Financial Decision Making 8 questions 4 papers

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retained earnings (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks profits reinvested into the company.

sales discounts (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account of any discounts offered to the customer to reduce the retail price.

sales returns and allowances (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks returns of merchandise.

sales taxes collected (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks taxes that have been collected from customers that need to be paid to the local, state, or federal government.

Sarbanes-Oxley Act of 2002 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Also known as the Public Company Accoun�ng Reform and Investor Protec�on Act, sets new or enhanced standards for external repor�ng.

statement of cash flows (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

This statement reveals how much cash flowed into and out of the business. The statement allows managers to determine whether the company received more or less cash in the current year versus the prior year.

statement of shareholders' equity (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Document that details the claims owners have against the company's assets. It can be found at the bo�om of the income statement or on a separate page.

stock (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Shares of ownership in a company that is sold to insiders and outsiders.

subsidiary ac�vi�es (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The ac�vi�es of a company wholly owned by a large corpora�on.

tangible assets (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Things the company owns that one can touch and feel, such as vehicles, furniture, and equipment.

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2 The Balance Sheet

The balance sheet provides a quick snapshot into the overall financial health of an organiza�on as of a par�cular date.

© Yong Hian Lim/iStock/Thinkstock

Learning Objec�ves

A�er 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, liabili�es, and shareholders'

equity. 3. Explore the different methods of accoun�ng for inventory (LIFO and FIFO) and the effects on the value of the

inventory. 4. Explain how to create a common-sized balance sheet.

Introduc�on In Chapter 1, we introduced the members of Best General Company's budget commi�ee. In this chapter, the budget commi�ee begins its analysis of the company's results by taking 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 corpora�ons. Later in the chapter we will explore the complex balance sheets of two real-world corpora�ons: IBM and 3M.

Figure 2.1: Sample balance sheet for Best General Company

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First, no�ce in Figure 2.1 that the Total Assets equal the Total Liabili�es and Equity. That must always be true on a balance sheet. If that is not the case, there is an error somewhere. 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 number, they know they will need to research it further to find out whether there is a problem collec�ng 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 si�ng on the shelf and not selling—or it could mean the company has added to the variety of inventory carried.

As the Best General budget commi�ee develops its budget report, its members will want to take a closer look 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 expecta�ons 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.

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2.1 The Elements of a Balance Sheet Consider a gymnast walking a balance beam: If she steps a bit to the right or le�, 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 financial posi�on) must stay in balance on a very thin line. Any devia�on can throw a company's books off balance. Balance is based on the key equa�on for all accoun�ng:

Assets = Liabili�es + Equity

This balancing act works because funds borrowed from lenders or cash raised from investors is used to fund the assets the company owns. The Liability sec�on shows the funds borrowed from lenders and the Equity sec�on shows money invested in the company by the investors (the owners of the company). The Equity sec�on also shows the profits retained to reinvest in the company in an account called Retained Earnings.

Every transac�on entered into the accoun�ng system must take this key formula into considera�on. In Chapter 1, we introduced these three key elements: assets, liabili�es, 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.

Some Notes on Entering Numbers Into the Accoun�ng System

Before exploring the balance sheet, let's discuss how the numbers are entered into the accoun�ng 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 transac�on would be entered in the accounts as shown in Table 2.1:

Table 2.1: Accoun�ng for cash transac�ons

Date Accounts Debit Credit

May 3 Furniture 1,000

Cash 1,000

In this entry, Assets are increased by $1,000 with the addi�on 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 transac�on would be entered into the books as shown in Table 2.2:

Table 2.2: Accoun�ng for credit card transac�ons

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 acquisi�on of furniture and Liabili�es 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 accoun�ng text. Rather, we will briefly explore the logis�cs that go into building the numbers for a balance sheet and their rela�onship to the key accoun�ng formula:

Assets = Liabili�es + Equity

If the transac�ons are not balanced when they enter the accoun�ng system, the balance sheet will not be in balance.

Note that debits and credits in accoun�ng 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.

In accoun�ng it is not that simple. Debits and credits can add to or subtract from the balance 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 liabili�es 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 accoun�ng system is to ensure that the debits always equal the credits in a transac�on 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

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A great deal of informa�on can be gleaned from the balance sheet. For example, from this par�al sheet we can determine that Best General Company has less cash than in the previous period and accounts receivable and inventory amounts have increased.

Assets Increase Decrease

Liabili�es Decrease Increase

Equity Decrease Increase

Income Decrease Increase

Expenses Increase Decrease

Balance Sheet Presenta�on

When preparing a balance sheet, several basic rules guide the dates for the statement, the numbers used, and the presenta�on 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 corpora�on that both develops technology solu�ons for its customers and sells the products for those solu�ons. This will provide a good overview of how both serviced-based and product-based corpora�ons present their financial reports. IBM deemphasized manufacturing hardware beginning in 1994, and in 2012 focused its opera�ons instead on services, so�ware, and technology solu�ons, yet it s�ll 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 (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf) and 3M (h�p://media.corporate-ir.net/media_files/irol/80/80574/Annual_Report_2012.pdf) . 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.

