CFA Level 1 (2009) - 3

Study Session 8

Cross-Referelll:e to eFA Institute Assigned Reading #33 - Understanding the Balance Sheet

increases by the amount of (he paymcnt. At the cnd of threc months, one-quarter of thc prepaid rcnt has heen used. Itt this poil1l, the firl1l l1lay recogniz.l' $100,000 of renl eXpl'llSe in its income SLltcllll'nt and rcducc .ISSCIS (!)rqnid relll) by SI 00,000 {O

$500,000.

Current Liabilities

Currem liabilities are obligations that will be satisfied within one ye:lI" or operating cyell:, \Vh ichever is greater.

Accounts payable (trade payables) arc amounts owcd to suppliers for goods or services purchased on credit.

Notes payable arc obligations in rhe form of promissory notes owed to creditors. Notes payable can also be included in noncurrent liabilities, if their maturities :tlT gre;ltlT 1han

(lilt' vear.

The current portion of long-term debt is the principal portion of dl'bt due within one year or the firm's operating cycle, whichever is greater.

Taxes payable are current taxes that have been recognized in the income statement bur have nor yet been paid.

Accrued liabilities (accrued expenses) are expenses that have been recognized in the income statement bur arc not yet contractually due. Accrued expenses result from the accrual method of accounting, under which expenses are recognized as incurred. For example, consider a firl1l that is required to make annual year-end interest payments of $100,000 on an outstanding b:lnk loan. At the end of March, the firm would recognize one-quarrer ($25,000) of the toLd imerest expense in its income statement and an accrued liability would he increased by the same amount, even though the liability is not actually due until the end of the year.

Unearned revenue (unearned income) is cash collected in advance of providing goods and services. For example, a magazine publisher receives subscription payments in advance of delivery. When payment is received, both assets (cash) and liabilities (unearned revenue) increase by the same amount. As the magazines are delivered, the publisher recognizes revenue in the income statement and the liability is reduced.

Tangible Assets

Long-term assets with physical substance are known as tangible assets. Tangible assets, such as plallt, equipment, and natural resources, are reporred on the balance sheer at historical cost less accumulated depreciation or depletion. l-listorical cost includes the original cost of the asset plus aJl costs necessary to get the asset ready for use (e.g., freight and installation).

Land is also a tangible asset that is reponed at hisrorical cost. However, land is not depreciated.

Study Se~sioll 8

Cross-Rderencc LO eFA Institutc Assigned Reading #33 - Understanding thc Balance Sheet

Tangiblc assets not used in the opnations of the firm should be classified as invcstl11el1l assets.

In tangi blc Assets

lntangible assets arc long-term assets that hck physical substance. Financial sl'curitics are not considered illlangilJIe assets. The value of an ielmtijiable ill/{lilgible IIHct is hased on the rights or privileges conveyed to its owner over a finite period. Accordingly, the cost of an identifiable intangible asset is amonized over its llseful life. Examples of identifiable intangihles include patents, trademarks, and copyrights. Note, however, that the value of internally produced intangible assets may not be recorded on the balance sheet.

An intangible asset that is unitimtijia!J!c cannot he purchased separately and may have an infinite life. llllJngiblc ;lssetS with inJlnile lives Jre not Jll1onized. Out arc tested for impairment at kast anllllall\,. The hestcxaml'!c of an uniclenliliJble inlJngiLJIc Jsst't is goodwill.

lntangible assets that arc purchased are reponed on the balance sheet at historical cost less accumulated amortization. Except for certain legal costs, il1langible assets that arc created il1lernally, including research and devclopmelll costs, are expensed as

incurred under U.S. CAAP. Under IFRS, a firm must identify the research stage and lhe development stage. Accordingly, the firm must expense costs during the research stage hut can capitalize costs during the developmelll stage.

All of the following should he expensed as incurred:

Start-up and training costs.

Administrative overhead.

Advertising and promotion.

•Relocation and reorganization costs. Termination COSts.

Some analysts completely eliminate intangible assets, particularly unidentifiable intangibles, fat analytical purposes. Analysts should, however, consider the value to the f1rm of each intangible asset before making any adjustmel1ts.

Goodwill is the excess of purchase price over the fair value of the identifiable assets

and liabilities acguired in a business acguisition. Let's look at an example of calculating goodwill.

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet.

