customers and franchisees (net of the allowance for uncollectible accounts) is $97,573,000 in Year One and $114,448,000 in Year Two. Inventories Inventory is the dollar amount of goods held by the company that the company plans to eventually sell. For a restaurant and coffee distributor like Astrobucks, it represents the food and beverage items in its coffee shops and warehouses that will be sold to customers. For a retail company, this figure represents the goods for sale on the shelves of the store. The inventory of a manufacturer is a little more complex as it is composed of three groups: raw materials that will be used in the production of the product, partially finished goods or work- in- process inventory, and finished goods, which represent goods ready for shipment to customers. The generally accepted accounting method of valuation of the inventory is purchase cost or current market value, whichever is lower. This method gives a conservative valuation to the inventory, thus avoiding the likelihood of overvaluing a company's inventory and inflating the value of its assets. Other Current Assets The most common account included in the other current asset account is prepaid expenses. Here is an example of prepaid expenses: During the year Astrobucks pays bills for insurance coverage or lease payments on an Astrobucks store or the Astrobucks corporate office. These 2

3 payments may be made quarterly or annually. It is often the case, though, that a billing cycle does not quite match up with a company's accounting cycle. Assume, for example, that Astrobucks pays insurance every three months on the 15th of the month. A payment is made on September 15th and the premium will be due again on January 15th. If Astrobucks closes its books out on December 31st, they still have 15 days of insurance prepaid. Those insurance premiums are as yet unused at the balance sheet close date (December 31st), so the company has an unexpended item, which will be used up during the next year. Considered from another angle, if the advance payments had not been made, the company would have had more cash in the bank, so this item reflects the fact that the company has an asset in the form of a pre- paid expense. The dollar value of the other current assets account of Astrobucks actually declined from Year One to Year Two, going from $312,219,000 to $265,730,000. Total Current Assets Total current assets sums up all of the items listed in the current assets section of the balance sheet and includes: cash and cash equivalents (marketable securities), accounts receivable, inventories, and other current assets (pre- paid expenses). Astrobucks' total current assets went from $772,643,000 in Year One to $924,029,000 in Year Two, an increase of $151,386,000 or 19.59%. Long- Term Assets This item generally includes all assets used in the production of income for the company that will be held by the company for more than 12 months. The most common long- term asset accounts found in a company's balance sheet are net fixed assets and other long- term assets such as intangibles and goodwill. Property, Plant, and Equipment Property, plant, and equipment represents those fixed assets held by the company that are used on an ongoing basis in the course of the business's operations and that are not intended for sale. For a restaurant and coffee shop, like Astrobucks, it would include all of the coffee- making equipment, kitchen and dining equipment, the furniture and fixtures in each of their stores, as well as the stores, office buildings, and land owned by Astrobucks. In addition, the value of the equipment such as computers, printers, and copying machines in their corporate office would also be included. For a manufacturing company it would include all the assets involved in the manufacturing, warehousing, sale, and transportation of the product. For a retail business it would include the stores, fixtures, and delivery and maintenance equipment. Overall, this category will include land, buildings, machinery, equipment, furniture, automobiles, and trucks. The generally accepted and approved method for valuation is to use the purchase cost of the asset. Astrobucks' property, plant, and equipment for Year One was $2,077,759, which grew to $2,434,712 for Year Two. 3

4 Less Accumulated Depreciation and Amortization This amount represents the sum of all the depreciation expenses shown on the company's income statement. Depreciation expense shown on the income statement is discussed in the previous section. The difference in the accumulated depreciation account between Year One and Year Two($812,003 and $1,049,810) equals the annual depreciation expense from the Year Two income statement of $237,807. Net Property, Plant, and Equipment The fixed assets of Astrobucks, net of depreciation, went from $1,265,756,000 to $1,384,902,000. This $119,146,000 increase is directly attributable to Astrobucks' increase in the number of stores and the equipment and fixtures associated with those new outlets. Other Long- Term Assets Other long- term assets include items like intangible assets. These may be defined assets having no physical existence, yet having substantial value to the company. Examples most often include goodwill, franchise rights to a restaurant company allowing exclusive rights to open new stores in certain areas, a patent for exclusive manufacture of a specific item like a pharmaceutical drug, trademarks, copyrights, and brand names (like Astrobucks Coffee). Perhaps the most important of the other long- term assets listed above is goodwill, since this asset often has the most material impact on a company's balance sheet when they are involved in an acquisition of another company. Goodwill represents the amount by which the price of an acquired company exceeds the related values of the net assets of the company acquired. For example, if Company X purchased Company Y for $100 million and Company Y at the time of the purchase only had $85 million of net assets on its books, Company X would allocate the $85 million to the respective accounts (current assets and property, plant, and equipment) and allocate the remaining $15 million to goodwill. Astrobucks' other long- term assets went from $175,993,000 to $420,815,000. This represents a whopping $244,822,000 or a % increase in other long- term assets. The majority of this increase is attributable to the acquisition of the Portland Coffee Company. Total Long- Term Assets The total long- term assets item sums up all of the items listed in the long- term asset section of the balance sheet and include net fixed assets and other long- term assets. Astrobucks' total long- term assets went from $1,441,749,000 in Year One to $1,805,717,000 in Year Two, an increase of $363,968,000 or 25.24%. 4