Dates of the Statement

A balance sheet is like a snapshot of a company's financial posi�on on a par�cular 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 posi�on changes daily as sales are made, inventory is bought or manufactured, and other transac�ons take place to keep the company opera�ng. So when reviewing a balance sheet, keep in mind that it provides the company's financial posi�on 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 opera�ons shown on the income statement. (We'll explore the income statement in Chapter 3.) Note in the heading (top por�on) 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 por�on of the Best General Company balance sheet

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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.

Richard Levine/age fotostock/SuperStock

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 star�ng on February 1 of any year un�l January 31 of the next year. They choose this 12-month period for two reasons:

1. They do not want to be preparing financial statements during their busiest �me of year, the Christmas holiday season. For example, Walmart prepares its annual reports at the end of January.

2. January sales o�en 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 organiza�on that does not usually report on a calendar-year basis is academic ins�tu�ons. Such ins�tu�ons are more likely to prepare statements based on their academic year. For example, the Apollo Group, which operates for-profit universi�es, reports annually at the end of August. Many non-profit learning ins�tu�ons, 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 ins�tu�ons, 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 comparable. 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 �me period.

Another way some companies prepare their financial statements is to base the end of each financial period on a par�cular day of the week. (We talk about that scenario in "World of Business.")

World of Business

Another Twist to Financial Report Da�ng

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 par�cular 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 accoun�ng period.

Darden has determined that the best way to compare the results of its restaurants is to end each repor�ng period on the same day of the week because in the restaurant business, the volume of business differs by day of the week.

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 repor�ng 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, repor�ng by the day of the week can add another complica�on to analyzing results of opera�ons. 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 repor�ng will explain how it calculates its results in

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In the report format, Assets are shown first, then Liabili�es and Equity. Note that Assets = Liabili�es + Equity.

In the account format, the Assets are in the le� column and the Liabili�es and Equity are in the right column. The two columns' totals will always be shown in balance.

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 �me 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 repor�ng on a weekly schedule versus a monthly schedule? 3. What types of businesses do you think might best be served by weekly repor�ng?

Numbers Used

In addi�on to knowing the date the report was generated, it is important to pay a�en�on to the way the numbers are shown. For example, IBM's Financial Posi�on Statement says "$ in millions except per share amounts." This is a cri�cal piece of informa�on 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 mathema�cal 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 cri�cal 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.

Presenta�on Format

Companies can use three different types of formats when presen�ng their balance sheet: report format, account format, or financial posi�on format. We present each format using simple numbers and just a few line items to illustrate what to expect for each.

For the Best General Company, we used the report format, which is shown in Figure 2.3.

Figure 2.3: Report format balance sheet

Another commonly used format is the account format, shown in Figure 2.4.

Figure 2.4: Account format balance sheet

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Net Assets is equal to Shareholders' Equity. Companies using this format also include a statement detailing the equity sec�on.

The third format is the financial posi�on format. This format is used interna�onally 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 in this format is the addi�on 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 subtrac�ng the current liabili�es from the current assets. Net Assets: This line shows what is le� for the company's owners a�er all liabili�es have been subtracted from total assets.

Using the same numbers as are seen in the examples of the other two formats, the financial posi�on format is shown in Figure 2.5.

Figure 2.5: Financial posi�on format balance sheet

Now that we have reviewed the items that appear on a balance sheet or statement of financial posi�on, we will inves�gate 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.

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 Posi�on 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 Securi�es. If you turn to the Notes to the Financial Statements, you will find out more detail about IBM's marketable securi�es.

The balance sheet for 3M is not as helpful. There is only one note men�oned on the statement (Note 13, Commitments and con�ngencies), but 3M does provide an index of its notes on page 43 of its 2012 annual report.

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 some�mes called non-current assets). The current assets are shown first, followed by the long-term assets. As a review, Figure 2.6 shows the assets sec�on of Best General Company's balance sheet.

Figure 2.6: Assets sec�on of Best General Company balance sheet

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Long-term, or non-current assets, are assets that will not be used within the next 12 months. These assets are listed a�er all current assets on the 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 pe�y cash drawers. 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 Equivalents in Note A of its Notes to the Financial Statements: "All highly liquid investments with maturi�es of three months or less at the date of purchase are considered to be cash equivalents." For example, a three-month Cer�ficate of Deposit (CD) would fit into this category. In Note D, IBM details that Cash includes �me deposits, cer�ficates of deposit, commercial paper, money market funds, and other securi�es.

In Note 1, 3M explains this line item in a similar way: "Cash and cash equivalents consist of cash and temporary investments with maturi�es 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 explana�on to be sure both companies use the same categoriza�on of cash.

In Chapter 1 we discussed that the first note in the Notes to the Financial Statements reviews significant accoun�ng policies. When searching for details about how a number is calculated (and the informa�on is not presented in a separate note), look for that informa�on in Note 1 or Note A, depending on how the company numbers its notes.

Marketable Securi�es

Marketable securi�es 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 securi�es, but many major corpora�ons will include this line item. Financial managers are likely to take a close look at this informa�on. For example, Bob, a financial analyst at Best General Company, would likely check compe�tors' balance sheets to find out if they hold marketable securi�es and which types of securi�es they hold. He could use this informa�on to make recommenda�ons 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 securi�es line items: one is current and another is non-current. In Note 8, 3M explains that classifica�on as current or non-current marketable securi�es is determined by "management's intended holding period." The note also indicates that 3M's marketable securi�es include U.S. and foreign government securi�es, commercial paper, corporate debt, and asset-back securi�es (such as automobile loans and credit card securi�es). Also at the bo�om of Note 8, 3M details its unrealized gains and losses on marketable securi�es and how it derives the valua�on for the balance sheet.

