Handout for week 2 Understanding Balance sheet

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Cameron Bradley
6 years ago
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1 Handout for week 2 Understanding Balance sheet The purpose of financial accounting is generating status and performance reports in the form of Balance Sheet and Statement of Profit & Loss (Income Statement). We can proceed to the next step of understanding the form, content and the manner of determining the values that appear in these two reports. The format and content (items to be disclosed) of the Balance Sheet and the Income statement is usually mandated by the regulators in a country. Note: Refer to illustrations in the Appendix section. BALANCE SHEET The balance sheet provides a snapshot view of the assets, liabilities and equity of an enterprise at a given point of time. In short we can say what the company owns and what the company owes to others. An asset is a resource controlled by an enterprise as a result of events and from which future economic benefits are expected to flow to the enterprise and the assets are arising from a past identifiable event and are objectively measurable. Liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Equity is the residual interest in the assets of the enterprise deducting all its other liabilities (or simply liabilities). How do these assets, liabilities and owners equity arise? All enterprises (also referred to as 'firms') make financial decisions, investment decisions and operating decisions. These decisions when implemented give rise to assets, liabilities and equity. Please note that every investment decision has to be matched, in terms of value with the financing decision involving raising money from outsiders or owners or both. As you have understood, the balance sheet can be represented as follows. Assets = Liabilities + Equity Most countries around the world require Consolidated Financial Statements. Some countries such as India prepare both the Consolidated and Standalone Financial statements. More about this is provided in the next module. Let us now briefly discuss the various elements of the balance sheet. I. ASSETS Assets are resources which are expected to provide a firm with future economic benefits, by way of cash flows or by their use. Resources are recognized as assets in accounting when (a) the firm acquires rights over them as a result of a past transaction and (b) the firm can quantify future economic benefits with a reasonable degree of accuracy.

2 As you can observe from the definition, assets give us future benefits either by use or through generation of cash flows. Things that constitute assets are Plant and Machinery, Cash and Bank Balances, Goods for sale, etc. Assets are classified as follows: Non-current assets Current assets 1.1 Non-current Assets: Non-current assets are relatively long-lived assets. They consist of fixed assets, non-current investments, other non-current items such as long-term loans and advances, and other noncurrent assets. Sometimes, you may find other classifications such as property plant and equipment, intangible assets, available for sale securities and other non-current assets. These act as the backbone of the business or help perform the operations of the business. These are important resources to the business as they help in performing the business operations effectively and smoothly. Let us elaborate each of the following. Fixed assets These are assets meant to be used for producing/providing goods or services and not intended to be sold in the ordinary course of business. These have a useful life of more than one year and are of material value. Fixed assets comprise tangible fixed assets and intangible assets. Tangible fixed assets also called as Property Plant and Equipment include items such as land, buildings, plant, machinery used in the manufacturing process, furniture & fixtures, computers etc. Fixed Assets are disclosed as Net fixed assets. Net fixed assets represents the gross book value less accumulated depreciation. The gross book value is normally the historical cost though this can be substituted with a revalued figure. Historical cost of a fixed asset is all costs incurred to bring the asset to its working condition for its intended use. The cost of an item of fixed asset comprises its purchase price, including import duties and other taxes and any other costs directly attributable to the fixed asset. The cost also includes installation cost such as special foundations for plant; and professional fees, for example, fees of architects, etc. Depreciation is the systematic allocation of the depreciable amount of the asset over its useful life. Accumulated depreciation is all depreciation charged to the profit and loss account till the end of the current financial year in respect of the assets. Net block is gross block less accumulated depreciation. More on depreciation in the next module.