5 Total Assets The total assets item sums up all of the items listed in the Assets section of the balance sheet and includes all current assets and long- term assets. Astrobucks' total assets went from $2,214,392,000 in Year One to $2,729,746,000 in Year Two, an increase of $515,354,000 or 23.27%. Liabilities & Stockholders Equity A liability represents a claim against the company's assets and future cash flows. Some liabilities represent general claims against the company and have no collateral pledged against them. An example of a short- term general liability is accounts payable and an example of a long- term general liability are debenture bonds. Other liabilities carry collateral claims; a common example of such a liability is a commercial mortgage. The most common liability accounts found in a company's balance sheet are current liabilities and long- term liabilities. Current Liabilities This item generally includes all debts that will come due within 12 months. These short- term liabilities include accounts payable, notes payable, accrued expenses, income tax payable, and other liabilities. The current liabilities item is a companion to current assets because current assets can be viewed as the source of funds from which payments on current liabilities will be made. The relationship between the two accounts is one of the most revealing things to be learned from an analysis of the balance sheet. Accounts Payable The accounts payable (A/P) item represents the amount that a company owes to its regular business creditors from whom it has purchased goods or services on a trade credit account. In fact, accounts payable represents the flip side of the accounts receivable relationship that was discussed earlier. One company's account receivable is another company's account payable. Accounts payable is another of a company's accrual accounts, created by the fact that the purchase and receipt of a good or service is not timed perfectly with the payment of the expense incurred by the purchase. Typically, companies are given 30 days to pay a bill for the purchase of a good or service from another company. Any accounts payable, or trade credit, not paid in the current year will be carried on the books into the next fiscal year as an account payable. For a company like Astrobucks, the accounts payable account represents money owed to suppliers of coffee, sugar, and dairy products and other food purveyors that sell goods to the company on trade credit. In Year One Astrobucks' A/P was $135,994,000 and in Year Two this account grew to $168,984,000. The $32,990,000 increase can be attributed to a rise in the prices of goods and services sold to each store, as well as to an increase in the number of stores operated by Astrobucks. 5

6 Short- Term Debt Where the company has written a promissory note to borrow money and it is due in the coming year to a bank, individual, corporation, or other lender, it appears on the balance sheet under notes payable. Notes payable are most commonly short- term bank loans, but this account also includes any payments to a long- term loan that are due in the next fiscal year. Finally, this account also includes any lease payments due in the coming fiscal year on leases that are capitalized on the company's balance sheet. Astrobucks has a very modest amount of short- term debt given the dollar amount of assets under their control. In Year One Astrobucks' short- term debt was only $710,000 and this account grew a modest $12,000 between Year One and Year Two to $722,000. Other Current Liabilities Other current liabilities include liabilities such as salaries and wages due to employees, fees to attorneys, insurance premiums owed but unpaid, and income taxes payable. As in the case of accounts payable, these accounts are all accrual accounts and are recognitions of the fact that an expense has occurred without the transfer of any funds. As such, there are a number of other payable accounts that will be paid in the coming year. For Astrobucks, other current liabilities went from $325,891,000 in Year One to $438,997,000 in Year Two. Total Current Liabilities The total current liabilities item is equal to the sum of all of the items listed under the Current Liabilities section of the balance sheet and includes accounts payable, notes payable, and other current liabilities. Long- Term Liabilities When we discussed current liabilities, we included all debts of the company due within one year from the balance sheet date. Those debts that are due more than one year from the closing date of the balance sheet are reported as long- term liabilities. Long- Term Debt (Notes and Debentures) These items represent long- term loans of the company and involve commitments where the money owed will not be paid off during the coming year. A note typically represents a long- term loan received from a bank or other lending institution. In the case of a debenture, the money was received by the company as a loan from bondholders, who in turn were given a certificate called a bond (or debenture) as evidence of the loan. The bond is a formal promissory note issued by the company who agrees to repay the debt at maturity. Bonds that are backed by the general credit of the corporation rather than by the company's assets are known as a debenture bonds. Debentures are the most common type of bond issued by large, well- established corporations. There are also long- term debts that carry a specific claim against an asset; these include mortgages and asset- backed bonds. Astrobucks had a relatively modest 6