IBM explains in Note A that all securi�es on this line item can be turned into cash in the next 12 months. IBM also explains that realized gains and losses on these securi�es are included in Other Income or Other Expense on the income statement (statement of earnings). These gains or losses are calculated based on the specific iden�fica�on method, which means they are based on the purchase and sold details of each individual asset. In addi�on, 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 securi�es owned by IBM as well as explana�ons about fair value calcula�ons. IBM also details the risks involved with its marketable securi�es.

With the details found in the notes, Bob can assess how well his company is managing its marketable securi�es compared to how the compe��on is managing theirs.

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An aging schedule, like the one shown here, is an internal report showing customer credit delinquencies that are more than 30 days past due.

Task Box 2.3: Comparing Marketable Securi�es

Review the details behind IBM's and 3M's marketable securi�es 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 ques�on? 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 commi�ee 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 commi�ee cannot know that for sure un�l it looks at the internal reports that detail what is behind these numbers. Internally, the budget commi�ee can request an aging schedule, which would be a confiden�al 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.

Figure 2.7: Best General Company accounts receivable aging schedule

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 commi�ee may need to recommend changes to Best General Company's credit policies. The execu�ve commi�ee would then need to determine whether a change is needed and how that change should be implemented.

When looking at their compe�tors' Accounts Receivable line item, Best General's budget commi�ee could not see this type of detail, but they can assess whether their compe�tors are experiencing similar problems. If so, it could be an indica�on of an industry-wide downturn or possibly even economic problems impac�ng a larger por�on of the na�on's economy, such as the recession the United States experienced between 2008 and 2012. If economic condi�ons are impac�ng receivables, the budget commi�ee may need to lower revenue expecta�ons 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 allowances 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 so�ware systems and services that are purchased using leases and long-term loans, so its Accounts Receivable can be very complex to sort out.

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 doub�ul 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 commi�ee 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 marke�ng 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 compe�tors to see whether their compe�tors are also experiencing an increase. If they are, it could be a sign of an industry downturn. If the compe�tors do not show the same problem, it could be an indica�on of a company-specific issue. Either

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Using deferred tax assets on future tax returns, companies can reduce their tax obliga�ons in the future.

way, the budget commi�ee would need to research why inventory is building up.

When looking at compe�tors, another factor could be of interest to the budget commi�ee: whether their compe�tors 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 balance sheet. Instead, the notes reveal informa�on 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 so�ware products, as well as the services offered, but the focus in this note is on how the company recognizes its revenues. We'll inves�gate those issues in Chapter 3.

Deferred Taxes

Some larger companies carry over tax deduc�ons 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�ons, then goes on to detail its taxes by geographic opera�ons and taxing jurisdic�ons.

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 represent tax write-offs that may be used to reduce income taxes in the future.

Figure 2.8: IBM's deferred tax assets

Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://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 transac�on when it occurs, but it will record it as an asset ini�ally. Each month it will develop an adjus�ng 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 accoun�ng, 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.

Other Current Assets

Other Current Assets is a miscellaneous line item for anything not detailed in the current assets por�on of the balance sheet. Usually this item reflects the value of assets not used in current opera�ons (and possibly up for sale). Neither IBM nor 3M details what is included in the Other Current Assets line item.

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One can find details about IBM's property, plant and equipment by reviewing the notes to the financial statements.

Property, Plant, and Equipment

Up un�l 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 summarize 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 a�er the reduc�on for deprecia�on. 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 reduc�on in that value for deprecia�on.

Deprecia�on 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 accumula�on of deprecia�on over the five-year period is shown on the balance sheet as accumulated deprecia�on. The third line item on IBM's and 3M's balance sheets is the net value of property, plant, and equipment a�er deprecia�on is subtracted.

Managers need to understand how deprecia�on reduces the net income of a company, but it is not actually a cash expense each year. The cash outlay (or ini�a�on 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. Deprecia�on expenses spread out the cost of an asset over �me, even though they do not require the use of cash. This enables a company to match its expenses with the �me over which the asset is used.

Task Box 2.4: Calcula�ng Deprecia�on

Review the Notes to the Financial Statements and find out how 3M and IBM calculate deprecia�on. (The method 3M uses to calculate deprecia�on 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 deprecia�on method does each company use?

Most companies use a straight-line deprecia�on 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 a�er 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 calcula�ng the annual deprecia�on amount. For tax purposes, the company may use a deprecia�on method, called accelerated deprecia�on, that speeds up the deduc�on 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 deprecia�on in its note called "Significant Accoun�ng Policies."

In addi�on to detailing its deprecia�on calcula�on, 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)

Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://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�on. 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

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deprecia�on purposes.

Deprecia�on of a building can be a complex calcula�on. Some accountants use cost segrega�on (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 segrega�on, but since they do separate buildings from other property, that may explain the separa�on. (Soled, 2004)

When looking at deprecia�on, 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 le� 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 facili�es or building new facili�es to maintain opera�ons.

