WEEK 2
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Chapter2.pdf
2 The Balance Sheet
Learning Objectives
After reading this chapter, you should be able to:
1. Describe the elements of a balance sheet.
2. Describe the different types of accounts contained in the balance sheet among assets, liabilities, and shareholders’ equity.
3. Explore the different methods of accounting for inventory (LIFO and FIFO) and the effects on the value of the inventory.
4. Explain how to create a common-sized balance sheet.
© Yong Hian Lim/iStock/Thinkstock
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Introduction
Pre-Test
1. What is the purpose of a balance sheet? a. to show that the books are in balance b. to give a snapshot of a company’s financial position on a given date c. to show what the company owns d. to show what the company owes
2. Which is the basic formula for a balance sheet? a. Assets minus Liabilities equal Equity b. Assets equal Liabilities plus Equity c. Net Assets equal Net Profit d. none of the above
3. What is the bottom line of the balance sheet shown in account format? a. Total Assets b. Total Liabilities and Equity c. Total Liabilities d. both A and B
4. What are inventory valuation methods? a. LIFO and FIDO b. LIFO and FIFO c. Average Cost d. both B and C
5. What is a tool used to compare balance sheets among various companies, large and small?
a. average balance sheets b. common-sized balance sheets c. industry balance sheets d. no tool available
Answers can be found at the end of the chapter.
Introduction In Chapter 1, we introduced the members of Best General Company’s budget committee. In this chapter, the budget committee begins its analysis of the company’s results by tak- ing a closer look at the balance sheet. To introduce the balance sheet, we have created a basic one for Best General Company (shown in Figure 2.1). It uses numbers that are much simpler than the ones that show up on the balance sheets of major corporations. Later in the chapter we will explore the complex balance sheets of two real-world corporations: IBM and 3M.
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Introduction
Figure 2.1: Sample balance sheet for Best General Company
The balance sheet provides a quick snapshot into the overall financial health of an organization as of a particular date.
Best General Company Balance Sheet
At December 31, 2013 and 2012
2013 2012
Current Assets:
Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
Long-Term Assets:
Property, Plant, & Equipment
Less: Accumulated Depreciation
Other Non-Current Assets
Total Assets
Current Liabilities:
Accounts Payable
Short-Term Debt
Other Current Liabilities
Total Current Liabilities
Long-Term Liabilities:
Long-Term Debt
Other Non-Current Liabilities
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
Assets
Liabilities
Shareholders’ Equity
$ 8,400
7,800
40,000
6,000
62,200
99,600
(9,600) 45,000
$ 197,200
$ 8,900
26,000
20,400
55,300
62,450
52,000
$ 169,750
20,000
7,450
$ 27,450
$ 197,200
$ 9,500
7,200
38,000
6,000
60,700
99,600
(7,200) 45,000
$ 198,100
$ 9,400
26,000
19,800
55,200
65,000
54,000
$ 174,200
20,000
3,900
$ 23,900
$ 198,100
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Section 2.1The Elements of a Balance Sheet
First, notice in Figure 2.1 that the Total Assets equal the Total Liabilities and Equity. That must always be true on a balance sheet. If that is not the case, there is an error some- where. We take a closer look at why this is so in this chapter. Also in Figure 2.1 we see that Accounts Receivable, which is where the accounts of customers who owe money to the company are tracked, is increasing in value. This could be a sign of trouble or it could mean that sales on credit increased from year to year. When Juan and Susan see this num- ber, they know they will need to research it further to find out whether there is a problem collecting from customers.
Another possible indicator of a problem is that Inventories are increasing in value. This could indicate that sales are slowing because inventory is sitting on the shelf and not sell- ing—or it could mean the company has added to the variety of inventory carried.
As the Best General budget committee develops its budget report, its members will want to take a closer at these numbers and determine why the value of inventory is increasing. They may need to recommend that the company plan for lower revenues or for new ways to increase its sales if it wants to keep revenue expectations at the same level or increase projected revenues for the next budget year.
Let’s take a closer look at the elements of a balance sheet.
2.1 The Elements of a Balance Sheet Consider a gymnast walking a balance beam: If she steps a bit to the right or left, she will fall off. She can only stay on the beam if she balances perfectly in the center.
Just like that gymnast, a company’s balance sheet (also known as the statement of finan- cial position) must stay in balance on a very thin line. Any deviation can throw a com- pany’s books off balance. Balance is based on the key equation for all accounting:
Assets 5 Liabilities 1 Equity
This balancing act works because funds borrowed from lenders or cash raised from inves- tors is used to fund the assets the company owns. The Liability section shows the funds borrowed from lenders and the Equity section shows money invested in the company by the investors (the owners of the company). The Equity section also shows the profits retained to reinvest in the company in an account called Retained Earnings.
Every transaction entered into the accounting system must take this key formula into consideration. In Chapter 1, we introduced these three key elements: assets, liabilities, and equity. In this chapter, we’ll explore how the numbers are developed for the balance sheet, as well as the key rules companies follow when preparing this statement.
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Section 2.1The Elements of a Balance Sheet
Some Notes on Entering Numbers Into the Accounting System
Before exploring the balance sheet, let’s discuss how the numbers are entered into the accounting system to be sure the balance sheet will be in balance.
For example, when a company makes a cash purchase, it trades an asset, such as cash, for another asset, such as furniture. The outlay of cash is considered a credit and the intake of furniture is called a debit. This cash transaction would be entered in the accounts as shown in Table 2.1:
Table 2.1: Accounting for cash transactions
Date Accounts Debit Credit
May 3 Furniture 1,000
Cash 1,000
In this entry, Assets are increased by $1,000 with the addition of furniture and decreased by $1,000 with the use of cash. So the balance sheet stays in balance.
Suppose the company didn’t pay cash for the item but instead used a credit card. This credit transaction would be entered into the books as shown in Table 2.2:
Table 2.2: Accounting for credit card transactions
Date Accounts Debit Credit
May 3 Furniture 1,000
Credit Card Payable 1,000
In this entry, Assets are increased by $1,000 with the acquisition of furniture and Liabilities are increased by $1,000 with credit card debt. Again, the balance sheet stays in balance.
In this text, we will not discuss how debits and credits work in detail; that is the subject of a basic accounting text. Rather, we will briefly explore the logistics that go into building the numbers for a balance sheet and their relationship to the key accounting formula:
Assets 5 Liabilities 1 Equity
If the transactions are not balanced when they enter the accounting system, the balance sheet will not be in balance.
Note that debits and credits in accounting mean very different things than they do when looking at bank accounts or credit cards. A debit in a bank account always means that the number will be subtracted from the bank balance. A credit always means that the number will be added to the bank balance.
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Section 2.1The Elements of a Balance Sheet
In accounting it is not that simple. Debits and credits can add to or subtract from the bal- ance in an account depending on the type of account. For accounts that track assets and expenses, a debit will increase the value of that account and a credit will decrease the value. For accounts that track liabilities and income, a credit will increase the value of the account and a debit will decrease the value.
The key to entering data into an accounting system is to ensure that the debits always equal the credits in a transaction entry in order to keep the books in balance. Table 2.3 summarizes how debits and credits impact a company’s accounts:
Table 2.3: How debits and credits impact accounts
Account type Debit Credit
Assets Increase Decrease
Liabilities Decrease Increase
Equity Decrease Increase
Income Decrease Increase
Expenses Increase Decrease
Balance Sheet Presentation
When preparing a balance sheet, several basic rules guide the dates for the statement, the numbers used, and the presentation format. We take a brief look at these key elements next.
Task Box 2.1: Exploring Financial Statements: IBM and 3M
As we explore the balance sheet and other financial statements in this and future chapters, we will occasionally use the financial statements of two companies, IBM and 3M, to find out how the numbers play out in the real world.
We have chosen IBM because it is a service-based corporation that both develops technology solutions for its customers and sells the products for those solutions. This will provide a good overview of how both serviced-based and product-based corporations present their financial reports. IBM deemphasized manufacturing hardware beginning in 1994, and in 2012 focused its operations instead on services, software, and technology solutions, yet it still does some manufacturing.
3M also sells and manufactures its own products. It puts a greater focus on manufacturing and its financial statements reflect that difference.
As we explore these financial statements, we will note some key differences presented in the financial reports for service, product, and manufacturing companies.
Download the PDFs for the 2012 annual reports of IBM and 3M. Find the financial statements and the Notes to the Financial Statements in each. Be prepared to use them to complete this chapter and throughout other chapters. Note that both companies indicate they are “Consolidated” statements, meaning that the results include all subsidiaries.
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Section 2.1The Elements of a Balance Sheet
Dates of the Statement A balance sheet is like a snapshot of a company’s financial position on a particular date. That is why the top of the balance sheet always includes the words “as of” or “at” and then a month, day, and year.
A company’s financial position changes daily as sales are made, inventory is bought or manufactured, and other transactions take place to keep the company operating. So when reviewing a balance sheet, keep in mind that it provides the company’s financial position only for the date shown at the top.
The date on the balance sheet will be the last date of the period being presented. This can be the end of a year, end of a quarter, end of a month, or end of another period, as designated by the company. The date on the balance sheet will be the same as the last day of operations shown on the income statement. (We’ll explore the income statement in Chapter 3.) Note in the heading (top portion) of Best General’s balance sheet shown in Figure 2.2 that the date of the statement is “At December 31” and the columns designate the two years shown (2013 and 2012).
Figure 2.2: Top portion of the Best General Company balance sheet
A great deal of information can be gleaned from the balance sheet. For example, from this partial sheet we can determine that Best General Company has less cash than in the previous period and accounts receivable and inventory amounts have increased.
Best General Company Balance Sheet (Partial)
At December 31, 2013 and 2012
2013 2012
Current Assets:
Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
Assets
$ 8,400
7,800
40,000
6,000
$ 62,200
$ 9,500
7,200
38,000
6,000
$ 60,700
Financial statements are not always presented on a calendar-year basis. Some companies report based on a different fiscal year. For example, many retail companies present their annual report starting on February 1 of any year until January 31 of the next year. They choose this 12-month period for two reasons:
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Section 2.1The Elements of a Balance Sheet
1. They do not want to be preparing financial statements during their busiest time of year, the Christmas holiday season. For example, Walmart prepares its annual reports at the end of January.
2. January sales often include December returns and new sales, so the flow of their finances is more accurately reflected with a year-end of January rather than December.
Another type of organization that does not usually report on a calendar-year basis is aca- demic institutions. Such institutions are more likely to prepare statements based on their academic year. For example, the Apollo Group, which operates for-profit universities, reports annually at the end of August. Many non-profit learning institutions, which do not need to report to the SEC, do provide annual reports to their donors. These reports are usually based on a year-end of August 31.
When comparing financial reports of various companies and institutions, always be sure to check the dates at the top of the reports. Be sure that the companies report using the same fiscal year in order to compare apples to apples. For example, suppose a manager wants to compare two retail companies. One company reports based on the calendar year ending December 31, 2012, and the second on a fiscal year ending January 31, 2013. The holiday season may affect these retailers very differently. If January was a big month in 2013, but sales were not as good in 2012, the two reports will not be easily compara- ble. Before the manager can conduct a financial comparison, he needs to find a quarterly report that gives month-by-month details of both companies and then adjust the financial reports of one these companies so the results represent the same time period.
Another way some companies prepare their financial statements is to base the end of each financial period on a particular day of the week. (We talk about that scenario in “World of Business.”)
World of Business
Another Twist to Financial Report Dating Most companies report on a calendar-year or fiscal-year basis that ends at the end of a month, but some companies prefer to report based on a particular day of the week. One such company is Darden, which operates popular restaurant chains such as Red Lobster, Olive Garden, and LongHorn Steakhouse. The company reports on the last Sunday of the month during each accounting period.
