Chapter 2. The balance sheet: a snapshot of assets and liabilities of the enterprise

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1 Chapter 2 The balance sheet: a snapshot of assets and liabilities of the enterprise 1

2 Fundamental Structure Resources Assets Claims to be satisfied Liabilities Asset: Resource owned or controlled by the accounting entity expected to provide future economic benefits to the accounting entity ownership or control acquired in a past transaction = Residual Claims Liability:= obligation to settle a past transaction by transferring resources to an outside party Residual claims = Assets Liabilities What if Assets < Liabilities 2

3 Balance Sheet of The Coca Cola Comp. Dec The Coca-Cola Company and Subsidiaries Condensed Consolidated Balance Sheets (UNAUDITED) (In millions except par value) ASSETS CURRENT ASSETS Cash and cash equivalents $ Marketable securities 278 Trade accounts receivable, less allowances Inventories Prepaid expenses and other assets TOTAL CURRENT ASSETS INVESTMENTS Equity method investments: *) Coca-Cola Enterprises Inc Coca-Cola Hellenic Bottling Company S.A. 877 Coca-Cola FEMSA, S.A. de C.V. 638 Coca-Cola Amatil Limited 0 Other, principally bottling companies Cost method investments, principally bottling companies 463 TOTAL INVESTMENTS OTHER ASSETS PROPERTY, PLANT AND EQUIPMENT net TRADEMARKS WITH INDEFINITE LIVES GOODWILL OTHER INTANGIBLE ASSETS TOTAL ASSETS $ Current maturities of long-term debt 465 Accrued income taxes 252 TOTAL CURRENT LIABILITIES LONG-TERM DEBT OTHER LIABILITIES DEFERRED INCOME TAXES 877 SHAREOWNERS' EQUITY Common stock, $0.25 par value; Authorized 5,600 shares 880 Capital surplus Reinvested earnings Accumulated other comprehensive income (loss) Treasury stock, at cost TOTAL SHAREOWNERS' EQUITY TOTAL LIABILITIES AND SHAREOWNERS' EQUITY $ *) See textbook, p. 426 and following pages 3

4 Consolidated balance sheet balance sheet for a group of companies where the group is understood as the accounting entity group consists of a parent and one or more subsidiaries under control of the parent essentials of consolidation process: starting point: the balance sheet of the parent company, where subsidiaries occur in the item long-run financial investments replacing the value of the subsidiaries under this item by the appropriate percentage of the assets and liabilities on the subsidiaries balance sheet elimination of intra-group capital interrelations and loans adjusting historical costs of assets acquired from other group members, profits due to transactions between group members are eliminated 4

5 Line items on the balance sheet Assets... economic resources owned (or controlled) by a business as a result of past transactions that are expected to yield future economic benefits and eventually result in cash inflows to the business enterprise. Examples: property, plant, cash, copyrights, patents, investments Liabilities... claims of those to whom money is owed, i.e. liabilities are existing debts and obligations Examples: loans payable to a bank, salaries payable to employees Owner s Equity... residual interest in the assets of a business enterprise after deducting its liabilities; also referred to as residual equity or net assets 5

6 Classification of assets and liabilities Assets current (to be converted within operating cycle) cash and marketable securities receivables inventories prepayments and accrued income fixed property, plant and equipment long-term financial investments intangible assets Liabilities current short-term debt and current portion of long-term debt payables accrued expenses and deferred income long-term long-term debt provisions for contingencies and charges other long-term liabilities 6

7 Shareholders equity Common Stocks at par value additional paid-in capital (= capital surplus, share premium) Reserves accumulated other comprehensive income / loss retained earnings net income for the year treasury shares 7

8 Explanations, assets by examples inventories: merchandise, raw materials, purchased parts, goods in process, finished goods prepayments and accrued income prepaid rent, interest earned but not yet received long-term financial investments long-term loans given, investments in shares of other companies as far as not consolidated intangible assets patents, trade marks, exclusive rights, software back if acquired at a cost 8

9 Explanations, liabilities short-term debt and current portion of long-term debt provisions for contingencies charges debt due within a short period, usually one year potential liabilities, provision for imminent risks e.g. litigation risks, risks from commitment whose costs are expected to exceed revenue provisions for taking back used products, recovery and cleaning up, dismantling nuclear power plants waste disposal recultivation of open pit mines,... obligation to pay money in the future, usually attached to an asset owned by the entity back 9