Task Box 2.5: Comparing Age of Assets

As a manager, when comparing your company to a compe�tor, you may want to consider the age of your compe�tor's property, plant, and equipment. A company with newer equipment will have higher deprecia�on costs but may have lower repair expenses. So when comparing these line items to analyze opera�ng costs, you may need to consider both deprecia�on expenses and repair expenses. This calcula�on can also make a big difference when preparing budgets. If a company has mostly older assets, the budget commi�ee may need to plan for the purchase of new assets or may need to plan for more repairs to facili�es and equipment.

Calculate the age of the assets of 3M using a similar calcula�on to the one shown for IBM and compare the age of assets for the two companies. When evalua�ng the value of a company, deprecia�on can give you a clue about the age of the company's assets.

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 simplified 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 informa�on.

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 obliga�ons each company has to pay its re�rees from these assets. Note that for both companies, the pension and post re�rement benefits on the liabili�es side are much higher than the prepaid pension assets shown on the asset side.

The notes explain how each company structures its re�rement benefits and how well funded each benefit may be. For many companies, pension obliga�ons are like a �cking �me bomb that may explode as the Baby Boomers re�re in large numbers. This future obliga�on could be a drag on a company's long-term earning poten�al, draining a company's cash that could instead be used for future growth.

IBM states in Note S that it ceased defined benefit accruals on December 31, 2007. This means that a�er that date, employees ceased to build defined benefits—the type of benefits 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 a�er re�rement. Today, all IBM employees par�cipate in a defined-contribu�on plan. In this type of plan, employees, and possibly their employers, contribute to the plan. Re�rement benefits are based on the cash saved in this re�rement plan. The 401(K) is an example of a defined contribu�on plan.

In Note 10, 3M states that its defined-benefit plan in the United States was closed to new par�cipants on January 1, 2009. The company currently offers defined- contribu�on 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 tangible assets were worth. O�en these intangible assets include things like customer base, desirable loca�ons, 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 companies 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 informa�on about recent acquisi�ons is located in Note 2 for 3M and Note C for IBM. The acquisi�on note contains specific financial details about the company's recent acquisi�ons. For example, if the company has sold any divisions, that informa�on is usually found in the acquisi�ons note, which is then called Acquisi�ons/Dives�tures. Only IBM details dives�tures.

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, so�ware, and drawings can be protected for between 50 and 100 years a�er the creator's death, assuming the creator is an individual. The �me is shorter for a corpora�on.

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The liabili�es sec�on of the balance sheet is set up just like the assets sec�on, lis�ng both current and long-term liabili�es.

Trademarks: These include symbols, logos, phrases, or combina�ons of these that legally dis�nguish the company. Patents: The exclusive right to an inven�on, design, or process for a designated period of �me.

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 reduc�on for amor�za�on. Amor�za�on is similar to deprecia�on. Many intangible assets have a limited life span. Amor�za�on is used to track the aging of these assets and to show what por�on of these assets has been used up.

Neither IBM nor 3M shows much detail in its Intangible Assets note. IBM shows some informa�on in Note I, and 3M includes informa�on 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 respec�ve 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 Liabili�es sec�on of the balance sheet more thoroughly.

Liabili�es

Liabili�es include things the company owes. Just as we saw with assets, there are two groupings: current liabili�es (money due within the next 12 months) and long- term liabili�es (money due in more than 12 months).

Financial analysts for Best General Company would be most interested in the liabili�es 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 liabili�es 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 sec�on and compare it to those sec�ons from IBM and 3M. Figure 2.10 is the liability sec�on of Best General Company balance sheet.

Figure 2.10: Liabili�es sec�on of Best General Company balance sheet

Taxes

Best General Company shows no tax liabili�es, nor does 3M, but IBM starts its 2012 Current Liabili�es sec�on of the balance sheet with a line item called Taxes. These are deferred tax liabili�es that IBM must pay during 2013. They are explained in Note N along with Deferred Tax Assets.

Corporate taxa�on 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 domes�c loss carryforwards (deduc�ons 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 cri�cal issue if the taxes represent a significant por�on of liabili�es due. For IBM, the deferred tax liabili�es of $6,508 million are offset by $11,428 million in deferred tax assets.

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In the notes to the financial statements, a chart shows a detailed breakdown of IBM's debt obliga�ons.

This chart from the notes to the financial statement shows the details about IBM's short-term debts.

Look in the notes to find out why the company is deferring such a large por�on of its taxes due. It is possible the company is in nego�a�ons with the IRS regarding tax obliga�ons. If so, the company will detail the informa�on 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.

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 sec�on 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 o�en 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 maturi�es 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 por�on 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

Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

3M gives this line item a longer name: Short-term borrowings and current por�on 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 effec�ve interest rate of 4.7%.

Figure 2.12: 3M's short-term borrowings and current por�on of long-term debt

Source: 3M. (2013). 2012 annual report. Retrieved from h�p://media.corporate- ir.net/media_files/irol/80/80574/Annual_Report_2012.pdf (h�p://media.corporate-

ir.net/media_files/irol/80/80574/Annual_Report_2012.pdf)

Note that 3M also details the current por�on of its long-term debt (the interest and principal 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 a�er the next 12-month period.

Both IBM and 3M detail their types of borrowing in their respec�ve notes. This informa�on is cri�cal 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 a�en�on to how the company is managing its debt.