Darden has determined that the best way to compare the results of its restaurants is to end each reporting period on the same day of the week because in the restaurant business, the volume of business differs by day of the week.
Richard Levine/age fotostock/SuperStock
Darden, which operates the restaurant chains Red Lobster and Olive Garden, chooses to report its financials on the last Sunday of each period because it helps the company compare the results of its various brands.
(continued)
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Section 2.1The Elements of a Balance Sheet
For example, Friday and Saturday are the busiest nights for many restaurants. Monday night tends to be the quietest. Preparing reports that measure revenue based on the same ending day of the week provides more consistent reporting that is easier to compare period to period. Managers in businesses that are dependent on traffic flows based on the day of the week can more easily manage the finances of their business with numbers generated based on that traffic flow.
However, reporting by the day of the week can add another complication to analyzing results of operations. This is because in some years, there will be 52 weeks, and in other years there will be 53 weeks. A company that uses this type of year-end reporting will explain how it calculates its results in the Notes to the Financial Statements. Darden discusses its fiscal year on page 68 of its 2012 annual report. The three years 2012, 2011, and 2010 were 52-week years. The last 53-week year was 2009. It is discussed on page 47 of the 2009 Darden annual report.
When financial statements show an end date other than the 30th or 31st of the month, look for the discussion of the 52/53-week year in the Notes to the Financial Statements. Also, when comparing companies, be sure to either find another company with a similar fiscal year or adjust the results to compare performance during the same time period. (Darden 2012)
Consider This:
1. You want to compare a restaurant chain that reports based on weekly financial data to one that reports on a calendar-year basis. What are the key differences you must consider in the way the figures are reported?
2. What benefits do you think companies gain by reporting on a weekly schedule versus a monthly schedule?
3. What types of businesses do you think might best be served by weekly reporting?
World of Business (continued)
Numbers Used
In addition to knowing the date the report was generated, it is important to pay atten- tion to the way the numbers are shown. For example, IBM’s Financial Position Statement says “$ in millions except per share amounts.” This is a critical piece of information and is found at the top of all financial statements. Imagine how difficult it would be to read all the numbers IBM includes on its financial statements if the numbers were shown without rounding—a mathematical decision to use less exact, abbreviated numbers. For example, if sales were $12,275,645,320 and the company reported in the millions, the number would be shown as $12,276. In this case, the company rounded up because the next number was 5 or more. If the next number had been 4 or less, the number would be shown as $12,275.
Companies normally provide their numbers in the thousands or millions, but either way, it is important to note how a company is rounding its numbers. This can be critical when comparing the results of a large company, which may report its numbers in the millions, to that of a mid-sized or small company, which may report its numbers in the thousands.
Presentation Format
Companies can use three different types of formats when presenting their balance sheet: report format, account format, or financial position format. We present each format using simple numbers and just a few line items to illustrate what to expect for each.
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Section 2.1The Elements of a Balance Sheet
For the Best General Company, we used the report format, which is shown in Figure 2.3.
Figure 2.3: Report format balance sheet
In the report format, Assets are shown first, then Liabilities and Equity. Note that Assets 5 Liabilities 1 Equity.
Current Assets
Long-Term Assets
Other Assets
Total Assets
Current Liabilities
Long-Term Liabilities
Total Liabilities
Shareholders’ Equity
Total Liabilities and Equity
Assets
Liabilities and Equity
62,200
90,000
45,000
197,200
55,300
114,450
169,750
27,450
197,200
$
$
$
$
Best General Company Balance Sheet (Report Format)
At December 31, 2013
Another commonly used format is the account format, shown in Figure 2.4.
Figure 2.4: Account format balance sheet
In the account format, the Assets are in the left column and the Liabilities and Equity are in the right column. The two columns’ totals will always be shown in balance.
Current Assets
Long-Term Assets
Other Assets
Total Assets
Assets 62,200
90,000
45,000
197,200
$
$
$
$
Current Liabilities
Long-Term Liabilities
Total Liabilities
Shareholders’ Equity
Total Liabilities and Equity
Liabilities and Equity 55,300
114,450
169,750
27,450
197,200
Best General Company Balance Sheet (Account Format)
At December 31, 2013
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Section 2.1The Elements of a Balance Sheet
The third format is the financial position format. This format is used internationally but is not commonly found in the United States, although it may be used by foreign compa- nies that do business in the United States. The key difference in this format is the addition of two lines that do not appear on the account or report formats:
• Working Capital: This line is the current assets the company has available to pay its bills. It is calculated by subtracting the current liabilities from the current assets.
• Net Assets: This line shows what is left for the company’s owners after all liabili- ties have been subtracted from total assets.
Using the same numbers as are seen in the examples of the other two formats, the financial position format is shown in Figure 2.5.
Figure 2.5: Financial position format balance sheet
Net Assets is equal to Shareholders’ Equity. Companies using this format also include a statement detailing the equity section.
Current Assets
Less: Current Liabilities
Working Capital Plus: Non-Current (Long-Term) Assets
Total Assets Less Current Liabilities Less: Long-Term Liabilities
Net Assets
62,200
(55,300)
6,900
135,000
141,900
(114,450)
27,450
$
$
Best General Company Balance Sheet (Financial Position Format)
At December 31, 2013
Now that we have reviewed the items that appear on a balance sheet or statement of financial position, we will investigate the most common line items and how these line items are calculated. We also will explore the Notes to the Financial Statements, which provide the details behind these numbers.
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Section 2.1The Elements of a Balance Sheet
Assets
As we discussed in Chapter 1, assets are divided into two groups: current assets and long- term assets. Current assets include those that will be used in the next 12 months. All other assets are considered long-term assets (also sometimes called non current assets). The cur- rent assets are shown first, followed by the long-term assets. As a review, Figure 2.6 shows the assets section of Best General Company’s balance sheet.
Figure 2.6: Assets section of Best General Company balance sheet
Long-term, or non-current assets, are assets that will not be used within the next 12 months. These assets are listed after all current assets on the balance sheet.
Best General Company Balance Sheet (Partial)
At December 31, 2013 and 2012
2013 2012
( ) ( )
Current Assets:
Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
Long-Term Assets:
Property, Plant, & Equipment
Less: Accumulated Depreciation
Other Non-Current Assets
Total Assets
Assets
$ 8,400
7,800
40,000
6,000
62,200
99,600
9,600
45,000
$ 197,200
$ 9,500
7,200
38,000
6,000
60,700
99,600
7,200
45,000
$ 198,100
Task Box 2.2: Exploring Notes on Financial Statements
Take a look at the 2012 financial statements you downloaded for IBM and 3M. You will see that IBM’s Statement of Financial Position makes it easy to find out more details about its line items because the appropriate note is indicated in a column called Notes.
The first note you will see is Note D, on the line item Marketable Securities. If you turn to the Notes to the Financial Statements, you will find out more detail about IBM’s marketable securities.
The balance sheet for 3M is not as helpful. There is only one note mentioned on the statement (Note 13, Commitments and contingencies), but 3M does provide an index of its notes on page 43 of its 2012 annual report.
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Section 2.1The Elements of a Balance Sheet
Cash and Cash Equivalents The first line item on the balance sheet is always Cash or Cash and Cash Equivalents. Cash is just that: cash in bank accounts, savings accounts, cash registers, and petty cash draw- ers. For Best General Company, Cash and Cash Equivalents was $8,400 in 2013.
On the balance sheets of more complicated companies, cash may include many different types of financial instruments. For example, IBM explains what it considers Cash Equiva- lents in Note A of its Notes to the Financial Statements: “All highly liquid investments with maturities of three months or less at the date of purchase are considered to be cash equivalents.” For example, a three-month Certificate of Deposit (CD) would fit into this category. In Note D, IBM details that Cash includes time deposits, certificates of deposit, commercial paper, money market funds, and other securities.
In Note 1, 3M explains this line item in a similar way: “Cash and cash equivalents con- sist of cash and temporary investments with maturities of three months or less when acquired.” (Maturity refers to the date the asset can be turned into cash. For example, if the asset is a CD, this will be the date the CD must be turned into cash or reinvested in another CD.)
When comparing how one company reports its cash to how other companies do it, look at the explanation to be sure both companies use the same categorization of cash.
In Chapter 1 we discussed that the first note in the Notes to the Financial Statements reviews significant accounting policies. When searching for details about how a number is calculated (and the information is not presented in a separate note), look for that informa- tion in Note 1 or Note A, depending on how the company numbers its notes.
Marketable Securities Marketable securities can include stocks, bonds, and other investments that can be turned into cash within 12 months. The simple balance sheet for Best General Company did not show any marketable securities, but many major corporations will include this line item. Financial managers are likely to take a close look at this information. For example, Bob, a financial analyst at Best General Company, would likely check competitors’ balance sheets to find out if they hold marketable securities and which types of securities they hold. He could use this information to make recommendations to his managers.
If Bob were looking at IBM and 3M, he would review the relevant Notes to the Financial Statements. He would see, for example, 3M’s balance sheet includes two marketable secu- rities line items: one is current and another is non-current. In Note 8, 3M explains that classification as current or non-current marketable securities is determined by “manage- ment’s intended holding period.” The note also indicates that 3M’s marketable securities include U.S. and foreign government securities, commercial paper, corporate debt, and asset-back securities (such as automobile loans and credit card securities). Also at the bot- tom of Note 8, 3M details its unrealized gains and losses on marketable securities and how it derives the valuation for the balance sheet.
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Section 2.1The Elements of a Balance Sheet
IBM explains in Note A that all securities on this line item can be turned into cash in the next 12 months. IBM also explains that realized gains and losses on these securities are included in Other Income or Other Expense on the income statement (statement of earn- ings). These gains or losses are calculated based on the specific identification method, which means they are based on the purchase and sold details of each individual asset. In addition, IBM says these assets are reported at “fair value with unrealized gains and losses, net of applicable taxes.” Note D includes a detailed breakdown of the marketable securities owned by IBM as well as explanations about fair value calculations. IBM also details the risks involved with its marketable securities.
With the details found in the notes, Bob can assess how well his company is managing its marketable securities compared to how the competition is managing theirs.
Task Box 2.3: Comparing Marketable Securities
Review the details behind IBM’s and 3M’s marketable securities in their 2012 financial statements. How much does each show in unrealized gains and unrealized losses for the two years? Which company makes it easier for you to answer this question? Explain why.
Accounts Receivable Accounts Receivable is where the company tracks money due from its customers. Note that these are customers who bought on credit offered directly by the company. Customers who use credit cards are not included in this number because the company will receive immediate cash payment from the credit card company, which in turn collects from the customers.
As indicated above, the budget committee for Best General Company would need to take a close look at the details for this account since the value of this asset went up from $7,200 in the prior year to $7,800 in the current year, even though revenue went down. This likely means more customers are not paying their bills, but the budget committee cannot know that for sure until it looks at the internal reports that detail what is behind these numbers. Internally, the budget committee can request an aging schedule, which would be a con- fidential report not found in the financial statements released to the public. This report might look something like the one shown for Best General Company in Figure 2.7.
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Section 2.1The Elements of a Balance Sheet
Figure 2.7: Best General Company accounts receivable aging schedule
An aging schedule, like the one shown here, is an internal report showing customer credit delinquencies that are more than 30 days past due.
Best General Company Accounts Receivable Aging Schedule
As of December 31, 2013
Customers 30–45 Days 46–60 Days 61–90 Days Over 90 Days Total
Sally Adams
Jerry Jones
Andy King
Total
100
100
200
150
300
150
600
$
$
$
$
$
$
$
$
$
$
500
300
300
1,100
900
900
750
1,500
550
2,800
$
$
A complete aging schedule would list all the customers and what they owe. The amount owed is grouped by the “age” of the purchase, such as 30 to 45 days or 46 to 60 days. Since Best General Company is experiencing an increase in its Accounts Receivable line item, it is likely that a greater number of its customers are paying their bills late. The budget com- mittee may need to recommend changes to Best General Company’s credit policies. The executive committee would then need to determine whether a change is needed and how that change should be implemented.