7 amount of long- term debt in Year One of $5,076,000, which declined to $4,345,000 in Year Two. Deferred Income Taxes Deferred income taxes are one of the long- term liabilities on Astrobucks' balance sheet. This liability results from differences in the income already earned and recognized, the expenses for taxable income according to the Financial Accounting Standards Board (FASB), and income reported to IRS. Companies like Astrobucks include a charge for deferred taxes in their tax calculations on the income statement and show what taxes would be without the differential. This differential was substantial for Astrobucks and amounted to $22,496,000 in Year One and $33,217,000 in Year Two. Other Long- Term Liabilities Other long- term liabilities include all long- term debt other than what is already reported in the balance sheet for the two accounts already discussed. This account can include long- term liabilities such as pension fund obligations and obligations arising from capitalized leases. Astrobucks had $1,036,000 in other long- term liabilities in Year One and $1,045,000 in Year Two. Total Long- Term Liabilities The total long- term liabilities item is equal to the sum of all of the items listed under the Long- Term Liabilities section of the balance sheet and includes notes and debentures, deferred income taxes, and other long- term liabilities. Total liabilities for Astrobucks increased from $28,608,000 in Year One to $38,616,000 in Year Two. Total Liabilities Current and long- term debt are summed together to produce the figure listed on the balance sheet as total liabilities. Total liabilities for Astrobucks went from $491,203,000 to $647,319,000. This increase of $156,116,000, or 31.78%, was substantially higher than the 25.24% increase in total assets shown by Astrobucks over the same period. This implies that, after considering the growth in their assets, Astrobucks is showing a disproportionate increase in its use of liabilities as a funding tool. Stockholder's Equity Companies can raise money either by incurring debt (either short- term in the form of a note payable to a bank, long- term in the form of a mortgage note payable to a bank or a long- term bond payable to investors in the bonds) or by selling shares of equity in the company. The two types of equity sold to investors by companies to raise capital include shares of preferred stock and shares of common stock. Also, the company may reinvest some of the common 7

8 shareholders' money each year; this is the amount by which net income exceeds the dividends paid out to the shareholders and appears on the balance sheet as retained earnings. Preferred Stock Preferred stock shares have a priority over common stock shares with respect to dividends, and in distribution of assets in the case of liquidation under bankruptcy. In the case of dividend payments, preferred stock normally carries a cumulative dividend provision. A cumulative dividend provision means that, if in any year the total amount of the dividend payment due to the preferred shareholder is not paid, it accumulates and must be paid in full to the preferred shareholders before any dividends are distributed to the common stock shareholders. Most often, preferred shareholders get little or no voting rights and therefore have no voice in company affairs unless the company fails to pay them dividends at the promised rate. Specific provisions relating to preferred stock can be obtained from a corporation's charter. Astrobucks had no preferred stock in either Year One or Year Two. Common Stock Common stock shares represent a proprietary interest in the company. These shares are represented by stock certificates issued by the corporation to its common stock shareholders. These shareholders are considered the "owners" of the company and voting rights are assigned to each share of common stock. Usually, each share of common stock is assigned one vote, so an investor who owns 10,000 shares of common stock is assigned 10,000 votes. Votes are cast at annual meetings where the company's Board of Directors is selected. The Board of Directors and the Chair of the Board will hire the Chief Executive Officer, Chief Financial Officer, and the Chief Operating Officer (the latter positions may or may not exist, depending on the size and structure of the company). The CEO, CFO, and COO will, in turn, be responsible for the daily activities of the company. If there were to be a takeover bid for the company, the common shareholders would vote on the proposal. If a majority votes to accept the tender offer for the takeover (the exact size of this majority will vary by company charter) then the takeover would be approved. A corporation may issue several different classes of common stock shares, where each class would have different attributes. For example, some corporations issue a Class A Common Stock and a Class B Common Stock, where the Class A Common Stock has 1000 votes compared to one vote for the Class B Common Stock. In Year One Astrobucks had $882,459,000 of Common Stocks on their books, and this amount increased to $973,351,000 in Year Two. The value shown on a company's books for common stock is the dollar amount paid for the shares when they were originally sold to investors when the stock was issued. This amount will most likely be quite different from the market value of the stock if it were to be traded on a public exchange like the New York Stock Exchange. If your company is publicly traded, you can check the value of its common stock through sites like Yahoo Finance. 8

9 Additional Paid- In Capital This is the amount paid in by shareholders above the par or face value of each share. Common stock typically has a par value of $0.01 per share. When a company sells shares of its own stock to the public, the amount that the sales price exceeds the par value is placed on the balance sheet as additional paid- in capital. Retained Earnings When a company first starts in business, it has no retained earnings. Retained earnings accumulate as the company earns a positive net income and reinvests or "retains" the income. Retained earnings increase each year by the amount of net income less the dividends declared to shareholders. Retained earnings do not represent some pile of cash that is sitting in a corporate account somewhere. Retained earnings simply represent the sum of the amount of money reinvested in the company by the company's stockholders. This money has probably already been invested in long- term assets or been used to pay off liabilities long ago. Since their inception, Astrobucks had accumulated $801,337,000 of retained earnings at the end of Year One, and this amount grew an additional $268,346,000 to $1,069,683,000 in Year Two. Some other accounts that you may encounter in your company's balance sheet: Treasury Stock When a company goes into the market and reacquires its own stock, it is reported as treasury stock, and this amount is deducted from the outstanding shares in the Stockholders' Equity section. Any dividends paid on shares held in the treasury are neither included as income to the company nor expensed as dividends paid. Foreign Currency Translation Adjustments If a company has an ownership interest in a foreign company, the component parts of the foreign company's financial statements must be translated into U.S. dollars when these results are captured in the company's consolidated financial statements. In general, the translation gain or loss from the repatriation should be reflected as a separate account in the Stockholders' Equity section. This account is called Foreign Currency Translation Adjustment. 9