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For example, Bob, as the financial analyst for Best General Company's budget commi�ee, 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 compe�tors. He may discover ideas for how to be�er structure his own company's debt by reviewing his compe�tors' financial obliga�ons. 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 �me 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 un�l 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 Statements. This is a basic rule of accrual accoun�ng and there usually is no need to detail the number.

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, installa�on, construc�on, 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 recogni�on in more detail when we discuss the income statement. IBM indicates how it recognizes income in Note A.

Other Liabili�es

Other Liabili�es is a catchall account for any current liabili�es not shown as an individual line item. Companies rarely detail their Other Liabili�es line item, and neither 3M nor IBM includes a note to explain what these liabili�es include.

Long-Term Debt

Up un�l this point, we have examined short-term liabili�es. We will now turn our a�en�on to long-term liabili�es. Recall that these are liabili�es that will be paid over a period longer than 12 months. The amount of interest or principal due on these long-term liabili�es was shown in a current liability called Current Por�on of Long- Term Liabili�es.

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 explana�ons 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 informa�on 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.

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 ma�er? The interest rates show that 3M was able to nego�ate be�er terms on its debt. When reviewing the long-term debt of his compe�tors, 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 compe�tors—just as he did with short-term debt, and for the same reason. Any opportunity to reduce interest payments has a posi�ve 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 determine the rela�ve importance of each quan�ty 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 x 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.

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All employees should be encouraged to look into the details of their company's re�rement plans.

©Jon Pa�on/iStock/Thinkstock

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 nego�ate be�er interest rates. If the two companies were compe�ng 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 posi�ve impact on the projected budget for the next year.

Re�rement and Post-Re�rement Benefits

For many large corpora�ons, Re�rement and Post-Re�rement Benefits is an obliga�on that is already big—and ge�ng bigger as Baby Boomers re�re. Many corpora�ons also have not fully funded the obliga�on. In the future, when employees re�re, these obliga�ons will become liabili�es 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 benefit obliga�ons . . . . Overall, including nonqualified plans, the company's defined benefit pension plans were 86 percent funded." That is s�ll above the average funding level for major corpora�ons, which is 80.6%, according to the annual analysis of corporate SEC filings done by Pensions and Investments.

For 3M, the detail can be found in Note 10. The company states its "qualified benefit plan does not have a mandatory cash contribu�on because the Company has a significant credit balance from previous discre�onary contribu�ons." So 3M has met the 100% funding criteria. It can be important for all managers and employees of a company to know whether their company is fully funding their re�rement benefits. Not only is this important 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 re�rement 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 sec�on. It essen�ally includes the same type of unearned obliga�ons as the Current Liabili�es line item men�oned 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 Liabili�es line item in long-term debt. Again, this is a catchall line item with li�le detail about what is included.

World of Business

Is Your Company Funding Your Pension?

As employees near re�rement, they become more concerned about whether there will be enough money for them to re�re. This can include what has been saved using the company's re�rement savings programs, as well as what the employee has saved outside that system.

Companies in recent years have been changing the rules for re�rees by shi�ing their re�rement benefits from defined-benefit plans to cash-balance plans or 401(k)s, which are defined-contribu�on plans. In most cases, this shi� will result in lower monthly re�rement income. (Zanona 2013)

Employees can review the details about the state of their company's re�rement plans and determine where they stand by reading the Notes to the Financial Statements. An excellent ar�cle 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 re�rement account is funded? Where could you go to learn more about this? 2. What type of re�rement plan or plans does your company offer? Is the one that you have chosen the most secure? Why or why not?

Commitments and Con�ngencies

Under Total Liabili�es, both 3M and IBM indicate there is a note called Commitments and Con�ngencies 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 poten�al commitments (contractual arrangements) or con�ngencies (legal ma�ers) that do not currently appear on the balance sheet but that may have a financial impact on the company at some point in the future. The commitments and con�ngencies include informa�on about legal ma�ers that could end up cos�ng the company money in the future, but at the �me the annual report was issued, no dollar amount could be es�mated for the future cost.

The most common type of commitment detailed is opera�ng 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 millions due in future payments on opera�ng leases, so the

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The equity sec�on 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.

obliga�on should be taken into considera�on when considering liabili�es. This is a form of off-balance sheet financing.

3M's long-term opera�ng lease obliga�ons—leases for equipment, such as copiers, considered an asset to the company—total $71 million. Also, 3M indicates it has accrued product warranty liabili�es 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 por�on 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 por�on of this security into stock.

IBM discusses three types of commitments in which it has unused extended lines of credit to third-party en��es 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 addi�on, the company states it guarantees certain financial agreements, which totaled $65 million as of December 31, 2012.

Con�ngencies involve legal ma�ers that have yet to be resolved. Both IBM's and 3M's notes include details of ongoing lawsuits. In many cases, legal ma�ers could take years to se�le with no idea of the outcome un�l se�lement. As soon as a company can determine the approximate cost of a legal ma�er, it must report that cost to shareholders.

Equity

The Equity sec�on of the balance sheet shows the claims that owners have against the assets of the company. For a major corpora�on, those owners are shareholders. In smaller companies, an owner's claim would be shown as Owners' Equity. Figure 2.13 is the equity sec�on of Best General Company's balance sheet.