When looking at their competitors’ Accounts Receivable line item, Best General’s budget committee could not see this type of detail, but they can assess whether their competitors are experiencing similar problems. If so, it could be an indication of an industry-wide downturn or possibly even economic problems impacting a larger portion of the nation’s economy, such as the recession the United States experienced between 2008 and 2012. If economic conditions are impacting receivables, the budget committee may need to lower revenue expectations for the next year.
Every company reports some detail about its Accounts Receivable in the Notes to the Financial Statements. Note that IBM actually includes three Accounts Receivable line items: notes and accounts receivable, short-term financing receivables, and other accounts receivable. Also note that IBM shows these numbers “net of allowances.” These allow- ances are for bad debt, which means the amount of this debt that IBM does not expect to be able to collect from nonpaying customers. There are also allowances for returns. In Note A, IBM details how it calculates its allowance for credit losses. In Note F, IBM details its short-term financing receivables. IBM sells large computer software systems and ser- vices that are purchased using leases and long-term loans, so its Accounts Receivable can be very complex to sort out.
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Section 2.1The Elements of a Balance Sheet
Accounts Receivable is only one line item on 3M’s balance sheet. Its product offerings are not as complex as IBM’s, and there aren’t many details about its Accounts Receivable and allowances. In Note 1, the company explains that the allowance for doubtful accounts (bad debt) is “based on historical write-off experience by industry and economic data and historical sales returns.” The company says it reviews this data monthly.
Inventories Inventories include the products the company has on hand to sell to its customers. When Best General’s budget committee looks at this number, it sees that the value of inventories is climbing from $38,000 in the prior year to $40,000 in the current year. If more inventory is on hand, this could indicate that business has slowed. Susan, the marketing manager, and Juan, the sales manager, would need to compare the sales reports to find out what products are selling and whether sales have dropped.
Mai and Frank would want to compare their inventory numbers to those of their competi- tors to see whether their competitors are also experiencing an increase. If they are, it could be a sign of an industry downturn. If the competitors do not show the same problem, it could be an indication of a company-specific issue. Either way, the budget committee would need to research why inventory is building up.
When looking at competitors, another factor could be of interest to the budget committee: whether their competitors manufacture the products they sell. For example, IBM includes only one line item for inventories, whereas 3M includes three stages of inventory: finished goods, work in process, and raw materials and supplies.
The primary reason for this difference is that 3M has a major manufacturing component. The only goods ready for sale are finished goods. The value of goods in work in process includes the value of goods currently in some stage of the manufacturing process but not yet ready for sale. Raw materials and supplies are goods on hand that have not yet entered the manufacturing process. In Note 1, 3M states it values its inventory “at the lower of cost or market, with cost generally determined on a first-in, first-out basis.” We explore what this means and how companies value inventory later in this chapter.
IBM does manufacture some of its products, but it does not show the detail on the bal- ance sheet. Instead, the notes reveal information about its inventories. IBM only provides details for finished goods separately. Work in process and raw materials are shown as one line item in Note E. In Note A, IBM details its hardware and software products, as well as the services offered, but the focus in this note is on how the company recognizes its rev- enues. We’ll investigate those issues in Chapter 3.
Deferred Taxes Some larger companies carry over tax deductions for another year. IBM is one company that carries assets on its balance sheet on a line item called Deferred Taxes. The item appears both as a current asset and as a long-term asset. The details about this line item can be found in Note N. IBM shows its income before taxes in both U.S. and foreign opera- tions, then goes on to detail its taxes by geographic operations and taxing jurisdictions.
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Section 2.1The Elements of a Balance Sheet
The key part of this note that affects deferred taxes can be found in a chart called Deferred Tax Assets (see Figure 2.8). Deferred taxes are an asset to a company because they repre- sent tax write-offs that may be used to reduce income taxes in the future.
Figure 2.8: IBM’s deferred tax assets
Using deferred tax assets on future tax returns, companies can reduce their tax obligations in the future.
Deferred Tax Assets
Retirement benefits
Share-based and other compensation
Deferred income
Domestic tax loss/credit carryforwards
Foreign tax loss/credit carryforwards
Bad debt, inventory and warranty reserves
Depreciation
Other
Gross deferred tax assets
Less: valuation allowance
Net deferred tax assets
($ in millions)
At December 31: 2012 2011 *
$ 5,870
1,666
1,018
954
681
586
456
1,384
12,615
1,187
$ 11,428
$ 5,169
1,598
834
914
752
608
474
1,479
11,828
912
$ 10,916
*Reclassed to conform with 2012 presentation.
Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
Prepaid Expenses Prepaid expenses include expenses paid in advance and not yet used. For example, a company pays an insurance policy on the first of the year that will cover the company for 12 months. The company must record the transaction when it occurs, but it will record it as an asset initially. Each month it will develop an adjusting entry to the books to show the amount of this asset used and offset it with an insurance expense. This way, the expense will be matched with the revenues generated that month. The expense account will be shown on the income statement.
This is a basic concept of accrual accounting, in which expenses and revenues are shown in the appropriate month. Revenues must be recognized in the month they are earned and expenses must be recognized in the month they are used, which is not necessarily the month that cash changed hands. Best General Company did not show any prepaid expenses. IBM lumps these with other assets, whereas 3M does not show the item on its balance sheet.
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Section 2.1The Elements of a Balance Sheet
Other Current Assets Other Current Assets is a miscellaneous line item for anything not detailed in the current assets portion of the balance sheet. Usually this item reflects the value of assets not used in current operations (and possibly up for sale). Neither IBM nor 3M details what is included in the Other Current Assets line item.
Property, Plant, and Equipment Up until now we have discussed current assets on the balance sheet. The rest of the assets on the balance sheet are long-term assets. These assets will be used for more than just a 12-month period.
The property, plant, and equipment line item is one such long-term asset. It will sum- marize the value of all the land, buildings, plants, laboratories, and office equipment on hand. It may include the value of rental equipment, as well, if that equipment is likely to become an asset at the end of the rental or lease period.
To keep things simple, Best General Company showed property, plant, and equipment net, which means after the reduction for depreciation. Note that there are three Property, Plant, and Equipment lines on both the IBM and 3M balance sheets. The first line item shows the gross value of property, plant, and equipment. The second line item shows the reduction in that value for depreciation.
Depreciation indicates how an asset is being expensed over its lifespan. For example, a vehicle that is expected to have a useful life of five years would be depreciated over that five-year period. That way its cost is spread over five years rather than being subtracted all in one year. The accumulation of depreciation over the five-year period is shown on the balance sheet as accumulated depreciation. The third line item on IBM’s and 3M’s balance sheets is the net value of property, plant, and equipment after depreciation is subtracted.
Managers need to understand how depreciation reduces the net income of a company, but it is not actually a cash expense each year. The cash outlay (or initiation of a long-term debt, such as a car loan) for an asset happens in the year of purchase. If a company were to report that as an expense, the profits would be greatly reduced. Depreciation expenses spread out the cost of an asset over time, even though they do not require the use of cash. This enables a company to match its expenses with the time over which the asset is used.
Task Box 2.4: Calculating Depreciation
Review the Notes to the Financial Statements and find out how 3M and IBM calculate depreciation. (The method 3M uses to calculate depreciation is shown in Note 1, page 53. IBM details this on page 81 in Note A.) List the different classes of depreciated assets and the number of years of useful life each company gives for its various types of assets. What depreciation method does each company use?
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Section 2.1The Elements of a Balance Sheet
Most companies use a straight-line depreciation method on their balance sheet. This means that the company determines an asset’s life span and then divides the cost of that asset by the number of years it will have a useful life to the company. If there will be a value after its useful life to the company, that is the salvage value at which the item could be sold to generate cash. If the company does not believe there will be a salvage value, the asset may be able to be sold for scrap.
Whether salvage or scrap, any value the company can get for the item will be subtracted from its cost prior to calculating the annual depreciation amount. For tax purposes, the company may use a depreciation method, called accelerated depreciation, that speeds up the deduction the company can take for the item. This will not be shown on the balance sheet. Occasionally, a company will detail a different method of depreciation in its note called “Significant Accounting Policies.”
In addition to detailing its depreciation calculation, IBM also separates out its Property, Plant, and Equipment in greater detail in Note G (see Figure 2.9).
Figure 2.9: IBM’s Note G (2012)
One can find details about IBM’s property, plant and equipment by reviewing the notes to the financial statements.
Note G. Property, Plant and Equipment
Land and land improvements
Building and building improvement
Plant, laboratory and office equipment
Plant and other property—gross
Less: Accumulated depreciation
Plant and other property—net
Rental machines
Less: Accumulated depreciation
Rental machines—net
Total—net
($ in millions)
At December 31: 2012 2011
$ 747
9,610
27,731
38,088
25,234
12,854
2,414
1,271
1,142
$ 13,996
$ 786
9,531
26,843
37,160
24,703
12,457
2,964
1,538
1,426
$ 13,883
Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
Note that land and land improvements are not shown with net of accumulated deprecia- tion. This is because land does not age and become useless, as other assets do. Buildings and building improvements are shown separately from plant and office equipment, but they are shown as total plant and other property for depreciation purposes.
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Section 2.1The Elements of a Balance Sheet
Depreciation of a building can be a complex calculation. Some accountants use cost seg- regation (dividing up a building’s structural components so write-offs can be developed based on the useful life of various key parts of a building; for example, a roof may age more slowly than the doors). We can’t determine by reading the Notes to the Financial Statements whether either IBM or 3M uses cost segregation, but since they do separate buildings from other property, that may explain the separation. (Soled, 2004)
When looking at depreciation, note what percentage of the assets has been depreciated. As we can see in Figure 2.9, IBM shows a gross value of $38,088 million for plant and other property, but $25,234 million has already been depreciated with only $12,854 million left to depreciate. This indicates that 66% (25,234/38,088) of the useful life of its assets has been used up. This could mean IBM may need to spend a good deal of money repairing older facilities or building new facilities to maintain operations.
Prepaid Pension The Prepaid Pension line item summarizes the assets on hand to pay for the company’s pension plans. We did not show a pension line item on the Best General Company’s sim- plified balance sheet, but managers will likely see them on company balance sheets, so let’s take a closer look at 3M’s and IBM’s information.
Both 3M and IBM have complex plans that differ based on the date of hire and by the country from which one works. 3M’s Note 10 indicates that the company has over 70 plans in 25 countries. The assets are offset by the obligations each company has to pay its retirees from these assets. Note that for both companies, the pension and post retirement benefits on the liabilities side are much higher than the prepaid pension assets shown on the asset side.
The notes explain how each company structures its retirement benefits and how well funded each benefit may be. For many companies, pension obligations are like a ticking time bomb that may explode as the Baby Boomers retire in large numbers. This future obligation could be a drag on a company’s long-term earning potential, draining a com- pany’s cash that could instead be used for future growth.
Task Box 2.5: Comparing Age of Assets
As a manager, when comparing your company to a competitor, you may want to consider the age of your competitor’s property, plant, and equipment. A company with newer equipment will have higher depreciation costs but may have lower repair expenses. So when comparing these line items to analyze operating costs, you may need to consider both depreciation expenses and repair expenses. This calculation can also make a big difference when preparing budgets. If a company has mostly older assets, the budget committee may need to plan for the purchase of new assets or may need to plan for more repairs to facilities and equipment.
Calculate the age of the assets of 3M using a similar calculation to the one shown for IBM and compare the age of assets for the two companies. When evaluating the value of a company, depreciation can give you a clue about the age of the company’s assets.