10 Conceptual Explanations Accruals accrued revenues an asset! accrued expenses a liability! a revenue that has been earned (= recognized) but not yet occurred as an addition to assets or a reduction of liabilities such as for instance a receivable an expense that has become economically unavoidable but not yet occurred as an addition to liabilities or a reduction of assets Deferrals deferred revenues a liability! the money is at the entity s disposal before the revenue is realized deferred expenses an asset! an expense has been paid for before the resource consumption occurred e.g. prepaid rent, prepaid interest 10

11 Further Explanations of balance sheet items Reserves also called: Provisions or Allowances among them: accumulated other comprehensive income / loss equity in excess of par value of shares legal or statutory reserves law or statute may prescribe to accumulate a certain volume of profits not distributable revaluation reserves cumulative profits due to revaluation of assets, e.g. due to exchange rate changes some changes in asset or liability values not due to transactions with the outside world are not reported in the income statement ( Dirty surplus accounting) reserves for specific purposes e.g. reserve for bad debts back 11

12 Further explanations Minority interests if a consolidated subsidiary Consolidated Balance Sheet is not owned 100% by the Assets of Parent Liabilities of Parent parent, then the minority +100% assets of S1 +100% Liabilities of S1 shares in the subsidiary are +100% assets of S2 +100% Liabilities of S2 shown on the consolidated balance sheet as M.i. back Minority Interests 20% of S1 s equity + 10% of S2 s equity Balance: owners equity attributable to Parent s shareholders example: assume Parent holds 80% of S1 and 90% of S2, no other subsidiaries. back 12

13 Explanations cont d Treasury shares shares bought back from shareholders and held for later resale or for ESOPs (Employee Stock Option Programs) or for use with convertible bonds or option warrants back 13

14 Financial Ratios Based on the Balance Sheet current ratio = current assets current liabilities a rough indicator of short term liquidity does not replace financial planning debt/equity ratio = Net debt Shareholders Equity explained later in connection with income statement net debt = Debt payables cash and cash equivalents marketable securities 14

15 Understanding the basic accounting equation The story : Angie has a degree in political science and economics, and decides to start her own business Vote- Consult. Some time ago she received from a very good friend, money that she now uses to invest in her enterprise. During the first days of her new enterprise s life the following transactions occurred (in chronological order): 1. Angie deposits in a bank account in the name of Vote- Consult. 2. She purchases computers and other office equipment for Angie buys office supply for 500 on credit. 4. She pays 300 of the total amount she spent on supplies. 5. She pays the remaining 200 out of her personal pocket. 15

16 What happens to the balance sheet? 1. Angie deposits in a bank account in the name of Vote-Consult. [Extension of both assets and liabilities side] 2. She purchases computers and other office equipment for [Exchange of assets] 3. Angie buys computer paper and office supply for 500 on credit. 4. She pays 300 of the total amount she spent on supplies. [Contraction of both sides] 5. She pays the remaining 200 out of her personal pocket. [Exchange on the liabilities side] 16

17 Valuation: general aspects Asset values on the balance sheet do not represent expected future economic benefits; they are valued either at cost (at the value of resources due or given in exchange for acquiring them) or at market (at current market price, if available) expected future benefits usually will be greater than asset values on the balance sheet If future benefits are estimated to be below cost or market the asset has to be depreciated accordingly Liabilities are valued at the amount (known or estimated) of assets to be given up to settle them Note that valuation of assets and liabilities is asymmetric! prudence or conservatism principle Assets < liabilities does not necessarily mean that the firm is unable to settle their obligations at due date But if the balance sheet indicates a deficit balance, then according to its country s legal rules creditors may launch a bankruptcy petition 17

18 Transactions that affect owner s equity the owner may put money (assets) into the business investment, or take them out of the business withdrawals operating the business entails revenues and expenses INCREASES owner s investment revenues owner s equity owner s owner s DECREASES owner s withdrawals expenses 18

Chapter 2: Main Financial Statements An overview

Chapter 2: Main Financial Statements An overview The objective of general purpose financial reporting is to provide information about the reporting entity that is useful to existing and potential investors,