Figure 2.13: Equity sec�on of Best General Company's balance sheet

The owners' equity por�on of the balance sheet for a partnership may show several different owner line items, which detail the por�on 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 por�on 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 presenta�on of the equity sec�on of the balance sheet for a major corpora�on. We review both IBM and 3M's equity sec�ons.

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 addi�onal details in Note 5. We will examine the common line items found in the Stockholders' Equity sec�on 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 compensa�on plans and for employee stock purchase plans.

Common shareholders have the right to vote on corporate policy and elect members of the board of directors, but they are on the bo�om of the totem pole when it comes to ownership priority. If the company were to go bankrupt, common shareholders would have to wait un�l bondholders, preferred shareholders, and other debt holders are paid before they get any money.

Preferred Stock

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The equity sec�on of IBM shows the detail about the claims owners of the company have against the company's assets.

Preferred Stock is another line item in the Stockholders' Equity sec�on 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 par�cular year, those dividends accumulate. When the company is again in a posi�on 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 vo�ng 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 poten�al to go up in value).

Neither IBM nor 3M show a Preferred Stock line item. IBM does indicate in Note L that there is authoriza�on 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.

Addi�onal Paid-In Capital

Companies set a price for their stock when it is first issued. Any money paid in above the issue price is addi�onal 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 addi�onal paid-in capital. Once a stock is in the market, its price does not change the equity por�on of the balance sheet. The balance sheet will always show the value ini�ally 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 addi�onal 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 addi�onal paid-in capital. Below that are details about the number of shares authorized and the number of shares already issued.

Figure 2.14: IBM's equity sec�on

Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

Retained Earnings

Retained earnings represent an accumula�on of earnings by the company since its incep�on and reinvested in the company each year. The balance in retained earnings is adjusted each year by adding any net income or subtrac�ng 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 calcula�ng retained earnings:

Prior Year's Retained Earnings

± Net Income (Loss)

− 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 s�ll 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—a�er 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.

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 securi�es, 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.

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This completes our survey of the key line items found on a balance sheet, as well as the types of detailed informa�on 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 informa�on in the Notes to the Financial Statements for an explana�on about how that line item was calculated. To inves�gate further, research the informa�on online.

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Companies can choose how to valuate their inventories, as long as the chosen method is consistent and accurate.

Blend Images/SuperStock

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 Iden�fica�on 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 compe�tors, it is important to know whether both companies value their inventory in the same way. Different inventory valua�on 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 discussed in Chapter 6, where we analyze financial reports.) Before discussing inventory valua�on methods, let's discuss two methods of coun�ng inventory: perpetual and periodic.

Coun�ng 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 so�ware program decreases the inventory in stock. When inventory is purchased, the addi�onal inventory is added to the totals of inventory in stock in the computer so�ware.

In order to use this method of inventory coun�ng, a company must have a computerized inventory system that is a�ached 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 business may not be able to sell goods to its customers un�l 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�mes customers will go to a store and find out it is closed for a few hours or even a day because the employees are coun�ng 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 preparing an adjus�ng entry for their accoun�ng system to record inventory shrinkage. The number on the financial statements will be net of that inventory shrinkage.

Most major corpora�ons use the perpetual inventory method, as more and more companies link their sales opera�ons to their inventory systems. This makes it much easier to know when more inventories are needed. Smaller companies without the required computer systems use the periodic inventory method.

Managers of companies s�ll using the periodic method may want to inves�gate whether it is logis�cally feasible to switch to the perpetual inventory method. This does require a new investment in computer hardware and so�ware, so this can be a major capital expenditure 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.

In calcula�ng the value of inventory using the LIFO method, we will prac�ce calcula�ng 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 hammers. At the end of the month, the company has 75 hammers le� on the shelf. What is the value of the hammers le� 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):

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Date Quan�ty 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

+ Purchases 300

= Goods Available for Sale 350

− Ending Inventory (75)

= Items Sold 275

From this calcula�on, we know that 275 hammers were sold. Using the LIFO method of valua�on, 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 s�ll 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

+ 25 hammers at $10.00 (April 3 Purchase) 250

= 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

+ 75 hammers at $10.00 (April 3 Purchase) 750

= Total Cost of Goods Sold $3,250

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 calcula�on 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 situa�on 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.")

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 Interna�onal Financial Repor�ng Standards (IFRS) set by the Interna�onal Accoun�ng 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 adop�ng IFRS or adap�ng GAAP to incorporate IFRS rules, there is no date set for this to happen, and some ques�on if it ever will (Fazal, 2011; Rosivach, 2012).

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 valua�on. For example, suppose a grocery store gets a new shipment 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 calcula�ng the value of inventory using FIFO, we will prac�ce calcula�ng 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

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the month, the company purchases 300 more hammers. At the end of the month, the company has 75 hammers le� on the shelf. What is the value of the hammers le� on the shelf at the end of the month using the FIFO method?

Again, we will assume the following schedule of purchases:

Date Quan�ty 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

+ Purchases 300

= Goods Available for Sale 350

− Ending Inventory (75)

= Items Sold 275

From this calcula�on, we know that 275 hammers were sold. Using the assump�on of the FIFO method of valua�on, 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

= 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

+ 100 hammers at $10.00 (April 3 Purchase) 1,000.00

+ 125 hammers at $12.50 (April 15 & 28 Purchases) 1,562.50

= 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 a�er adding the Cost of Goods sold to Ending Inventory.