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Section 2.1The Elements of a Balance Sheet
IBM states in Note S that it ceased defined benefit accruals on December 31, 2007. This means that after that date, employees ceased to build defined benefits—the type of ben- efits in which an employee gets a set amount per year based on a formula calculated by the employee’s years of service and salary for the rest of his or her life after retirement. Today, all IBM employees participate in a defined-contribution plan. In this type of plan, employees, and possibly their employers, contribute to the plan. Retirement benefits are based on the cash saved in this retirement plan. The 401(K) is an example of a defined contribution plan.
In Note 10, 3M states that its defined-benefit plan in the United States was closed to new participants on January 1, 2009. The company currently offers defined-contribution plans to all its employees. Changes to pension plans for subsidiaries outside the United States are also detailed in this note.
Goodwill Goodwill is an intangible asset (an asset that cannot be touched or felt but that has value for the company). This asset is built by acquiring companies whose value is greater than the physical or tangible assets the company holds. In other words, when a company shows goodwill on its balance sheet, it means it paid more for at least one company than its tan- gible assets were worth. Often these intangible assets include things like customer base, desirable locations, or popular technology, products, or services.
We do not show goodwill on Best General Company’s balance sheet, but both IBM and 3M show goodwill on their books, and both companies have bought many smaller com- panies over the years. Details about IBM’s goodwill are located in Note I, whereas 3M’s are located in Note 3. Both companies show goodwill broken down by industry segments, but they do not provide much more detail.
More information about recent acquisitions is located in Note 2 for 3M and Note C for IBM. The acquisition note contains specific financial details about the company’s recent acquisitions. For example, if the company has sold any divisions, that information is usu- ally found in the acquisitions note, which is then called Acquisitions/Divestitures. Only IBM details divestitures.
Intangible Assets—Net Goodwill is not the only intangible asset on a balance sheet. Intangible assets also include things such as:
• Copyrights: Original works such as books, film, audio, software, and drawings can be protected for between 50 and 100 years after the creator’s death, assuming the creator is an individual. The time is shorter for a corporation.
• Trademarks: These include symbols, logos, phrases, or combinations of these that legally distinguish the company.
• Patents: The exclusive right to an invention, design, or process for a designated period of time.
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Section 2.1The Elements of a Balance Sheet
All non-goodwill intangible assets are usually lumped in one line and shown as “net.” This means that the asset’s value is shown minus any reduction for amortization. Amor- tization is similar to depreciation. Many intangible assets have a limited life span. Amor- tization is used to track the aging of these assets and to show what portion of these assets has been used up.
Neither IBM nor 3M shows much detail in its Intangible Assets note. IBM shows some information in Note I, and 3M includes information in Note 3.
IBM has two line items on its balance sheet that we will not explore in detail: Long-Term Financing Receivables and Deferred Taxes. The Long-Term Financing Receivables is a long-term account similar to the Current Assets account discussed above. Deferred taxes also was discussed above as a current asset. The only difference between these items and the respective Current Asset line items above is that these items will be useful for more than 12 months. The details for the line items can be found in the notes cited above.
Other Assets Other Assets is a catchall category for assets not shown individually on the balance sheet. IBM calls this line item “Investments and sundry assets.” Some detail can be found in Note H, but not much. There is no note specifically for other assets in 3M’s financial reports.
Let’s now examine the Liabilities section of the balance sheet more thoroughly.
Liabilities
Liabilities include things the company owes. Just as we saw with assets, there are two groupings: current liabilities (money due within the next 12 months) and long-term liabil- ities (money due in more than 12 months).
Financial analysts for Best General Company would be most interested in the liabilities side of the balance sheet. They would want to test the company’s ability to pay its debts, both in the short term and long term. (We will discuss how to test that in Chapter 6.) In this chapter, we explain the various types of liabilities that a company might incur.
In the beginning of this chapter we saw the balance sheet of the Best General Company. Let’s take a closer look at its liability section and compare it to those sections from IBM and 3M. Figure 2.10 is the liability section of Best General Company balance sheet.
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Section 2.1The Elements of a Balance Sheet
Figure 2.10: Liabilities section of Best General Company balance sheet
The liabilities section of the balance sheet is set up just like the assets section, listing both current and long-term liabilities.
Best General Company Balance Sheet (Partial)
At December 31, 2013 and 2012
2013 2012
Current Liabilities:
Accounts Payable
Short-Term Debt
Other Current Liabilities
Total Current Liabilities
Long-Term Liabilities:
Long-Term Debt
Other Non-Current Liabilities
Total Liabilities
Liabilities
$ 8,900
26,000
20,400
55,300
62,450
52,000
$ 169,750
$ 9,400
26,000
19,800
55,200
65,000
54,000
$ 174,200
Taxes Best General Company shows no tax liabilities, nor does 3M, but IBM starts its 2012 Cur- rent Liabilities section of the balance sheet with a line item called Taxes. These are deferred tax liabilities that IBM must pay during 2013. They are explained in Note N along with Deferred Tax Assets.
Corporate taxation can be a course in itself, and its discussion goes beyond the scope of this course. IBM states that its tax deferrals are related to foreign and domestic loss carryforwards (deductions for losses that could not all be taken in the current year but can be taken in future years). When comparing companies, this can be a critical issue if the taxes represent a significant portion of liabilities due. For IBM, the deferred tax liabilities of $6,508 million are offset by $11,428 million in deferred tax assets.
Look in the notes to find out why the company is deferring such a large portion of its taxes due. It is possible the company is in negotiations with the IRS regarding tax obliga- tions. If so, the company will detail the information in the notes. For example, IBM states that in the fourth quarter of 2011, the IRS started an audit of its U.S. tax returns for the years 2008 through 2010, and IBM expects the audit to be complete in 2013. When that audit is complete, any changes to IBM’s tax bill will be reported in a future report to shareholders.
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Section 2.1The Elements of a Balance Sheet
Short-Term Debt Short-term debt includes all debt payments that must be made in the next 12 months. This is the second line item of Best General Company’s current liability section of the balance sheet as shown in Figure 2.10. IBM details this further for its balance sheet in the notes to the financial statements. In the notes it breaks down short-term debt into three line items, as shown in Figure 2.11:
• Commercial paper is often used to finance accounts receivable, inventories, and other cash needed to meet short-term needs.
• Short-term loans are loans due in full during the next 12 months. • Long-term debt—current maturities shows the amount the company will have
to pay on the interest and principal due in the next 12 months for long-term debt borrowings.
IBM includes the current portion of its long-term debt as part of its short-term debt detail in Note J (shown in Figure 2.11). IBM also indicates that the weighted-average interest rate was 1.8% in 2012 and 1.2% in 2011 for short-term debt.
Figure 2.11: IBM’s Note J
In the notes to the financial statements, a chart shows a detailed breakdown of IBM’s debt obligations.
Note J. Borrowings
Short-Term Debt
Commercial paper
Short-term loans
Long-term debt—current maturities
Total
($ in millions)
At December 31: 2012 2011
$ 1,800
1,789
5,593
$ 9,181
$ 2,300
1,859
4,306
$ 8,463
Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
3M gives this line item a longer name: Short-term borrowings and current portion of long- term debt (see Figure 2.12). The detail for this line item is in Note 9. Note that 3M does not use commercial paper as part of its short-term borrowings, but it does have a line item for other borrowings, with an effective interest rate of 4.7%.
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Section 2.1The Elements of a Balance Sheet
Figure 2.12: 3M’s short-term borrowings and current portion of long-term debt
This chart from the notes to the financial statement shows the details about IBM’s short-term debts.
Effective Interest Rate
$ 986 — 99
$ 1,085
3.85%
—%
4.70%
$ 563
—
119
$ 682
Short-Term Borrowings and Current Portion of Long-Term Debt
Current portion of long-term debt
U.S. dollar commercial paper
Other borrowings
Total short-term borrowings and current portion of long-term debt
(Millions) 2012 2011
Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
Note that 3M also details the current portion of its long-term debt (the interest and princi- pal of the loan that is due during the next 12-month period). This is separated out because this part of long-term debt is a current debt, whereas the rest of the money owed on long- term debt will be paid after the next 12-month period.
Both IBM and 3M detail their types of borrowing in their respective notes. This infor- mation is critical to a company’s financial managers. They need to be fully aware of the amount of borrowing, type of borrowing, and the interest rates the company pays on its borrowings. Interest can be a drag on earnings, so it is important to pay close attention to how the company is managing its debt.
For example, Bob, as the financial analyst for Best General Company’s budget committee, would need to look closely not only at how his company structures its debt, but he may want to review the debt structure of his company’s competitors. He may discover ideas for how to better structure his own company’s debt by reviewing his competitors’ finan- cial obligations. If Bob can develop a plan to lower his company’s interest payments, he could improve his company’s net income and impress his managers.
Accounts Payable The Accounts Payable line item represents bills that were received in the previous year but have not yet been paid. Companies must record expenses at the time they are incurred (when bills were received) even if they have not yet paid cash to cover those expenses. For example, suppose a company gets a bill at the end of December 2012 for inventories sold in 2012, but the payment is not due until January 2013. The company must report the receipt of the bill in 2012. These bills are tracked in an account called Accounts Payable.
Companies do not usually discuss this number in detail in the Notes to the Financial State- ments. This is a basic rule of accrual accounting and there usually is no need to detail the number.
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Section 2.1The Elements of a Balance Sheet
Accrued Payroll The Accrued Payroll account tracks payroll expenses that have not yet been paid. At the end of the year, it is not uncommon for companies to owe money to employees that will be paid at the beginning of the next year. For example, suppose employees are paid every two weeks, and one week falls in the last week of December 2012 and the second week falls in the first week of January 2013. The money due employees for that last week in December will be paid in the first week of January 2013. The company needs to include the December 2012 expense in the 2012 reports, so it accrues the one week at the end of December in an account called Accrued Payroll. When the employees are paid in January 2013, that accrual will be reversed to zero.
Deferred Income Deferred income is a line item found on the balance sheets of service businesses that get paid up front for services, training, installation, construction, or other items before they have completed the work. The Deferred Income account is therefore a liability account because the company has not yet earned the money. Some companies call this Unearned Revenue.
Only IBM shows a line item for deferred income. It does not include a specific note for this line item, but this liability represents income that has been received but not yet earned. Note that in the next chapter, we will examine revenue recognition in more detail when we discuss the income statement. IBM indicates how it recognizes income in Note A.
Other Liabilities Other Liabilities is a catchall account for any current liabilities not shown as an individual line item. Companies rarely detail their Other Liabilities line item, and neither 3M nor IBM includes a note to explain what these liabilities include.
Long-Term Debt Up until this point, we have examined short-term liabilities. We will now turn our atten- tion to long-term liabilities. Recall that these are liabilities that will be paid over a period longer than 12 months. The amount of interest or principal due on these long-term liabili- ties was shown in a current liability called Current Portion of Long-Term Liabilities.
Best General Company includes just one line item called Long-Term Debt, but more details can be seen when looking at the long-term debt explanations of IBM and 3M. IBM details its long-term debt in Note J, whereas 3M details it in Note 9. The details show the bonds or notes outstanding with information about the interest rates on each debt security and the date of maturity. IBM’s Note J shows that IBM’s long-term debt ranges from 2.7% to 7.125%. IBM also holds debt in foreign currencies, including the Euro, Japanese Yen, Swiss Franc, and Canadian dollar. IBM separates its U.S. debt and details each debt type, but it does not show individual details for each debt held in a foreign currency.
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Section 2.1The Elements of a Balance Sheet
3M’s Note 9 explains that the company combines U.S. and foreign debt instruments and details each holding. Its interest rates range from 0.0% to 6.01%. The dates of maturity for this debt range from 2013 to 2044.