3 Intangible Assets Intangible asset is an identifiable non-monetary asset, without physical substance. Intangible assets include items such as patents, copyrights, trademarks, and software etc. These include the rights which give the business a competitive advantage. Intangible assets are reported at their net book value, which is simply the gross value less accumulated amortization. Selfgenerated intangible assets cannot be recorded in the books. Only acquired intangible assets can be recorded. A special category of intangible asset is goodwill. Goodwill is not good name in the business. Goodwill represents the excess amount paid over the fair value of net assets taken over in case of merger of companies and is found only in the acquirers books. Goodwill is also disclosed in the consolidated financial statements on consolidation. Non-current investments (also referred to as available for sale securities) generally comprises financial securities such as equity shares, bonds or other financial securities that are intended to be held for more than 12 months from the date of the balance sheet Other non-current assets consist of items such as long term advances (receivables) given to others including employees, suppliers etc. that are due for repayment /adjustment for a beyond a period of more than one year 1.2 Current Assets Current Assets An asset is classified as a current asset when it satisfies any of the following criteria: (a) It is expected to be realized in, or is intended for sale or consumption in, the company s normal operating cycle;. (b) It is held primarily for the purpose of being traded. (c) It is expected to be realized within 12 months after the reporting date. (d) It is cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting date. Current assets include current investments (Marketable securities), inventories, trade receivables, cash and cash equivalents, short-term loans and advances, and other currents assets. Current investments (Marketable securities) mainly represent short-term holdings of units or shares of mutual fund schemes. These investments are made primarily to deploy idle funds to generate an income. Also referred as securities that are held at fair value through the income statement.

4 Inventories comprise raw materials, work-in-process, finished goods, packing materials, and stores and spares. Inventories are generally valued at cost or net realizable value, whichever is lower. The cost of inventories includes purchase cost, conversion cost, and other cost incurred to bring them to their respective present location and condition. The cost of raw materials, stores and spares, packing materials, trading and other products is generally determined on weighted average basis. The cost of work-in-process and finished goods is generally determined on absorption costing basis this means that the cost figure includes allocation of manufacturing overheads. Cost Flow vs. Physical flow of goods: Inventory is purchased and sold at different points in time and at different prices. This results in difficulty in identification of the items that were purchased or sold. If each and every item is identifiable, then a firm can find the exact rate at which they are held in the inventory. However, this practice may not be feasible for a company to maintain such efficient tracking systems, particularly if the items are standardized, small and too many. Hence, the company tracks the cost flow of goods instead of the physical flow of goods. There are three methods used for identifying the cost of inventory on hand. First-in-first-out method or FIFO assumes that goods received first are consumed or sold first and hence the closing inventory consists of goods recently purchased. Last-in-first-out method or LIFO assumes exactly the opposite. Here, we assume that the goods last received are used or sold first and the closing inventory consists of units purchased earlier. Accordingly, consumption or sales is valued at the last invoice price and closing inventory is computed by deducting the cost of consumption or sales from total purchase cost. LIFO is not permitted under IFRS. US GAAP has elaborate provisions to be complied if a company is following the LIFO method. The weighted average cost method updates the inventory value every time a purchase is made taking into account the value of inventory available at that point of time on a continuous averaging basis. The process of updating the value of the inventory continues and closing inventorys are valued at this weighted average rate. Among the three methods, weighted average cost method is widely used by most companies.

5 Trade receivables (also called accounts receivable) Business practice requires companies to sell goods or provide services on credit. Receivables represent the amounts owed to the firm by its customers (who have bought goods and services on credit). The period of credit given is based on the negotiating power, the liquidity position and the risk profile of the customer. They are part of current assets since these dues are normally collected within one year. Trade receivables are the disclosed net of any provision (allowance) for bad and doubtful debts. Generally, firms make a provision for doubtful debts which is equal to debts considered doubtful. The net figure of trade receivables is arrived at after deducting the provision for doubtful debts. Cash and cash equivalents consist of cash on hand and bank balances. Cash and bank balances are required to meet the day-to-day operations of the company. However, any excess holding will of cash would result in assets being idle. Companies have to hold a certain level of cash to meet the day-to-day expenses and any other contingencies. Other current assets include loans and advances given to suppliers, employees, and other companies that are recoverable within a year. Current Investments are financial assets which the company plans to sell/dispose within 12 months. These include investment in securities such as Mutual fund etc. They are also referred as marketable securities II. Equity and Liabilities Equity and liabilities represent what the firm owes to its financers. 2.1 Equity Equity (also shareholders funds/stockholders equity): Shareholders funds represent the contribution made by shareholders in some form or the other. They include share capital (also termed as common stock) and retained earnings (reserves and surplus). Share capital (Common Stock): Equity capital represents the contribution of equity shareholders to finance the business. The share capital is usually divided into a face value (par value) and number of shares. The share capital is initially brought in at the time of registering a company. When the company first raises capital from the public after its formation, it is called 'Initial Public Offer' (IPO). Subsequently, the company can raise additional capital. Shares are issued to investors at more than the face value; these are termed as share (securities) premium or additional paid in capital.

