CHAPTER 2:

UNDERSTANDING
THE BALANCE SHEET
MSc. Thuy Tien Dinh| Faculty of Banking and Finance

Email: [email protected]
CONTENT
v Balance sheet elements and format

v Accounting issues

§ Current and non-current assets and liabilities

§ Measurement bases of different assets and liabilities

v Components of shareholders’ equity

 OVERVIEW ABOUT BALANCE SHEET
v The balance sheet presents a comprehensive overview of total asset value and total resource

financing the assets of an enterprise at the point of time.

v The balance sheet is also called the statement of financial position or statement of financial

condition. Assets Liabilities + Equity

Current
liabilities
Current Assets
Non-current
liabilities
Non-current Shareholders’
Assets equity

Total asset = Liabilities + Equity

OVERVIEW ABOUT BALANCE SHEET
v 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.

v 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.

v Equity (E): represents the owners’ residual interest in the company’s assets after
deducting its liabilities.
OVERVIEW ABOUT BALANCE SHEET
ASSETS LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Assets Current Liabilities
§ Cash and cash equivalents § Current liabilities
§ Marketable securities § Non-current liabilities
§ Accounts receivable
§ Inventories
§ Other current assets
Non-current Assets Stockholders’ Equity
§ Property, plant and equipment § Contributed capital
§ Investment property § Preferred stock
§ Intangible assets § Treasury stock
§ Goodwill § Retained earnings
§ Non-controlling interest
§ Accumulated other comprehensive Income
OVERVIEW ABOUT BALANCE SHEET
v Balance sheet ordering according to liquidity:

Ø Companies using U.S. GAAP order items on the balance sheet from most liquid to
least liquid.

Ø Companies using IFRS order balance sheet information from least liquid to most
liquid.
OVERVIEW ABOUT BALANCE SHEET
 CURRENT AND NON-CURRENT
ASSETS AND LIABILITIES
v 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.

v Non-current assets: Assets not classified as current. Also known as long-term or long-
lived assets.

v Current liabilities: Liabilities expected to be settled within one year or within one
operating cycle of the business.

v Non-current liabilities: All liabilities not classified as current.

MEASUREMENT BASES OF CURRENT ASSETS
v Cash and cash equivalents are short-term, highly liquid investments that are readily convertible to cash
and near enough to maturity that interest rate risk is insignificant. Cash and cash equivalent are reported on
the balance sheet at amortized cost and fair value.

v Marketable securities are financial assets that are traded in a public market and whose market value can
be readily determined.

v Account receivables are financial assets that represent amounts owed to the firm by customers for goods
or services sold on credit. Accounts receivable are reported at net realized value, which based on estimated
bad debt expense.
Ø Bad debt expense increase the allowance for doubtful accounts, a contra-asset account.
Ø A contra-asset account is used to reduce the value of its controlling account.

v Prepaid expenses are operating costs have been paid in advance.

MEASUREMENT BASES OF CURRENT ASSETS
v Inventories are goods held for sale to customers or used in manufacture of goods to be
sold.
§ Manufacturing firms separately report inventories of raw materials, work-in-process and

finished goods.
§ The cost included in inventory include purchase cost, conversion costs, and other costs

necessary to bring the inventory to its present location and condition.

§ Costs that are excluded from inventory include abnormal waste of material, labour, and

overhead, storage costs (unless they are necessary as a part of the production process),
administrative overhead, and selling costs.
MEASUREMENT BASES OF CURRENT ASSETS
Costs included in inventories Costs excluded in inventories
Costs included in Inventories and § Costs excluded from Inventories and
recognized as expenses when goods are recognized as expenses in period
sold: incurred:
§ Costs of purchase, e.g. ü Abnormal costs incurred as a result
ü purchase price, net of discounts of waste of materials, labor or other
ü import duties and taxes production conversion inputs
ü transport and handling ü Storage costs (unless required as part
ü insurance during transport of the production process)
§ Costs of conversion ü All administrative overhead and
§ Other costs incurred in bringing the selling costs
inventories to their present location and
condition
MEASUREMENT BASES OF CURRENT ASSETS
v Inventories Cost Flow

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

Balance Sheet Income Statement

MEASUREMENT BASES OF CURRENT ASSETS
v Summary table on inventory valuation methods

Method Description

Assumes that earliest items purchased were sold first.

FIFO (First in-First out)
First in to inventory = first out to COGS.
Assumes most recent items purchased were sold first.
LIFO (Last In-First Out)*
Last in to inventory = first out to COGS.
Weighted Average Cost Averages total costs over total units available.