Why do these numbers matter? The interest rates show that 3M was able to negotiate better terms on its debt. When reviewing the long-term debt of his competitors, Bob, Best General Company’s financial analyst, will assess whether the interest rates his company is paying on long-term debt are reasonable compared to those of the competitors—just as he did with short-term debt, and for the same reason. Any opportunity to reduce interest payments has a positive impact on a company’s net income.
Both IBM and 3M show a weighted average for interest rates on their debt. (To calculate weighted average, the interest rate for each debt instrument is given a weight to deter- mine the relative importance of each quantity on the average. A $50,000 debt at 4% would have a larger weight than a $10,000 debt at 5% because more of the interest is generated by the larger debt. IBM’s weighted average interest rate is 3.43% and 3M’s is 3.16% on long- term debt. The difference is just 0.27%, which may not seem like much, but for IBM, that extra 0.27% translates into about $65 million ($24,049 million 3 0.27 percent) in interest expenses on its fixed-rate debt.
Another key factor to look at when reviewing a company’s long-term debt is to determine whether a company is paying down debt or adding to that debt. IBM’s fixed-rate debt increased from $18,547 million in 2011 to $24,049 million in 2012. The story is somewhat similar for 3M, which also increased its long-term debt in 2012. Long-term debt for 3M was $5,047 million in 2011 and $5,902 million in 2012. For IBM, long-term debt is 12.1% (24,088 million/199,213 million) of its total assets. For 3M, long-term debt is 14.5% (4,916 million/33,876 million) of its total assets.
Companies with lower debt, like IBM and 3M, can negotiate better interest rates. If the two companies were competing in the same industry, the company with the lower weighted average and the same level of debt would likely have lower interest rate expenses and higher net income. A financial analyst, like Bob at Best General Company, might see an opportunity to refinance some of his company’s debt and lower interest payments, which would have a positive impact on the projected budget for the next year.
Retirement and Post-Retirement Benefits For many large corporations, Retirement and Post-Retirement Benefits is an obligation that is already big—and getting bigger as Baby Boomers retire. Many corporations also have not fully funded the obligation. In the future, when employees retire, these obliga- tions will become liabilities if the company does not fully fund their pension benefits. When reading the notes behind this line item, be sure to look for a statement that indicates how well funded these benefits are.
For IBM, the detail can be found in Note S. IBM states that as of December 31, 2012, the “qualified defined-benefit plans worldwide were 94 percent funded compared to the ben- efit obligations . . . . Overall, including nonqualified plans, the company’s defined benefit pension plans were 86 percent funded.” That is still above the average funding level for major corporations, which is 80.6%, according to the annual analysis of corporate SEC fil- ings done by Pensions and Investments.
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Section 2.1The Elements of a Balance Sheet
For 3M, the detail can be found in Note 10. The company states its “qualified benefit plan does not have a mandatory cash contribution because the Company has a significant credit balance from previous discretionary contributions.” So 3M has met the 100% fund- ing criteria. It can be important for all managers and employees of a company to know whether their company is fully funding their retirement benefits. Not only is this impor- tant for the individuals’ futures, it can also be significant for the future of the company itself. If the company must catch up on funding its retirement system at some point in the future, fewer resources may be available for the growth of the company. (We talk more about funding pensions in “World of Business.”)
IBM includes another line item called Deferred Income in the long-term liability section. It essentially includes the same type of unearned obligations as the Current Liabilities line item mentioned earlier. The only difference is that this line item shows income that will not be earned for more than 12 months.
Both IBM and 3M include an Other Liabilities line item in long-term debt. Again, this is a catchall line item with little detail about what is included.
World of Business
Is Your Company Funding Your Pension? As employees near retirement, they become more concerned about whether there will be enough money for them to retire. This can include what has been saved using the company’s retirement savings programs, as well as what the employee has saved outside that system.
Companies in recent years have been changing the rules for retirees by shifting their retirement benefits from defined-benefit plans to cash- balance plans or 401(k)s, which are defined- contribution plans. In most cases, this shift will result in lower monthly retirement income. (Zanona 2013)
Employees can review the details about the state of their company’s retirement plans and determine where they stand by reading the Notes to the Financial Statements. An excellent article by the U.S. Department of Labor, “What You Should Know about Your Pension Plan,” helps employees sort out this very complex issue.
Consider This:
1. Do you know how your retirement account is funded? Where could you go to learn more about this?
2. What type of retirement plan or plans does your company offer? Is the one that you have chosen the most secure? Why or why not?
.Jon Patton/iStock/Thinkstock
All employees should be encouraged to look into the details of their company’s retirement plans.
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Section 2.1The Elements of a Balance Sheet
Commitments and Contingencies Under Total Liabilities, both 3M and IBM indicate there is a note called Commitments and Contingencies without any numbers included on the line item. (For IBM, this is Note M; for 3M, it is Note 13.) This is to alert readers to the fact that there are other potential commitments (contractual arrangements) or contingencies (legal matters) that do not cur- rently appear on the balance sheet but that may have a financial impact on the company at some point in the future. The commitments and contingencies include information about legal matters that could end up costing the company money in the future, but at the time the annual report was issued, no dollar amount could be estimated for the future cost.
The most common type of commitment detailed is operating leases that do not appear on the balance sheet. These types of leases appear as a rent expense, but since they are not owned, they do not appear as an asset. Yet the company could have thousands if not mil- lions due in future payments on operating leases, so the obligation should be taken into consideration when considering liabilities. This is a form of off-balance sheet financing.
3M’s long-term operating lease obligations—leases for equipment, such as copiers, con- sidered an asset to the company—total $71 million. Also, 3M indicates it has accrued product warranty liabilities of $28 million.
Another type of commitment can be a hybrid security, which is a financial instrument that can be both a bond and an equity holding. The bond portion of the money paid in by the investor must be paid back, just like any other bond. The investor holding this type of security also has equity rights and may be able to convert some portion of this security into stock.
IBM discusses three types of commitments in which it has unused extended lines of credit to third-party entities of $4,717 million as of December 31, 2012. These are like credit lines that IBM may use later. IBM may loan this money in the future to its business partners to support working capital needs. The company also discusses guarantees that it does not expect will result in expenses to the company related to contract promises. In addition, the company states it guarantees certain financial agreements, which totaled $65 million as of December 31, 2012.
Contingencies involve legal matters that have yet to be resolved. Both IBM’s and 3M’s notes include details of ongoing lawsuits. In many cases, legal matters could take years to settle with no idea of the outcome until settlement. As soon as a company can determine the approximate cost of a legal matter, it must report that cost to shareholders.
Equity
The Equity section of the balance sheet shows the claims that owners have against the assets of the company. For a major corporation, those owners are shareholders. In smaller companies, an owner’s claim would be shown as Owners’ Equity. Figure 2.13 is the equity section of Best General Company’s balance sheet.
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Section 2.1The Elements of a Balance Sheet
Figure 2.13: Equity section of Best General Company’s balance sheet
The equity section of a balance sheet details the amount the owners of the company have invested in the company. For a public company, the owners would be shareholders of the company’s stock.
2013 2012
Common Stock
Retained Earnings
Total Shareholders’ Equity
Shareholders’ Equity 20,000
3,900
23,900
20,000
7,450
27,450
$
$
$
$
Best General Company Balance Sheet (Partial)
At December 31, 2013 and 2012
The owners’ equity portion of the balance sheet for a partnership may show several differ- ent owner line items, which detail the portion of ownership each owner has. For example, suppose Raul and Catherine own the Best General Company. There would be an Owners’ Equity line item showing Raul’s portion of the ownership and there would be an Owners’ Equity line item showing Catherine’s ownership. In public documents, this detail likely would not be shown; instead, a summary of all owners’ equity would be shown on one line item.
Now let’s look at the more complicated presentation of the equity section of the balance sheet for a major corporation. We review both IBM and 3M’s equity sections.
Stockholders’ Equity As noted, equity represents the claims company owners have against the company’s assets. Most of these holdings are in different types of stock. IBM details its Stockholders’ Equity in Note L, and 3M includes additional details in Note 5. We will examine the com- mon line items found in the Stockholders’ Equity section of the balance sheet.
Common Stock Common Stock details the number of shares authorized to be sold on the public stock market and the number of shares issued. In Note L, IBM indicates that 4,687 million shares have been authorized, but as of December 2012, only 2,197 million shares are outstanding. In Note 9, 3M indicates that 3 million shares have been authorized but less than 1 million are in the market. IBM also details in Note L the number of shares issued for stock-based compensation plans and for employee stock purchase plans.
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Section 2.1The Elements of a Balance Sheet
Common shareholders have the right to vote on corporate policy and elect members of the board of directors, but they are on the bottom of the totem pole when it comes to owner- ship priority. If the company were to go bankrupt, common shareholders would have to wait until bondholders, preferred shareholders, and other debt holders are paid before they get any money.
Preferred Stock Preferred Stock is another line item in the Stockholders’ Equity section of the balance sheet. Preferred stock differs from common stock in three ways:
1. If a company is not able to pay dividends in a particular year, those dividends accumulate. When the company is again in a position to pay dividends, all past due dividends (which can also be shown as dividends in arrears) must be paid to preferred shareholders before common stock holders get any money.
2. Preferred shareholders usually do not have voting rights. 3. If a company goes bankrupt, preferred shareholders get paid before common
shareholders. Each company can structure its preferred stock differently, but all preferred stock usually can be thought of in two ways: it is a type of debt (fixed dividends) and a type of equity (it has the potential to go up in value).
Neither IBM nor 3M show a Preferred Stock line item. IBM does indicate in Note L that there is authorization for 150 million shares of preferred stock, but none of this type of stock is currently in the market. In Note 5, 3M indicates that 10 million shares of preferred stock are authorized, but none have been issued.
Additional Paid-In Capital Companies set a price for their stock when it is first issued. Any money paid in above the issue price is additional paid-in capital. For example, IBM sets a “par value” for its stock of $20 per share. If people bought the stock for $50 per share from IBM, then $30 per share would be shown as additional paid-in capital. Once a stock is in the market, its price does not change the equity portion of the balance sheet. The balance sheet will always show the value initially paid for the stock when the investor bought the stock directly from the company.
Some companies will include a line item at par value plus an additional paid-in capital line item. Others will only show the value of common stock based on the amount paid when the stock was bought. For example, in Figure 2.14, IBM shows common stock at a par value of $20 plus additional paid-in capital. Below that are details about the number of shares authorized and the number of shares already issued.
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Section 2.1The Elements of a Balance Sheet
Figure 2.14: IBM’s equity section
The equity section of IBM shows the detail about the claims owners of the company have against the company’s assets.
Equity
IBM stockholders’ equity
Common stock par value $20 per share, and additional paid-in capital
Shares authorized: 4,687,500,000
Shares issued (2012–2,197,561,159; 2011–2,182,469,838)
50,110 48,129
Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
Retained Earnings Retained earnings represent an accumulation of earnings by the company since its incep- tion and reinvested in the company each year. The balance in retained earnings is adjusted each year by adding any net income or subtracting any net loss. Any dividends paid are subtracted from net income before any adjustment is made to the retained earnings account. This does not reflect cash held by the company. These earnings are used to grow the company or pay down debt. The line item tracks the historical value of undistributed earnings. Here is the formula for calculating retained earnings:
Prior Year’s Retained Earnings
6 Net Income (Loss)
2 Dividends Current Year’s Retained Earnings
Treasury Stock The treasury stock line item refers to stock that has been bought back by the company from shareholders. In some companies, it may represent stock that has never been sold. IBM indicates in Note L that the Board of Directors has authorized the repurchase of stock, and up to $8,652 million was still available for repurchase. In 2012, IBM bought back over 267 million shares. Currently, 3M does not detail any plans to buy back stock in Note 5.