6 Equity share capital or common stock carries high risk. The equity holders get a dividend only if there is profit. Further, if a company is in liquidation, it will receive capital only after meeting the claims of all other fund providers such as bank borrowings and other liabilities. A great advantage of equity is that the liability of the shareholders is limited (i.e. on winding up, their personal wealth will not be used). The concept of limited liability enabled formation of large companies with several million shareholders which will help build a strong capital market. Subsequent to the initial offering, companies may have 2 other events related to equity; Stock Split and Buy back of shares and Bonus Issue. Stock split Stock split is a process by which the companies split their existing shares into multiple shares of lower par value or face value. Stock splits result in an increase in the number of issued shares of the company. For example, a company is having 10,000 shares outstanding with a par value of $10 each. The company decides to split the face value or par value to half say of $5 each. After stock split, the number of shares will increase to 20,000 with a par value of $5 each. Although the number of shares increases after stock split, the total amount of shareholder s funds or common equity remains unchanged. A reasons for splitting the stock of the company may be its high stock market price. Splitting into smaller face value splits the market price as well, thus enable access to small investors. Companies also sometime split stocks par value to compensate for not declaring cash dividends. Buyback of shares Buyback of shares or stocks refers to a process by which a company buys backs or reacquires its own shares. It is also known as share repurchases in some countries. Share buyback leads to a reduction in the number of outstanding shares. In some countries, these shares have to be cancelled. However, in some countries, these shares can be resold (subject to certain rules specific to that country). The shares which are repurchased and are not immediately retired or reissued are called as treasury stocks Treasury Stock. Treasury stocks do not carry any voting right nor do they receive dividends. As per IFRS guidance, treasury stocks are required to be reported as deduction from equity. The cost of an entity's own equity instruments that it has reacquired ('treasury shares') is deducted from equity. The gain or loss is not recognized on the purchase, sale, issue, or cancellation of treasury shares. Treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received is recognized directly in equity. [IAS 32.33]

7 Why do companies buy back their own stock? There are many reasons for a business to buy back its own issued stock. Some of the common reasons for a buyback are as follows. The company s stock is undervalued which prompts the management to opt for buyback of shares. This has an immediate impact on the stock price. Company has excess cash with no immediate use for the cash. To reduce dilution of shares and strengthen majority shareholders (promoter s) control over business. To improve key financial ratios such as earnings per share, and return on equity Companies reacquire shares usually through the open market although there are other ways to buyback such as entering into private negotiations or making a fixed price offer to its shareholders. Many of the top US companies such as Apple and Microsoft have ongoing stock repurchase plans. Bonus Shares Bonus shares are the shares which are issued to the shareholders without any consideration in cash. Bonus issues can be called as the distribution of a company s earnings in the form of stocks or shares. Bonus issue is also known a scrip issue, capitalization issue or stock dividends as known in the USA. It is a free issue of shares or stocks to its existing shareholders or stockholders in a certain proportion to their shareholding. For example, if a company makes 1:1 bonus issue; a shareholder gets 1 share for every 1 share held. There is no transfer of cash to the shareholders in the case of bonus issue. Bonus issue involves a transfer of amounts from the retained earnings. It is a convenient way of providing shareholders their return on investments when the company is having huge reserves and surplus but not adequate cash. There are several reasons why a company opts for bonus issue: Bonus shares are a signaling mechanism for future growth potential (as in future they have to pay a dividend on the higher share capital), thus raising the company s overall market value. High stock market price may discourage potential investors from buying shares in the stock market. Issue of bonus reduces the market price in the same proportion as that of the bonus (on that date) and consequent to increase in the number of shares. Thus, bonus issue helps in reducing the price to a more realistic level. For example, a company with a share price of $20 may decide to issue bonus shares in the ratio of 1 share for every 1 share. On the date of bonus issue, the share price will split to $10