*LIFO not permitted under IFRS

MEASUREMENT BASES OF CURRENT ASSETS
v Inventory valuation methods
Example: M&M Inc. purchases inventory items for resale. At the beginning of 2020,
M&M had no inventory on hand. During 2020, M&M had the following transactions:

Quantity Unit price

First quarter 2,000 units $40/unit
Second quarter 1,500 units $41/unit
Third quarter 2,200 units $43/unit
Fourth quarter 1,900 units $45/unit
Total 7,600 units Total cost: $321,600
M&M sold 5,600 units of inventory during the year, and received cash. Using
inventory valuation methods, calculate COGS and ending inventory cost:
a. FIFO b. LIFO c. Weighted Average Cost
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Deferred tax assets are created when the amount of taxes payable exceeds the amount
of income tax expense recognized in the income statement.

vProperty, plant, and equipment (PP&E) are tangible assets used in the production of
goods and services, for rental to others, or for administrative purposes, and expected to
be used during more than one period.

§ PP&E includes land and buildings, machinery and equipment, furniture, and natural
resources such as mineral and petroleum resources.
MEASUREMENT BASES OF NON-CURRENT ASSETS
vProperty, Plant and Equipment

Ø Initial measurement: PPE should initially be measured at ‘cost’ and the cost of an
item of PPE should be recognised if, and only if:

(a) it is probable that future economic benefits associated with the item will flow
to the entity, and

(b) the cost of the item can be measured reliably.

Ø Where any of these costs are incurred over a period of time, the period for which
the costs can be included in the cost of PPE ends when the asset is ready for use.
MEASUREMENT BASES OF NON-CURRENT ASSETS
vProperty, Plant and Equipment
Ø The cost of an item of PPE comprises:
§ its purchase price, including import duties and non-refundable purchase taxes, after deducting trade
discounts and rebates.
§ any costs directly attributable to bringing the asset to its present location and condition for its
intended use. Directly attributable costs include:
• Costs of employee benefits arising directly from the construction or acquisition of the item of
PPE
• costs of site preparation
• initial delivery and handling costs
• installation and assembly costs
• the cost of testing whether the asset is functioning properly, and
• professional fees.
§ The initial estimate of the costs of dismantling and removing the item and restoring the site on which
it is located.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment
Ø Examples of costs that are not costs of an item of PPE include:
§ costs of opening a new facility
§ costs of introducing a new product or service (including costs of advertising and promotional
activities)
§ costs of conducting business in a new location or with a new class of customer (including costs of
staff training), and
§ administration and other general overhead costs.
These costs should be charged to the statement of profit or loss as they arise.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment
Example: On 1 March 2020 Yucca Co acquired a machine from Plant Co under the following terms:

$
List price of machine 82,000
Import duty 1,500
Delivery fees 2,050
Installation costs 9,500
Pre-production testing 4,900
Purchase of a five-year maintenance contract with Plant Co 7,000

In addition to the above information, Yucca Co was granted a trade discount of 10% on the initial list price of
the machine and a settlement discount of 5% if payment was received within one month of purchase. Yucca
Co paid for the machine on 25 March 2020.
Explain how the above information should be accounted for in the financial statements of Yucca Co for the
year ended 28 February 2021.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment
Ø Subsequent measurement: should be recognised as an expense in income statement in the period that
they are incurred. This includes costs such as day-to-day servicing or repairs and maintenance.
Ø Under IFRS, PP&E can be reported using the cost model or the revaluation model.
Ø Under US.GAAP, only the cost model is allowed.
§ Under the cost model, PP&E is reported at amortized cost (historical cost minus accumulated
depreciation, amortization, depletion, impairment losses).
§ Under the valuation model, PP&E is reported at fair value less any accumulated depreciation.

Cost model Revaluation model

– IFRS & US GAAP - IFRS
Cost X Fair value X
+ accumulated depreciation (X) + accumulated depreciation (X)
+ accumulated impairment losses (X) + accumulated impairment losses (X)
Carrying amount XX Carrying amount XX
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment
Ø Depreciation is is the process of allocating (recognizing as an expense) the cost of
a long-lived asset over its useful life.
Ø Depreciation methods
§ Straight-line method
§ Declining balance method (double-declining balance depreciation - DDB)
§ Units of production method
Ø Because PP&E is presented on the balance sheet net of depreciation and
depreciation expense is recognized in the income statement, the choice of
depreciation method and the related estimates of useful life and salvage value affect
both a company’s balance sheet and income statement.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment
Ø Depreciation methods
§ Straight-line depreciation – SL: When the cost of the asset is allocated to
expense evenly over its useful life.
Cost – residual value
Annual depreciation expense =
Estimated useful life
Example: An item of plant was acquired for $220,000 on 1 January 2016. The estimated
useful life of the plant was five years and the estimated residual value was $20,000. The
asset is depreciated on a straight-line basis. On 31 December 2016, the remaining useful
life of the plant was estimated to be three years, with an estimated residual value of
$12,000. Explain how depreciation would be calculated for the plant for each year of its
useful life.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment

Ø Depreciation methods

§ Declining balance method (double-declining balance depreciation - DDB): When

the allocation of cost is greater in earlier years.

i. Determine straight-line rate (100%/Useful life)

ii. Determine acceleration factor (e.g., 1.5× or 2×)

iii. Depreciation rate = (Straight-line rate x acceleration factor)

iv. Depreciation expense = Net book value (NBV) x Depreciation rate

v. Discontinue depreciation when net book value = Salvage value

MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment

Ø Depreciation methods

§ Declining balance method (double-declining balance depreciation - DDB)

Example: What is the annual depreciation expense each year?

§ Asset cost: $11,000

§ Estimated residual value: $1,000

§ Estimated useful life: 5 years

§ Acceleration factor: 2×
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Property, Plant and Equipment

Ø Depreciation methods
§ Units of production method: When the allocation of cost corresponds to the actual
use of an asset in a particular period.
Cost – residual value
Depreciation expense =
Units of production
Example: A company has a machine with a cost of $500,000 and a useful life that is
expected to end after producing 240,000 units of a component part. Further, the
machine's residual value at that point is $20,000. What is the annual depreciation
expense each year if the machine produces 10,000 units and 50,000 units in the first
year and the second year respectively?
MEASUREMENT BASES OF NON-CURRENT ASSETS
Example: At the beginning of 2016, three companies including Evenstar Co., Mint Inc.
and Cotta Co. buys an identical piece of box manufacturing equipment for $2,300 and has
the same assumptions about useful life (4 years), estimated residual value ($100), and
productive capacity (800 boxes). Production in each of the four years: 200 boxes in the
first year, 300 in the second year, 200 in the third year, and 100 in the fourth year. Each
company uses a different method of depreciation. Evenstar, Mint and Cotta respectively
use straight-line method, double-declining balance method and units-of-production
method. Using the following template for each company, record the beginning and ending
net book value (carrying amount), end-of-year accumulated depreciation, and annual
depreciation expense for the box manufacturing equipment.
MEASUREMENT BASES OF NON-CURRENT ASSETS

Beginning net Depreciation Accumulated Ending net

Year
book value expense depreciation book value

2016

2017

2018

2019
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Costs that are capitalized and costs that are expensed when incurred
ü When a firm makes an expenditures, it can either capitalize the costs as an asset on
the balance sheet or expense the cost in the income statement in the period incurred.
ü An expenditure that is capitalized is initially recorded as an asset on the balance
sheet at cost, typically its fair value at acquisition plus any costs necessary to
prepare the asset for use.
ü The cost is allocated to the income statement over the life of the asset as
depreciation expense (for tangible assets) or amortization expense (for intangible
assets with finite lives).
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Costs that are capitalized and costs that are expensed when incurred
ü In the period of the expenditure, capitalize:
§ purchase price and

§ expenditures necessary to prepare asset for intended use.

ü Subsequent expenditures are
§ capitalized if expected to provide benefits beyond one year (extend life or
capacity).
§ expensed otherwise.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Costs that are capitalized and costs that are expensed when incurred
Example: Which of the following expenditures are capitalized?
Related to purchase of towel and tissue roll machine:
§ €10,900 purchase price including taxes
§ €200 for delivery of the machine
§ €300 for installation and testing of the machine
§ €100 to train staff on maintaining the machine
§ €350 paid to a construction team to reinforce the factory floor and ceiling joists to
accommodate the machine’s weight
Maintenance:
§ €1,500 for roof repair; expected to extend useful life of the factory by 5 years.
§ €1,000 for repainting exterior of the factory and adjoining offices; repainting neither
extends the life of factory and offices nor improves their usability.
MEASUREMENT BASES OF NON-CURRENT ASSETS
Example: Two identical companies, Cece Inc. và Costa Inc., start with €1,000 cash and €1,000 common stock.
Each year the companies recognise total revenues of €1,500 cash and make cash expenditures, excluding an
equipment purchase, of €500. At the beginning of operations, each company pays €900 to purchase equipment.
Cece estimates the equipment will have a useful life of three years and an estimated salvage value of €0 at the
end of the three years. Costa estimates a much shorter useful life and expenses the equipment immediately.