When a company buys back stock, it means fewer shares are in the market, and the market value per share will likely go up. There is never a guarantee of what the market will do when it comes to share price—after all, companies do not control the share price on the open market. It is controlled by the basic rules of supply and demand. For a share price to go up, there must be more people who want to buy the share than who want to sell it. With greater demand, the share price rises. Of course, the opposite is true as well. If there aren’t any buyers, those who want to sell the share would need to drop their price to find a willing buyer.
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Section 2.2Inventory Value
Accumulated Other Comprehensive Income (Loss) The Accumulated Other Comprehensive Income (Loss) line item shows income or losses that have not yet been realized. These unrealized gains or losses can be from things such as unrealized pension costs, unrealized gains or losses on securities, and unrealized gains or loss on foreign currency exchanges or other foreign investments. IBM includes these details in Note L, and 3M includes them in Note 5.
This completes our survey of the key line items found on a balance sheet, as well as the types of detailed information located in the Notes to the Financial Statements. This is by no means a complete list of all possible line items. Financial statements from companies in different industries will list other items not detailed here. Whenever a line item seems unclear on financial statements, first look for more information in the Notes to the Finan- cial Statements for an explanation about how that line item was calculated. To investigate further, research the information online.
2.2 Inventory Value Companies value their inventory using five different methods:
• LIFO (Last In, First Out) • FIFO (First in, First Out) • Average Cost • Specific Identification • Lower of Cost or Market
We will discuss each in detail below. A company explains how it values its inventory in the Notes to the Financial Statements. To compare one company’s assets to those of its competitors, it is important to know whether both companies value their inventory in the same way. Different inventory valuation methods can impact formulas for determining a company’s ability to pay its bills. It can also impact formulas for measuring a company’s profitability. (How inventory factors into credit worthiness and profitability will be dis- cussed in Chapter 6, where we analyze financial reports.) Before discussing inventory val- uation methods, let’s discuss two methods of counting inventory: perpetual and periodic.
Counting Inventory: Perpetual and Periodic
Perpetual inventory method means that inventory is counted as it is sold. Companies that use this method usually make changes to the inventory in stock at the cash register. When an item is sold, a computer software program decreases the inventory in stock. When inventory is purchased, the additional inventory is added to the totals of inventory in stock in the computer software.
In order to use this method of inventory counting, a company must have a computerized inventory system that is attached in some way to the actual sale of goods or services. One big disadvantage of this type of inventory method is that if the system goes down, a
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Section 2.2Inventory Value
business may not be able to sell goods to its customers until the computer system goes back up.
Periodic inventory method means that the company periodically does a physical count of the inventory on hand. Depending on the type of business, this could be done daily, weekly, monthly, or yearly. Some- times customers will go to a store and find out it is closed for a few hours or even a day because the employees are counting inventory.
Even if a company chooses to use the perpetual inventory method, it will do periodic physical counts to be sure the numbers in the computer match what is actually on the shelves and in the warehouses. Not all items leave the store as a sale. Some may be broken or stolen instead. Both of these fall into the category of inventory shrinkage. Companies adjust their books by pre- paring an adjusting entry for their accounting system to record inventory shrinkage. The number on the financial statements will be net of that inventory shrinkage.
Most major corporations use the perpetual inventory method, as more and more compa- nies link their sales operations to their inventory systems. This makes it much easier to know when more inventories are needed. Smaller companies without the required com- puter systems use the periodic inventory method.
Managers of companies still using the periodic method may want to investigate whether it is logistically feasible to switch to the perpetual inventory method. This does require a new investment in computer hardware and software, so this can be a major capital expen- diture for a company.
Now let’s take a closer look at the five different methods for valuing inventory.
LIFO
The LIFO (Last In, First Out) method assumes that the last piece of inventory purchased is the first piece of inventory sold. This method works for companies selling inventory that does not spoil or become obsolete. For example, a hardware store would likely use this method since the tools it sells—hammers, saws, and shovels—do not spoil or become obsolete. Also, when the store gets new hammers, for example, employees are unlikely to take everything off a shelf to put the newest items in the back so that the older items are sold first. In this case, the item most recently put on the shelf would be the one most likely picked up and bought by the customer.
Blend Images/SuperStock
Companies can choose how to valuate their invento- ries, as long as the chosen method is consistent and accurate.
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Section 2.2Inventory Value
In calculating the value of inventory using the LIFO method, we will practice calculat- ing the value of inventory at the end of the month. Most companies value inventory on a monthly basis as they prepare their month-end financial statements. Suppose a company sells hammers. At the beginning of the month, the company has 50 hammers in inventory worth $400 (at $8 per hammer). During the month, the company purchases 300 more ham- mers. At the end of the month, the company has 75 hammers left on the shelf. What is the value of the hammers left on the shelf at the end of the month using the LIFO method?
We will assume the following schedule of purchases (note that prices are rising, so the unit price goes up from $8 to $10 before the first of the month, and again from $10 to $12.50 near the middle of the month):
Date Quantity Unit price
April 3 100 ,$10.00
April 15 100 ,$12.50
April 28 100 ,$12.50
First, we calculate the number of units sold:
Units
Beginning Inventory 50
1 Purchases 300
5 Goods Available for Sale 350
2 Ending Inventory (75)
5 Items Sold 275
From this calculation, we know that 275 hammers were sold. Using the LIFO method of valuation, we assume the hammers purchased on April 28 and on April 15 were sold first, for a total of 200 hammers. The remaining 75 hammers were bought on April 3. So we know that we still have 25 hammers bought on April 3 and the 50 hammers we had in inventory when the month started. So our Ending Inventory would be worth:
50 hammers at $8.00 (Beginning Inventory) $400
1 25 hammers at $10.00 (April 3 Purchase) 250
5 Total Ending Inventory $650
We also know that 200 of the hammers that were sold were bought for $12.50 and 75 were bought for $10, so the Cost of Goods Sold would be:
200 hammers at $12.50 (April 15 & 28 Purchases) $2,500
1 75 hammers at $10.00 (April 3 Purchase) 750
5 Total Cost of Goods Sold $3,250
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Section 2.2Inventory Value
The balance sheet will show the amount $650 for Inventory if this is the only item being sold. Of course, it’s unlikely that a company would have only one type of inventory, but we are using this simple calculation to explain the LIFO method.
In this example, we saw that prices were rising. When that happens, the inventory amount shown on the balance sheet tends to understate the true value of inventory. To replace that inventory at current prices in this example, the store would have to purchase 75 hammers at $12.50 for a total of $937.50.
If the market situation were reversed and prices were dropping, then the inventory amount shown on the balance sheet would overstate its value when the LIFO method is used. (Rules may soon change for companies using LIFO. See “New World of Financial Report Oversight.”)
FIFO
The FIFO (First In, First Out) method assumes that the first item put on the shelves will be the first item sold. Companies whose products spoil quickly or become obsolete use this method of inventory valuation. For example, suppose a grocery store gets a new ship- ment of milk. When stocking the shelves, employees put the newest milk at the back of the shelves and the oldest milk up front, hoping that customers will buy the oldest milk first. Many of us know this and look for milk at the back of the shelf anyway. But the store wants the products put on the shelves first to sell first.
In calculating the value of inventory using FIFO, we will practice calculating the value of inventory at the end of the month. Just for the sake of comparison, we will use the same product discussed with LIFO—hammers. At the beginning of the month, the company has 50 hammers in inventory worth $400, or $8 per hammer. During the month, the com- pany purchases 300 more hammers. At the end of the month, the company has 75 ham- mers left on the shelf. What is the value of the hammers left on the shelf at the end of the month using the FIFO method?
New World of Financial Report Oversight
The use of LIFO is unique to the United States. Most other countries have banned its use and it does not meet International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB).
At some point in the future, LIFO could be banned in the United States as well, if the United States decides to accept IFRS. While there have been discussions about adopting IFRS or adapting GAAP to incorporate IFRS rules, there is no date set for this to happen, and some question if it ever will. (Fazal 2011) (Rosivach 2012)
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Section 2.2Inventory Value
Again, we will assume the following schedule of purchases:
Date Quantity Unit price
April 3 100 ,$10.00
April 15 100 ,$12.50
April 28 100 ,$12.50
First, we calculate the number of units sold:
Units
Beginning Inventory 50
1 Purchases 300
5 Goods Available for Sale 350
2 Ending Inventory (75)
5 Items Sold 275
From this calculation, we know that 275 hammers were sold. Using the assumption of the FIFO method of valuation, we assume the hammers in inventory were sold first. Then the hammers bought on April 3 and 15 were sold next. The last 25 sold were bought on April 28. So our Ending Inventory would be worth:
75 hammers at $12.50 (April 28 Purchase) $937.50
5 Total Ending Inventory $937.50
We also know that 50 of the hammers sold were bought for $8, 100 of the hammers sold were bought for $10, and 125 of the hammers sold were bought for $12.50, so the Cost of Goods Sold would be:
50 hammers at $8.00 (Beginning Inventory) $400.00
1 100 hammers at $10.00 (April 3 Purchase) 1,000.00
1 125 hammers at $12.50 (April 15 & 28 Purchases) 1,562.50
5 Total Cost of Goods Sold $2,962.50
The balance sheet will show the amount $937.50 for Inventory if this is the only item being sold. This number more accurately reflects the current cost of replacing that inventory. Note that both methods result in a total cost of goods available for sale of $3,900 after add- ing the Cost of Goods sold to Ending Inventory.
Average Costing
The inventory valuation method that is the easiest to calculate and that gives companies the best picture of inventory trends is average costing. This method can level out the ups and downs of inventory pricing and give the company an average through the year
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Section 2.2Inventory Value
because the average cost is adjusted using a weighted average method as inventory is purchased.
When using this method, companies do not need to worry about what gets sold first. Companies that sell liquid or other products, such as oil, that gets mixed on the shelf (or in tanks buried underground, such as at a gas station) find this method the most logical to use. However, others use it as well because, as noted, it is simple to calculate and evens out the ups and downs of inventory pricing.
We will use the same scenario as above to practice calculating this method so that the inventory methods are easily compared.
In calculating the value of inventory using average costing, we will again calculate the value of inventory at the end of the month for a company that sells hammers. At the beginning of the month, the company has 50 hammers in inventory worth $400, or $8 per hammer. During the month, the company purchases 300 more hammers. At the end of the month, the company has 75 hammers left on the shelf. What is the value of the hammers left on the shelf at the end of the month using the average cost method?
Again, we will assume the following schedule of purchases:
Date Quantity Unit price
April 3 100 ,$10.00
April 15 100 ,$12.50
April 28 100 ,$12.50
First, we calculate the number of units sold:
Units
Beginning Inventory 50
1 Purchases 300
5 Goods Available for Sale 350
2 Ending Inventory (75)
5 Items Sold 275
From this calculation, we know that 275 hammers were sold. Using the average cost method, we first need to figure out the average cost of a hammer. Here is how to calculate the average cost:
50 hammers at $8.00 (Beginning Inventory) $400
1 100 hammers at $10.00 (April 3 Purchase) 1,000
1 200 hammers at $12.50 (April 15 & 28 Purchases) 2,500
5 Total Cost of Goods Available for 350 Hammers $3,900
** Average Cost Per Hammer ($3,900/350 units) $11.14
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Section 2.2Inventory Value
We then calculate the Cost of Goods Sold and value of Ending Inventory using the aver- age cost of $11.14:
Total Cost of Goods Sold (275 hammers at $11.14/unit) $3,063.50
Total Ending Inventory (75 hammers at $11.14/unit) $ 835.50
The balance sheet will show the amount $835.50 for Inventory if this is the only item being sold. Note that the Inventory amount shown on the balance sheet falls between LIFO and FIFO. Note that the total of Cost of Goods Sold and Ending Inventory is $3,899, which is just slightly different from the $3,900 found with FIFO and LIFO. When averaging costs, rounding can result in a slight difference in the totals. If averaging is calculated without using rounding, the total will be the same.