IExample: Goodwill

Wood Corporation paid $600 million for the outstanding stock of Pine Corporation. At the acquisition date, Pinc rcported the following condensed balance shect.

Pine Corporation - Condensed Balance Sheet

The fair value of the plant and equipment was $120 million more than its recorded book value. The fair values of all other identifiable assets and liabilities were equal to their recorded book values. Calculate the amount of goodwill Wood should report on its consolidated balance sheet.

Answer:

Goodwill is equal to the excess of purchase price over the fair value of identifiable assets and liabilities acquired. The plant and equipment was "written-up" by $120 million to reAect fair value. The goodwill reported on Pine's balance sheet is an unidentifiable asset and is thus ignored in the calculation of Wood's goodwill.

Accounting goodwill should not bc confused with cconomic goodwill. Economic goodwill derives from the expected future performance of the firm, whilc accounting goodwill is the result of past acquisitions.

Goodwill is created in a purchase acquisition. Internally generated goodwill is expensed as incurred. Goodwill is not amortized but must be tested for impairmcnt at least annually. If impaired, goodwill is reduccd and a loss is recognizcd in the income statement. The impairment loss does not affcct cash flow. As long as goodwill is not impaired, it can remain on the balance sheet indefinitely.

Study SCSSill/l 8

Cross-Reference to CFA Institute Assigned Reading tf33 - Understanding the Balance Sheet

Since ljoodwill is not an\OnizeJ, firms can nunipul~lle Ih·t income upward by allocating more of the acquisition price 10 gnndwill and less ro the idemifiablc assets. The result is less dcpreciation and an1lJrti:t.~lti[)nexpense, resulting in highl'1' net income.

When computing ratios, alLllysts should eliminate goodwill from the balance sheer and goodwill impairment charges from the incomc st~\lcmcm fll!' comparability. Also, analysts should cvaluate futllre aClluisitinns in tClms of tlll' priu: paid reLlliv<: to the earning power of the acquired assets.

LOS .D.r: Discuss off-balance-sheet disclosures.

Till: financial stJ.tel11e!H fl)()tnotes should disclose inl(1rnJ:ltion abolH the I1rm's:

Accouming policies, including revenue recognition, other accou/lting I11cthods, alld judgmcn ts uSl'd.

Estimation of unccrl:limy, including key assul11ptions that POSl' a signdiclI1t risk.

Debt agrecmen t terms.

Leascs and off-balance-sheet flnancing.

Business segmelHs.

CO!ltingelH asscts and liahilities.

Pension plans.

The footnotcs should include a dcscription of the 111'111 and its legal identification details.

LOS 33.g: Demonstrate the appropriate classifications and related accounting treatments for marketable and non-marketable financial instruments held as assets or owed by the company as liabilities.

Financial instruments can be found on both the asset side and liability side of the balance sheet. Financial assets include invcsrmellt securities (stocks and bonds), derivatives, loans, ~1I1d receivables. Financial liabilities include derivatives, notes payable, and bonds payable.

Some financial assets and liabilities are reponed on rhe balance sheet at fair value, while others are reported at cost or present value. Reporting assets and liabilities at fair value is known as marking-ta-market. Certain marketable investmenr securities and derivatives (hath assets and liabilities) are subject to mark-to-market adjustments,

Professor's Note: The Financial Accounting Standards Board recently issued SF-AS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities." This new standard extmds the ability to report almost all jinancird assets and liabilities at fair value ifa firm chooses to do so,

Marketable investment securities arc classified as either held-to-maturity, trading, or

avail able-far-sal e.

Study Session 8

Cross-Reference to erA Institute Assigned Reading ll.n - Understanding the Balance Sheet

Held-to-maturity securities are debr securities alquircd with the intent r1l;H they will be held to maturity. Held-to-maturity securilies arc reported on Ihe balance sheer at :ln1olTizcd cos!. Amortizcd cost is equal to the face (par) valuc less an)' un:lIl1OrI i'led discoullt or plus any unamortized premium. Subsequent changes in market value :IIT ignored.

Trading securities arc debt and equity securities acquired wilh rhe inrelll to pro/It over the near term. Trading sccurities are reported on rhe balance sheet at fair value. Unreali"ed gains and losses, rhat is, changes in marker value before the securitics are sold, 3re reported in the income st3ternent.