The companies have no other assets and make no other asset purchases during the three-year period.

Assume the companies pay no dividends, earn zero interest on cash balances, have a tax rate of 30 percent, and
use the same accounting method for financial and tax purposes.

Question:

a. Which company reports higher net income over the three years? Total cash flow? Cash from operations?

b. Based on ROE and net profit margin, how does the profitability of the two companies compare?
MEASUREMENT BASES OF NON-CURRENT ASSETS
(1) Income statement (3) Balance sheet
For year 1 2 3 End End End
Revenue Time of of of
As of
0 Year Year Year
Cash expenses
1 2 3
Depreciation
Cash
Income before tax
PP&E (net)
Tax at 30%
Total assets
Net income
Retained earnings
(2) Cash flow statement Common stock
For year 1 2 3 Total shareholders’ equity
Cash from operations
Cash used in investing
Total change in cash
MEASUREMENT BASES OF NON-CURRENT ASSETS
v Capitalize versus expense: Effect on Financial statements

Item Balance Sheet Income Statement Statement of Cash Flow

Costs that are capitalized

• In the period of the expenditure Increase assets −−−− Investing cash outflow

Expensed via
• In subsequent periods −−−− −−−−
depreciation
Immediately reduce
Costs that are expensed when incurred −−−− Operating cash outflow
net income

Ø All else being equal,

v Capitalizing results in higher profitability ratios (return on equity and net profit margin) in the first
year and lower profitability ratios in subsequent years.
v Expensing will give the appearance of greater subsequent growth in profits.
MEASUREMENT BASES OF NON-CURRENT ASSETS
v 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.
v 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.

v Measurement of intangible assets subsequent to acquisition:

§ An intangible asset with an indefinite useful life is not amortized.
§ An intangible asset with a finite useful life is amortized using the same methods as
depreciation. Calculating amortization requires:
ü The original amount at which the intangible asset is recognized,
ü The estimated length of its useful life, and
ü The estimated residual value at the end of its useful life.
COMMON TYPES OF CURRENT LIABILITIES
v Accounts payables are amounts the firm owes to suppliers for goods or services purchased

on credit.
v Notes payables are obligations in the form of promissory notes owed to creditors and lenders

v Accrued liabilities (accrued expenses) are expenses that have been recognized in the

income statement but are not yet contractually due.

v Unearned revenue (unearned income, deferred revenue, or deferred income) is cash

collected in advance of providing goods and services.

 COMMON TYPES OF NON-CURRENT LIABILITIES
v Long-term financial liabilities:
Ø 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
v Deferred tax liabilities are the amounts of income taxes payable in future periods as a result
of taxable temporary differences.
§ Deferred tax liabilities are created when the amount of income tax expense recognized
in the income statement is greater than taxes payable.
§ This can occur when expenses or losses are tax deductible before they are recognized
in the income statement.
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Bonds payable

Ø Bonds are contractual promises made by a company (or other borrowing entity) to pay cash

in the future to its lenders (i.e., bondholders) in exchange for receiving cash in the present.
Ø The cash or sales proceeds received by a company when it issues bonds is based on the value

(price) of the bonds at the time of issue. The price at the time of issue is determined as the
present value of the future cash payments promised by the company in the bond agreement.
Ø Bonds contain promises of two types of future cash payments:

i) the face value of the bonds

ii) periodic interest payments
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Calculate the value of the bonds at issuance and thus the sales proceeds involves three steps:

(1) identifying key features of the bonds and the market interest rate,
(2) determining future cash outflows, and
(3) discounting the future cash flows to the present (sum of the present value of the future
payments of interest and principal).
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Determine the value of a bond:
Example: Debond Corp. issues £1,000,000 worth of five-year bonds, dated 1 January 2018, when
the market interest rate on bonds of comparable risk and terms is 5 percent per annum. The bonds
pay 5 percent interest annually on 31 December. What are the sales proceeds of the bonds when
issued, and how is the issuance reflected in the balance sheet?
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Discount or premium on bonds

v Bonds are issued at a premium to face value when the bonds’ coupon rate is greater
than the market rate, the market value of the bonds and thus the amount of cash the
company receives will be higher than the face value of the bonds.

v Bonds are issued at a discount to face value when the bonds’ coupon rate is lower
than the market rate, the market value and thus the sale proceeds from the bonds will
be less than the face value of the bonds.
 COMMON TYPES OF NON-CURRENT LIABILITIES
For example: Principal = $1,000; Coupon interest rate = 10%, paid annually; Maturity = 5
years.

v Assume that the market rate on the bond on day we are valuing it = 12%. Issued at 92.8
(i.e., 92.8% of face value).