Specific Identification
Companies that sell products that each have a different value use the specific identification method. For example, a company that sells cars would likely use this method. Each car comes with a different set of features, and so the price for each car is unique. These companies would calculate their Inventory value by adding up the value of each product in inventory.
Lower of Cost or Market
Companies that sell products whose value is constantly fluctuating use the lower of cost or market method. With this method of inventory costing, the company calculates both the cost of the product when purchased and the current market value of the product. The value shown on the balance sheet should be whichever one is lower.
Comparing the Effects of Valuation Methods
Now that we have considered the various types of inventory valuation methods, we will compare how these methods affect the balance sheet and income statement. Here is a summary of the numbers we calculated above for the three most common methods:
LIFO FIFO Average costing
Beginning Inventory $400.00 $400.00 $400.00
Cost of Goods Sold $3,250.00 $2,962.50 $3,063.50
Ending Inventory $ 650.00 $937.50 $835.50
The highest Ending Inventory value is generated using the FIFO method of inventory valuation, and the highest Cost of Goods Sold value is generated using the LIFO method of inventory valuation. In this example, the cost of purchasing inventory was going up. The results would be opposite if the costs of purchasing inventory were going down. The average costing method will always be between these two methods.
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Section 2.3Common-Sized Balance Sheets
The biggest impact is the amount shown for Cost of Goods Sold because that directly affects the profits of a company as well as the taxes to be paid. When Cost of Goods Sold is higher, profits will be lower. Lower profits also mean a lower tax bill. So in the scenario shown above, using LIFO would result in the lowest inventory valuation, as well as the lowest profit.
While the numbers used here are small, for a major corporation, the choice of inventory method can have a big impact on the assets shown on the balance sheet and the profits shown on the income statement. We will take a closer look at Cost of Goods Sold and its impact on the income statement in Chapter 3.
Companies cannot switch inventory valuation methods as the prices change, according to IRS rules. The GAAP rules require companies to consistently use the same method of inventory valuation. If a company determines with its accountants that a different inven- tory valuation method would better show the way inventory is sold, then a long expla- nation of this decision will be included in the Notes to the Financial Statements under Accounting Changes. The company would need to show the financial impact of this change for prior years as well as on the current financial statements to enable financial report readers to see the impact of the change.
Task Box 2.6: Selecting Inventory Valuation Methods
Think about the types of businesses that would likely use each of the five inventory valuation methods. Name one type of business that best matches each of the methods discussed.
Do you know what type of inventory valuation method your company uses? Why do you think it chose to use that method?
2.3 Common-Sized Balance Sheets When comparing a large company to a small company, it can be difficult to compare apples to apples. For example, the Best General Company budget committee may want to look at larger companies with similar business models to see how their sales and other bench- marks compare, but this would be hard to do by just looking at the dollar values. While the common-sized balance sheet is not a required format of the SEC, it can be a helpful tool. Few companies provide this information, but anyone can generate this statement.
Creating a common-sized balance sheet makes comparison easier no matter what size the company, because it is based on percentages rather than dollars. A common-sized balance sheet enables users to analyze the balance sheet from a different perspective by calculating each number as a percentage. A common-sized balance sheet therefore presents the infor- mation in two ways: both as dollar figures and as percentages. The Asset section of the col- umn shows all assets as a percentage of Total Assets. The Liabilities and Equity section of the column shows all Liabilities and Equity as a percentage of Total Liabilities and Equity.
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Section 2.3Common-Sized Balance Sheets
Figure 2.15 is a sample common-sized balance sheet for Best General Company.
Figure 2.15: Common-sized balance sheet for Best General Company
A common-sized balance sheet enables easier comparisons of smaller to larger companies. It also gives users a different perspective for comparing financial results from period to period.
Best General Company Common-Sized Balance Sheet
At December 31, 2013 and 2012
2013 2012 2013 2012
Current Assets:
Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
Long-Term Assets:
Property, Plant, & Equipment
Other Non-Current Assets
Total Assets
Current Liabilities:
Accounts Payable
Short-Term Debt
Other Current Liabilities
Total Current Liabilities
Long-Term Liabilities:
Long-Term Debt
Other Non-Current Liabilities
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders’ Equity Total Liabilities and Shareholders’ Equity
Assets
Liabilities
Shareholders’ Equity
4.80%
3.63%
19.18%
3.03%
30.64%
46.64%
22.72%
100.00%
4.75%
13.12%
9.99%
27.86%
32.81%
27.26%
87.94%
10.10%
1.97%
12.06%
100.00%
4.26%
3.96%
20.28%
3.04%
31.54%
45.64%
22.82%
100.00%
4.51%
13.18%
10.34%
28.04%
31.67%
26.37%
86.08%
10.14%
3.78%
13.92%
100.00%
$ 8,400
7,800
40,000
6,000
62,200
90,000
45,000
$197,200
$ 8,900
26,000
20,400
55,300
62,450
52,000
$169,750
20,000
7,450
$ 27,450
$197,200
$ 9,500
7,200
38,000
6,000
60,700
92,400
45,000
$198,100
$ 9,400
26,000
19,800
55,200
65,000
54,000
$174,200
20,000
3,900
$ 23,900
$198,100
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Section 2.3Common-Sized Balance Sheets
Taking a quick look at Best General Company’s common-sized balance sheet in Figure 2.15, the budget committee can see what proportion of the company’s funds is allocated to what line items. For example, the largest portion of current assets is held in inventories: 20.28%. Property, plant and equipment claim 45.64% of assets. Are these percentages com- mon in the industry in which Best General Company operates?
The budget committee could answer this question by looking at industry averages and comparing its common-sized balance sheet to competitors. No matter how large a com- pany is, the percentage allocations for each type of asset should be similar. Looking at only the dollar figures, one cannot do the same comparison for different-sized companies.
Therefore, common-sized balance sheets can help managers and executives analyze the numbers for three different and critical purposes:
1. To benchmark a company’s financial position to that of other similar compa- nies and industry norms. For example, suppose one company holds 20% of its total assets in inventory, but other companies in the same industry normally hold 15%. Managers may then have questions about how well the company holding a higher percentage of inventory is managing its inventory.
2. To compare two companies in the same industry, regardless of size. By using a common-sized balance sheet, managers can compare the percentage each com- pany has for each line item. Size of the company won’t matter.
3. To find trends in the line items of a balance sheet. If managers prepare a common- sized balance sheet with five years’ worth of data, they can more easily spot a trend for the various line items on the balance sheet. For example, if Accounts Receivable is gradually going up as a percentage of Total Assets, managers can quickly recog- nize that with a common-sized balance sheet.
The SEC rules do not require companies to prepare a common-sized balance sheet. These are reports generated by companies to spot trends, so there are no SEC rules about how these reports need to be prepared.
Common-sized balance sheets are most often prepared by showing the current year and then the last fiscal year as dollar amounts in the first two columns. Then the same infor- mation for the two years of data is shown as percentages. Some analysts prefer to show only the percentages and not the dollar amounts. Both ways are acceptable.
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Section 2.3Common-Sized Balance Sheets
Figure 2.16 shows a common-sized balance sheet for IBM. To make it easier to compare IBM with other companies, this balance sheet totals all three types of Accounts Receivable into one line item. Also to keep things easy for comparison, it uses only the net numbers for Property, Plant, and Equipment and Intangible Assets.
Task Box 2.7: Creating a Common-Sized Balance Sheet for IBM
To prepare a common-sized balance sheet, start an Excel worksheet. Copy the information from the IBM balance sheet into the Excel worksheet.
Develop a formula to divide each line item in the Assets section by Total Assets. Next, develop a formula to divide each line item in the Liabilities and Equity section by Total Liabilities and Equity.
To make things easier for you, we have developed a template that includes the most common line items on a balance sheet and the formulas already developed for the percentage columns. You can download that template here.
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Section 2.3Common-Sized Balance Sheets
Figure 2.16: Common-sized balance sheet for IBM
This common-sized balance sheet was created using IBM’s 2012 Balance Sheet.
IBM Common-Sized Balance Sheet
At December 31, 2012 and 2011 (in millions)
2012 2011 2012 2011
Current Assets: Cash and Cash Equivalents Marketable Securities Accounts Receivable Inventories Deferred Taxes Prepaid Expenses and Other Assets Total Current Assets Long-Term Assets: Property, Plant, & Equipment – Net Long-Term Financing Receivables Prepaid Pension Assets Deferred Taxes Goodwill Intangible Assets – Net Investments and Sundry Assets Total Assets
Current Liabilities: Taxes Short-Term Debt Accounts Payable Compensation and Benefits Deferred Income Other Liabilities Total Current Liabilities Long-Term Debt Retirement Benefit Obligations Deferred Income Other Liabilities Total Liabilities
IBM Stockholders’ Equity Retained Earnings Treasury Stock Accumulated Other Income (Loss) Total IBM Shareholder Equity Noncontrolling interests Total Equity Total Liabilities and Equity
$ 10,412 717
30,578 2,287 1,415 4,024
$ 49,433
$ 13,996 12,812
945 3,973
29,247 3,787 5,021
$ 119,213
$ 4,948 9,181 7,952 4,745
11,952 4,847
$ 43,625 24,088 20,418
4,491 7,607
$100,229
$ 50,110 117,641
(123,131) (25,759)
$ 18,860 124
$ 18,984 $ 119,213
$ 11,922 0
29,561 2,595 1,601 5,249
$ 50,928
$ 13,883 10,776 2,843 3,503
26,213 3,392 4,895
$ 116,433
$ 3,313 8,463 8,517 5,099
12,197 4,535
$ 42,123 22,857 18,374 3,847 8,996
$ 96,197
$ 48,129 104,857
(110,963) (21,885)
$ 20,138 97
$ 20,236 $ 116,433
8.73% 0.60%
25.65% 1.92% 1.19% 3.38%
41.47%
11.74% 10.75% 0.79% 3.33%
24.53% 3.18% 4.21%
100.00%
4.15% 7.70% 6.67% 3.98%
10.03% 4.07%
36.59% 20.21% 17.13% 3.77% 6.38%
84.08%
42.03% 98.68%
-103.29% -21.61% 15.82% 0.10%
15.92% 100.00%
10.24% 0.00%
25.39% 2.23% 1.38% 4.51%
43.74%
11.92% 9.26% 2.44% 3.01%
22.51% 2.91% 4.20%
100.00%
2.85% 7.27% 7.31% 4.38%
10.48% 3.89%
36.18% 19.63% 15.78% 3.30% 7.73%
82.62%
41.34% 90.06%
-95.30% -18.80% 17.30% 0.08%
17.38% 100.00%
Assets
Liabilities and Equity
Equity
Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
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Section 2.3Common-Sized Balance Sheets
Viewing this information as percentages makes it easier to analyze the trends. Note that IBM is holding a lower percentage of Cash in 2012 (8.73%) versus 2011 (10.24%). Accounts Receivable is just a slightly higher percentage, 25.65% versus 25.39%. Total Current Assets is lower at 41.47% in 2012 versus 43.74% in 2011.
Not much can be gleaned from these trends because not a lot of data is presented. To truly determine whether any of this represents a true trend for the company, managers and executives would need to add the numbers for 2010, 2009, and 2008. Those numbers could be found by downloading IBM’s 2010 annual report, which includes the 2010, 2009, and 2008 annual reports.
Task Box 2.8: Creating a Common-Sized Balance Sheet for 3M
Use the template provided for a common-sized balance sheet (available here). Prepare a common-sized balance sheet for 3M. Comment on key differences between IBM and 3M for five line items you think are relevant.
Which company is doing a better job of managing these five line items: IBM or 3M? Why do you think that is the case? Use information from the Notes to the Financial Statements to support your argument.