Average Cos�ng

The inventory valua�on method that is the easiest to calculate and that gives companies the best picture of inventory trends is average cos�ng. This method can level out the ups and downs of inventory pricing and give the company an average through the year 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 sta�on) 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 prac�ce calcula�ng this method so that the inventory methods are easily compared.

In calcula�ng the value of inventory using average cos�ng, 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 le� on the shelf. What is the value of the hammers le� on the shelf at the end of the month using the average cost method?

Again, we will assume the following schedule of purchases:

Date Quan�ty Unit price

April 3 100 @$10.00

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April 15 100 @$12.50

April 28 100 @$12.50

First, we calculate the number of units sold:

Units

Beginning Inventory 50

+ Purchases 300

= Goods Available for Sale 350

− Ending Inventory (75)

= Items Sold 275

From this calcula�on, 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

+ 100 hammers at $10.00 (April 3 Purchase) 1,000

+ 200 hammers at $12.50 (April 15 & 28 Purchases) 2,500

= Total Cost of Goods Available for 350 Hammers $3,900

** Average Cost Per Hammer ($3,900/350 units) $11.14

We then calculate the Cost of Goods Sold and value of Ending Inventory using the average 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 Iden�fica�on

Companies that sell products that each have a different value use the specific iden�fica�on 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 fluctua�ng use the lower of cost or market method. With this method of inventory cos�ng, 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 Valua�on Methods

Now that we have considered the various types of inventory valua�on 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 cos�ng

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 valua�on, and the highest Cost of Goods Sold value is generated using the LIFO method of inventory valua�on. 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 cos�ng method will always be between these two methods.

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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 valua�on, as well as the lowest profit.

While the numbers used here are small, for a major corpora�on, 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 valua�on methods as the prices change, according to IRS rules. The GAAP rules require companies to consistently use the same method of inventory valua�on. If a company determines with its accountants that a different inventory valua�on method would be�er show the way inventory is sold, then a long explana�on of this decision will be included in the Notes to the Financial Statements under Accoun�ng 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: Selec�ng Inventory Valua�on Methods

Think about the types of businesses that would likely use each of the five inventory valua�on methods. Name one type of business that best matches each of the methods discussed.

Do you know what type of inventory valua�on method your company uses? Why do you think it chose to use that method?

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A common-sized balance sheet enables easier comparisons of smaller to larger companies. It also gives users a different perspec�ve for comparing financial results from period to period.

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 commi�ee may want to look at larger companies with similar business models to see how their sales and other benchmarks 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 informa�on, but anyone can generate this statement.

Crea�ng a common-sized balance sheet makes comparison easier no ma�er 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 perspec�ve by calcula�ng each number as a percentage. A common-sized balance sheet therefore presents the informa�on in two ways: both as dollar figures and as percentages. The Asset sec�on of the column shows all assets as a percentage of Total Assets. The Liabili�es and Equity sec�on of the column shows all Liabili�es and Equity as a percentage of Total Liabili�es and Equity.

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

Taking a quick look at Best General Company's common-sized balance sheet in Figure 2.15, the budget commi�ee can see what propor�on of the company's funds is allocated to what line items. For example, the largest por�on of current assets is held in inventories: 20.28%. Property, plant and equipment claim 45.64% of assets. Are these percentages common in the industry in which Best General Company operates?

The budget commi�ee could answer this ques�on by looking at industry averages and comparing its common-sized balance sheet to compe�tors. No ma�er how large a company is, the percentage alloca�ons 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 execu�ves analyze the numbers for three different and cri�cal purposes:

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This common-sized balance sheet was created using IBM's 2012 Balance Sheet.

1. To benchmark a company's financial posi�on to that of other similar companies 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 ques�ons 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 company has for each line item. Size of the company won't ma�er.

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 recognize 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 o�en prepared by showing the current year and then the last fiscal year as dollar amounts in the first two columns. Then the same informa�on 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.

Task Box 2.7: Crea�ng a Common-Sized Balance Sheet for IBM

To prepare a common-sized balance sheet, start an Excel worksheet. Copy the informa�on from the IBM balance sheet into the Excel worksheet.

Develop a formula to divide each line item in the Assets sec�on by Total Assets. Next, develop a formula to divide each line item in the Liabili�es and Equity sec�on by Total Liabili�es 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 (h�ps://ne.edgecastcdn.net/0004BA/constella�on/Ar�culate/OMM622/Financial_Decision_Making_Template.xlsx) .

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.

Figure 2.16: Common-sized balance sheet for IBM

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Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

Viewing this informa�on 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 execu�ves 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: Crea�ng a Common-Sized Balance Sheet for 3M

Use the template (h�ps://ne.edgecastcdn.net/0004BA/constella�on/Ar�culate/OMM622/Financial_Decision_Making_Template.xlsx) 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 be�er job of managing these five line items: IBM or 3M? Why do you think that is the case? Use informa�on from the Notes to the Financial Statements to support your argument.

Task Box 2.9: Analyzing Industry Compe�tors, Part A

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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 iden�fy 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 cri�cal areas below. You may want to use the Notes to the Financial Statements to help make your points.