Ø The sales proceeds of the bonds when issued are $928. The bonds sell at a discount of
$72 ($1,000 – $928) because the market rate when the bonds are issued (12%) is greater
than the bonds’ coupon rate (10%). Long-Term Liabilities
Bonds Payable $1,000
Less: Discount $72 $928

Book value
(also known as carrying value)
 COMMON TYPES OF NON-CURRENT LIABILITIES
For example: Principal = $1,000; Coupon interest rate = 10%, paid annually; Maturity = 5
years.

v Assume that the market rate on the bond on day we are valuing it = 8%. Issued at 108
(i.e., 108% of face value).

Ø The sales proceeds of the bonds when issued are $1,080. The bonds sell at a premium of
$80 because the market rate when the bonds are issued (8%) is less than the bonds’
coupon rate (10%). Long-Term Liabilities
Bonds Payable $1,000
Add: Premium $80 $1,080

Book value
(also known as carrying value)
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Two methods for amortising the premium or discount of bonds:

v The effective interest rate method: The effective interest rate method applies the
market rate in effect when the bonds were issued to the current amortised cost
(carrying amount) of the bonds to obtain interest expense for the period. The
difference between the interest expense (based on the effective interest rate and
amortised cost) and the interest payment (based on the coupon rate and face value) is
the amortisation of the discount or premium.

v The straight-line method: evenly amortises the premium or discount over the life of
the bond, similar to straight-line depreciation on long-lived assets.
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Amortising a Bond Discount
Example: Debond Corp. issues £1,000,000 face value of five-year bonds, dated 1 January 2017,
when the market interest rate is 6 percent. The sales proceeds are £957,876. The bonds pay 5
percent interest annually on 31 December.
a. What is the interest payment on the bonds each year?
b. What amount of interest expense on the bonds would be reported in 2017 and 2018 using the
effective interest rate method?
c. Determine the reported value of the bonds (i.e., the carrying amount) at 31 December 2017
and 2018, assuming the effective interest rate method is used to amortise the discount.
d. What amount of interest expense on the bonds would be reported under the straight-line
method of amortising the discount?
 COMMON TYPES OF NON-CURRENT LIABILITIES
v Amortising a Bond Premium
Example: Prembond Corp. issues £1,000,000 face value of five-year bonds, dated 1 January 2017,
when the market interest rate is 4 percent. The sales proceeds are £1,044,518. The bonds pay 5
percent interest annually on 31 December.
a. What is the interest payment on the bonds each year?
b. What amount of interest expense on the bonds would be reported in 2017 and 2018 using the
effective interest rate method?
c. Determine the reported value of the bonds (i.e., the carrying amount) at 31 December 2017
and 2018, assuming the effective interest rate method is used to amortise the premium.
d. What amount of interest expense on the bonds would be reported under the straight-line
method of amortising the premium?
COMPONENTS OF SHAREHOLDERS’EQUITY
v Stockholders’ equity is the residual interest in asset that remains after subtracting a firm’s

liabilities.

v Shareholders’ equity is classified into:

§ Contributed capital

§ Preferred stock

§ Treasury stock

§ Retained earnings

§ Non-controlling interest

§ Accumulated other comprehensive income

COMPONENTS OF SHAREHOLDERS’EQUITY
v Shareholders’ equity is classified into:

Ø Contributed capital:

§ Total amount paid in by the common and preferred shareholders

§ Par value is a legal value and has no relationship to fair value

§ Authorized shares are the number of shares that may be sold under the firm’s articles

of incorporation

§ Issued shares are the number of shares that have actually been sold to shareholders

§ Outstanding shares is equal to the issued shares less treasury shares

COMPONENTS OF SHAREHOLDERS’EQUITY
v Shareholders’ equity is classified into:

Ø Treasury stock is stock that has been reacquired by the issuing firm but not yet retired.

Treasury stock reduces stockholders’ equity and has no voting rights as well as dividends

Ø Retained earnings are the undistributed earnings (net income) of the firm since inception

Ø Minority interest is the minority shareholders’ pro-rata share of equity of a subsidiary that is

not wholly owned by the parent

Ø Accumulated other comprehensive income (IFRS and U.S GAAP) includes all changes in

stockholders’ equity except for transactions recognized in the income statement (net income)
and transactions with shareholders such as issuing stock, reacquiring stock and paying
dividends. Example: differences from asset revaluation, differences from foreign exchange