Task Box 2.9: Analyzing Industry Competitors, Part A
Pick an industry that interests you. This could be the industry in which you currently work or an industry in which you would like to work. It could be an industry in which you would like to invest. You may even want to compare the company you are currently working for with another in the same industry.
Select two public companies to compare in the selected industry. You can use the Yahoo Finance Industry List to help identify possible candidates: Just click on the industry that interests you to get a list of public companies in that industry.
Prepare a common-sized balance sheet for each company you are comparing. Then discuss how the two companies compare in the five critical areas below. You may want to use the Notes to the Financial Statements to help make your points.
1. Which company does a better job of managing its Inventory and why? 2. Which company does a better job of managing its Accounts Payable and why? 3. Which company does a better job of managing its Long-Term Debt and why? 4. Which company does a better job of managing its Retirement Benefits and why? 5. Is either company buying back stock or have they bought back stock in the past? If so,
discuss their buy-back plans.
Throughout the following chapters, you will have the opportunity to fully analyze the financial reports of these two companies. Each chapter will guide you through the process, step by step, as you learn about the key financial statements. Lastly, we will show you how to use basic financial analysis calculations to complete your analysis.
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Summary and Resources
Summary and Resources
Chapter Summary • In this chapter, we examined the balance sheet, or statement of financial position.
This critical statement provides a snapshot of a company’s financial position at one point in time. It reveals what the company owns and owes as well as details regarding the claims shareholders have on the company’s assets.
• The valuation of inventory can be very different within each company. There are five common valuation methods: LIFO (last item received is first item sold), FIFO (first item received is first item sold), average cost (averages costs of inventory no matter when the inventory is received), specific identification (tracks the cost of each unique piece of inventory), and lower of cost or market (used for assets whose value can change dramatically depending on market conditions).
• A common-sized balance sheet is a tool used to help managers and executives compare competing companies of varying size. Managers can use this tool for benchmarking, spotting trends, and comparing the key line items of the balance sheet. A manager can make this comparison by looking at the results of various years of their own company’s activities along with the results of their competitors.
Takeaways for Chapter 2 • Managers need to watch the trends in the value of their assets, whether they are
going down or up. Each asset line item can tell a story about the direction of the company’s financial position.
• Managers need to analyze each asset’s proportion of the total assets. Managers should ask whether the proportions make sense for the industry or whether one asset has more value than is common in the industry. If so, what adjustments should be made to be more competitive within the industry?
• Managers must watch the expense of their liabilities and whether the company is generating enough cash to pay its bills, meet interest obligations, and pay the principal due on each of its liabilities. They should also watch closely the inter- est rates paid and whether those rates compare favorably to the current market interest rates. If not, refinancing may be needed.
Post-Test 1. Why do some companies choose not to report as of December 31 each year? a. The company is a retail store and prefers to close its books at the end of January. b. The company is an educational institution and it prefers to close its books at
the end of an academic year. c. The company prefers to close its books based on a particular day of the week. d. all of the above
2. Which of the following is not a common format for the balance sheet? a. account format b. report format c. bookkeeping format d. financial position format
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Summary and Resources
3. Which of the following are types of marketable securities? a. government securities b. corporate debt c. asset-backed securities d. all of the above
4. Which of the following is not a type of cash equivalent? a. certificates of deposit b. bonds c. money market funds d. commercial paper
5. Which of these items in Property, Plant, and Equipment is not depreciated? a. buildings b. land c. plants d. equipment
6. What are examples of current liabilities? a. Accounts Payable b. Short-Term Debt c. Long-Term Debt d. both (a) and (b)
7. Which is method for counting inventory? a. periodic b. perpetual c. annual d. both (a) and (b)
8. Which are methods used to value inventory? a. FIFO b. LIFO c. average cost d. all of the above
9. Which inventory valuation method is likely to give you the lowest net profit when prices are going up?
a. FIFO b. LIFO c. average cost d. specific identification
10. How can a common-sized balance sheet assist you with financial statement analysis?
a. It helps you to spot trends. b. It helps you to compare companies of different sizes. c. It helps you to benchmark the company’s financials. d. all of the above
Answers: 1 (d), 2 (c), 3 (d), 4 (b), 5 (b), 6 (d), 7 (d), 8 (d), 9 (b), 10 (d)
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Summary and Resources
Answers and Rejoinders to Chapter Pre-Test 1. b. All other options are shown, but the purpose of the balance sheet is to give a
snapshot in time of the financial position. 2. b. Assets include everything the company owns. Liabilities include the claims
lenders have on the company’s assets. Equity includes claims the company’s owners have on the assets.
3. d. The account format of the balance sheet has a bottom line for the assets sec- tion, which shows total assets and a bottom line for the liabilities and equity sections, which shows total liabilities and equity.
4. d. LIFO, FIFO, and average cost are three types of inventory valuation methods. 5. b. One tool used to compare companies period to period or to other companies
is the common-sized balance sheet, which gives another perspective of the companies’ financial results.
Rejoinders to Chapter Post-Test 1. Not all companies must prepare their reports based on a calendar year. Some com-
panies choose a fiscal year that better matches the actual operations of the com- pany. When comparing financial reports of more than one company, it’s critical to make sure they have the same fiscal year or make adjustments for different ones.
2. The account and report formats are the two most common formats. The financial position format is most commonly used when comparing non-U.S. companies. Foreign companies can file their statements based on international financial reporting standards. There is no such thing as a bookkeeping format for the bal- ance sheet.
3. Marketable securities can be stocks, bonds, and other investments that can be turned into cash in 12 months.
4. Cash equivalents are temporary investments that can be turned into cash within three months. Bonds are longer-term investments.
5. Land does not depreciate in value. Depreciation shows the “using up” of an asset because of age.
6. Both (a) and (b) are types of current liabilities. Long-term debt is a long-term liability.
7. Both (a) and (b) are types of methods for counting inventory. Periodic means the inventory is physically counted on a regular basis, whether weekly, monthly, or annually. Perpetual means inventory is counted using a software program that adjusts inventory levels at the time of sale. While some companies may only count inventory on an annual basis, it is not a method for counting inventory. Even if it were done once per year, the count would be considered a periodic count.
8. FIFO, LIFO, and average cost are methods for valuing inventory. 9. LIFO means that the last in is the first out. So if prices are going up, the most
expensive inventory will be sold first and the lower-priced inventory will be left on the shelves. That means the Cost of Goods Sold will be higher and the profits will be lower.
10. Common-sized balance sheets are a useful tool to help managers spot trends, compare companies of different sizes, and benchmark a company’s financials based on industry norms.
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Summary and Resources
Discussion Questions 1. Why should managers compare the level of inventory from one year to the next?
Why should managers compare inventory levels with their competitors? 2. What should managers review if they see that Accounts Receivable is increasing
in value? What changes may be needed? 3. A manager works for a pharmacy and sees that inventory is valued using LIFO.
Considering that pharmaceuticals can become outdated quickly, should he ques- tion the use of LIFO rather than FIFO? Why or why not?
4. A finance manager reviews the short- and long-term liabilities detailed in the Notes to the Financial Statements and sees that the interest rates being paid are higher than current market rates. What should she do?
5. What line items on a common-sized balance sheet might be the most useful to compare over a number of years of data? Why?
Further Reading/Resources Janssen, C. (2012, March 3). A Breakdown of Stock Buybacks. Investopedia. Retrieved from http://www.investopedia.com/articles/02/041702.asp
U.S. Department of Labor. (n.d.). What You Should Know About Your Retirement Plan. Retrieved from http://www.dol.gov/ebsa/publications/wyskapr.html
White, R. (2012, June 26). Is your defined-benefit pension plan safe? Investopedia. Retrieved from http://www.investopedia.com/articles/retirement/08/safe-db-plan.asp
Yahoo Finance Industry List
Key Terms account format One type of format for a balance sheet. Assets are shown on the left and Liabilities and Equity are shown on the right.
accrual accounting A method of account- ing in which expenses and revenues are shown in the appropriate month. Rev- enues must be recognized in the period they are earned and expenses must be recognized in the period they are used, which is not necessarily the period that cash changed hands.
accrued payroll Account that tracks pay- roll due to employees not yet paid.
accumulated depreciation An account that tracks the depreciation of an asset over the years the asset is owned.
Accumulated Other Comprehensive Income (Loss) A line item that shows income or losses that have not yet been realized. These unrealized gains or losses can be from things such as unrealized pension costs, unrealized gains or losses on securities, and unrealized gains or loss on foreign currency exchanges or other foreign investments.
aging schedule A report generated that lists the customers who purchased items on company credit and the amounts owed. The amounts owed are grouped by the age of the debt.
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Summary and Resources
average costing One method for valuing inventory. As inventory is purchased, the cost of the new inventory is averaged with the cost of the other inventory on hand.
bad debt Debt the company is owed by its customers that it does not expect to col- lect from them.
carryforwards A deduction for losses that could not all be taken in the current year but can be taken in future years.
commitments Contractual agreements.
common-sized balance sheet Document that converts the financial results into percentages to make it easier to compare companies, no matter what their sizes.
contingencies Pending legal matters.
credit A type of entry in an accounting system. For some types of accounts it will increase its balance; for other types of accounts it will decrease its balance.
debit A type of entry in an accounting system. For some types of accounts it will increase its balance; for other types of accounts it will decrease its balance.
deferred income An account that tracks income received by the company, but not yet earned.
deferred taxes Taxes that are not paid immediately, but instead are paid at some point in the future. These can represent tax deductions that could not be taken in the current tax year, but could be taken in the future.
FIFO (First In, First Out) An inventory valuation method that assumes the first item put on the shelves will be the first item sold. Companies whose products spoil quickly or become obsolete use this method of inventory valuation.
financial position format A balance sheet format that is used internationally but is not commonly found in the United States, although it may be used by foreign companies that do business in the United States. The key difference with this format is the addition of two lines that do not appear on the account or report formats: working capital and net assets.
goodwill An intangible asset (an asset that cannot be touched but that has value for the company). When a company shows goodwill on its balance sheet, it means it paid more for at least one com- pany than its tangible assets were worth. Often these intangible assets include things like customer base, desirable loca- tions, or popular technology, products, or services.
inventories Products or merchandise the company has on hand to sell to its customers.
LIFO (Last In, First Out) An inventory valuation method that assumes the last piece of inventory purchased is the first piece of inventory sold. This method works for companies selling inventory that does not spoil or become obsolete.
lower of cost or market method A method of inventory costing in which the company calculates both the cost of the product when purchased and the current value of the product. The value shown on the balance sheet would be whichever one is lower.
maturity The date at which time a finan- cial instrument, such as a bond or certifi- cate of deposit, will cease to exist. The principal is repaid with interest on the maturity date.
operating lease obligations A type of lease for equipment, such as copiers, con- sidered an asset to the company.
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Summary and Resources
periodic inventory method A physical count of the inventory on hand. Depend- ing on the type of business, this could be done daily, weekly, monthly, or yearly.
perpetual inventory method A method for counting inventory as it is sold. Com- panies that use this method usually make changes to the inventory in stock at the cash register.
prepaid expenses Expenses that are paid in advance. For example, a 12-month insurance policy paid at the beginning of the year. This is held as an asset and reduced monthly as the expense for each month is recorded.
property, plant, and equipment A line item on the balance sheet that shows the net value of all the property, plants, and equipment a company owns.
report format One type of balance sheet format. Assets are shown first, Liabilities and Equity are shown below.
rounding A mathematical decision made to use less-exact (but easier-to-use) numbers.
short-term debt All debt payments that must be made in the next 12 months.
specific identification method A way of calculating inventory values by adding up the value of each product in inventory (based on the purchase and sold details of each).
straight-line depreciation method A way to value inventory. The company deter- mines an asset’s life span and then divides the cost of that asset by the number of years it will have a useful life to the company.
treasury stock Stock that has been bought back by the company from stockholders.
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