1. Which company does a be�er job of managing its Inventory and why? 2. Which company does a be�er job of managing its Accounts Payable and why? 3. Which company does a be�er job of managing its Long-Term Debt and why? 4. Which company does a be�er job of managing its Re�rement 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 calcula�ons to complete your analysis.

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Summary and Resources

Chapter Summary

In this chapter, we examined the balance sheet, or statement of financial posi�on. This cri�cal statement provides a snapshot of a company's financial posi�on at one point in �me. It reveals what the company owns and owes as well as details regarding the claims shareholders have on the company's assets. The valua�on of inventory can be very different within each company. There are five common valua�on methods: LIFO (last item received is first item sold), FIFO (first item received is first item sold), average cost (averages costs of inventory no ma�er when the inventory is received), specific iden�fica�on (tracks the cost of each unique piece of inventory), and lower of cost or market (used for assets whose value can change drama�cally depending on market condi�ons). A common-sized balance sheet is a tool used to help managers and execu�ves compare compe�ng companies of varying size. Managers can use this tool for benchmarking, spo�ng 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 ac�vi�es along with the results of their compe�tors.

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 direc�on of the company's financial posi�on. Managers need to analyze each asset's propor�on of the total assets. Managers should ask whether the propor�ons 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 compe��ve within the industry? Managers must watch the expense of their liabili�es and whether the company is genera�ng enough cash to pay its bills, meet interest obliga�ons, and pay the principal due on each of its liabili�es. They should also watch closely the interest rates paid and whether those rates compare favorably to the current market interest rates. If not, refinancing may be needed.

Discussion Ques�ons

1. Why should managers compare the level of inventory from one year to the next? Why should managers compare inventory levels with their compe�tors? 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 pharmaceu�cals can become outdated quickly, should he

ques�on the use of LIFO rather than FIFO? Why or why not? 4. A finance manager reviews the short- and long-term liabili�es 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 h�p://www.investopedia.com/ar�cles/02/041702.asp (h�p://www.investopedia.com/ar�cles/02/041702.asp)

U.S. Department of Labor. (n.d.). What You Should Know About Your Re�rement Plan. Retrieved from h�p://www.dol.gov/ebsa/publica�ons/wyskapr.html (h�p://www.dol.gov/ebsa/publica�ons/wyskapr.html)

White, R. (2012, June 26). Is your defined-benefit pension plan safe? Investopedia. Retrieved from h�p://www.investopedia.com/ar�cles/re�rement/08/safe-db- plan.asp (h�p://www.investopedia.com/ar�cles/re�rement/08/safe-db-plan.asp)

Yahoo Finance Industry List (h�p://biz.yahoo.com/p/sum_conameu.html)

Key Terms

Click on each key term to see the defini�on.

account format (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

One type of format for a balance sheet. Assets are shown on the le� and Liabili�es and Equity are shown on the right.

accrual accoun�ng (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A method of accoun�ng in which expenses and revenues are shown in the appropriate month. Revenues 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 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Account that tracks payroll due to employees not yet paid.

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accumulated deprecia�on (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks the deprecia�on of an asset over the years the asset is owned.

Accumulated Other Comprehensive Income (Loss) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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 securi�es, and unrealized gains or loss on foreign currency exchanges or other foreign investments.

aging schedule (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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.

average cos�ng (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Debt the company is owed by its customers that it does not expect to collect from them.

carryforwards (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A deduc�on for losses that could not all be taken in the current year but can be taken in future years.

commitments (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Contractual agreements.

common-sized balance sheet (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Document that converts the financial results into percentages to make it easier to compare companies, no ma�er what their sizes.

con�ngencies (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Pending legal ma�ers.

credit (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A type of entry in an accoun�ng system. For some types of accounts it will increase its balance; for other types of accounts it will decrease its balance.

debit (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A type of entry in an accoun�ng system. For some types of accounts it will increase its balance; for other types of accounts it will decrease its balance.

deferred income (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks income received by the company, but not yet earned.

deferred taxes (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Taxes that are not paid immediately, but instead are paid at some point in the future. These can represent tax deduc�ons that could not be taken in the current tax year, but could be taken in the future.

FIFO (First In, First Out) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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An inventory valua�on 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 valua�on.

financial posi�on format (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A balance sheet format that is used interna�onally 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 addi�on of two lines that do not appear on the account or report formats: working capital and net assets.

goodwill (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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 company than its tangible assets were worth. O�en these intangible assets include things like customer base, desirable loca�ons, or popular technology, products, or services.

inventories (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Products or merchandise the company has on hand to sell to its customers.

LIFO (Last In, First Out) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An inventory valua�on 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 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A method of inventory cos�ng 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 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The date at which �me a financial instrument, such as a bond or cer�ficate of deposit, will cease to exist. The principal is repaid with interest on the maturity date.

opera�ng lease obliga�ons (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A type of lease for equipment, such as copiers, considered an asset to the company.

periodic inventory method (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A physical count of the inventory on hand. Depending on the type of business, this could be done daily, weekly, monthly, or yearly.

perpetual inventory method (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A method for coun�ng inventory as it is sold. Companies that use this method usually make changes to the inventory in stock at the cash register.

prepaid expenses (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A line item on the balance sheet that shows the net value of all the property, plants, and equipment a company owns.

report format (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

One type of balance sheet format. Assets are shown first, Liabili�es and Equity are shown below.