8 (subsequent to the issue, the price may move either way depending on other factors). Market price of the share is impacted in the same way as that of the stock split. Retained Earnings /Reserves and surplus/other Equity Retained earnings often is the most significant item on the balance sheet, represents profits retained in the business as well as non-earnings items such as reserves. Retained earnings is the amount of accumulated profits owed by the business entity to the equity shareholders. It is the profits remaining after distributing dividends to the shareholders. Retained earnings are reinvestment of profits in the business. Companies create certain reserves for meeting any future liability or contingencies. Reserves are the amount set side from the profits of the company before paying dividends. Reserves comprise statutory reserves required to be created by law), and general reserves. Apart from the statutory reserves, companies create certain general reserves out of the profits of the business. These reserves are not held for any specific reason. These are also called revenue reserves since they are created out of the normal profits of the company. Statement of shareholders equity is discussed in the next module. 2.2 Liabilities Liabilities are present obligations that a firm owes to the outsiders. The can be borrowings, or amounts payables to suppliers of goods and services etc. Liabilities are broadly classified into: Non-Current liabilities Current Liabilities Non-current Liabilities Non-current liabilities are liabilities which are expected to be settled after one year of the reporting date. They include long-term borrowings, deferred tax liabilities, long-term provisions, and other long-term liabilities. Long-term borrowings are borrowings which have a tenor of more than one year. They generally comprise term loans from financial institutions and banks. They could be in the form of bonds and foreign currency bonds, and public deposits and many other forms of

9 borrowings. Term loans and bonds are typically secured by a charge on the assets of the firm, whereas public deposits represent unsecured borrowings. Other long-term liabilities: This includes provisions for employee benefits such as retirement benefits and other liabilities that are due beyond a year. Current Liabilities Current liabilities are those which are due to be settled within 12 months after the reporting date. They include short-term borrowings, trade payables (amount that you need to pay the suppliers of goods and services), short-term provisions, and other current liabilities. Short-term borrowings are borrowings which have a tenor of less than one year. They comprise mainly working capital loans, inter-corporate deposits, commercial paper, and public deposits maturing in less than one year. Trade payables are amounts owed to suppliers who have sold goods and services on credit. Other current liabilities are items such as current maturities of long-term borrowings, advance payments from customers, and so on.

10 Appendix Ginger Co. Balance Sheet as at 31 st December $ million $ million Note Assets Non-current assets Property, plant and equipment 9 14,500 13,970 Intangible assets 10 1,750 1,660 Financial Assets (Available for sale investments) Other non-current assets 11 B 1, Total non-current assets 17,700 16,860 Current assets Inventories Trade receivables less provision for doubtful debt 13 5,460 5,790 Other current assets 14 2,445 3,657 Marketable securities 14A 1,122 1,125 Cash and cash equivalents 14B 1,954 1,923 Total current assets 11,662 13,240 Total Assets 29,362 30,100 Liabilities and Equity Non-current liabilities Financial Liabilities 15A 935 1,680 Deferred tax liabilities 1,690 1,760 Other non-current liabilities Total non-current liabilities 3,015 4,060 Current liabilities Financial Liabilities 15B 1,750 1,930 Short-term provisions for liabilities Trade payables 3,040 3,000 Total current liabilities 5,010 5,240 Total Liabilities 8,025 9,300 Equity Share capital Share premium Other reserves 9,320 9,850

11 Retained earnings 11,707 10,640 Total equity 21,337 20,800 Total Liabilities & Equity 29,362 30,100 Balance Sheet

12 Few additional links for reference:

A Primer on Financial Statements

A Primer on Financial Statements Much of the information that is used in valuation and corporate finance comes from financial statements. An understanding of the basic financial statements and some of