Available-for-sale securities arc debt 3nd equity seeuril ies that are not expeerel! to be hdd to marurity or tr3ded in the ncar term. Like trading securities, available-for-

sale securities arc reported on the balance sheet at flir v3111e. However, any unrealized gains and losses are not recognized in the income starement but arc reported in other ulillprehensi\'t' inCOllll' :IS a parr of stockholders' l'qllin·.

Dividcnd and interest income and realized gains and losses (auual gains or losses when the securities arc sold) arc recognized in the income statement for all three c1assific3tions of securiries.

Figure 4 summarizes the different classifications or inve.slI11t'nt securities.

Figure 4: Summary of Investment Security Classifications

Example: Classification of investment securities

Triple D Corporation purchased a 6% bond, at par, for $1,000,000 ar the beginning of the yeaL Interest rates have recently increased and the market value of the bond declined $20,000. Determine the bond's effect On Triple D's financial statements under each classification of securities.

Sludy SeSSiOIl 8

Cross-Reference to crA Institurc Assigned Reading #33 ~ Understanding the Balance Sheet

Answer:

If the bond is classified as a held-ta-maturity security, the bond is reponed on the balance sheet at $1,000,000. Interest income 0['$60,000 [$1,000,000 x G%] IS reponcd in the income statement.

If the bond is classified as a trading security, the bond is reponed on the balance sheet at $980,000. The $20,000 unrealized loss and $60,000 of interest income are both recognized in the income statement.

H'the bond is classified as an a1Jailable-jor-sale security, the bond is reponed on the balance sheet at $980,000. Interest income of $60,000 is recognized in the income statement. The $20,000 unrealized loss is not recognized in the income statemenr. Rather, ir is reponed as a change in srockholders' equity.

Most financial liabilities, sueh as bonds and notes payable, arc reported at tlleir amortized cost. Derivatives, as wcll as non-derivative financial instruments with exposures hedged by derivatives, arc reported at fair value. Financial liabilities classified as held-far-trading, such as a short position in a stock taken to earn a ncar-term profil, :ue also reponed at fair value.

-~------~---_._----------~

lOS .1,).h: List and c\plain the components of owners' equity.

Owners' c<Iuity is the residual interest in assets dlat remains afrer subtracting an entity's liabilities. The owners' equity section of the balance sheet includes col1tributed capital, any minority (nonconrrolling) interest, retained earnings, treasury stock, and accumulated other comprehensive income.

Contributed capital is the total amount paid in by the common and preferred shareholders. Preferred shareholders have certain rights and privileges not possessed by the common shareholders. For example, preferred shareholders arc paid dividends at a specified rate, usually expressed as a percel1tage of their par values, and have priority over the claims of the common shareholders in the event of liquidation.

The par value of common stock and preferred srock is a "stated" or "legal" value. Par value has no relationship to fair value. Some common shares are even issued without a par value. When par value exists, it is reported separately in stockholders' equity.

Also disclosed is the number of common shares that are authorized, issued, and outstanding. Authorized shares arc the number of shares that may be sold under the firm's articles of incorporation. Issued shares are the number of shares that have acrually been sold to shareholders. The number of outstanding shares is equal to the issued shares less shares that have been reacquired by the firm (i.e., treasury srock).

Minority interest (noncontrolling interest) is the minority shareholders' pro-rata share of the net assets (equity) of a subsidiary that is not wholly owned by the parent.

Srudy Sl:ssion 8

Cross-Refl;rence ro CFA Insrirure Assigned Reading #33 - Undersranding rhe Balance Sheer

Retained earnings are lhe undistributed earnings (net income) of the firm since inception, the cumulative l:arnings thar have not been paid out (() shareholdns as dividends.

Treasury srock is stock that has been reacquired by the issuing f1rm but not ycr retired. Treasury srock reduces stockholders' equity. It docs not represent an investIllent in the firm. Treasury srock has no voting rights and docs not receive dividends.

Accumulated other comprehensive income includes all changes in stockholders' equity except for transactions recognized in the income statement (net income) and transactions with shareholders, such as issuing srock, reacquiring stock, and paying dividends.

As discussed in the topic review on understanding the income statement, comprehensive income aggregates net incoml: and cenain special rransactions that ;1["e not reponed in the income statemenr hut that affCct stockholders' equit),. These special transactions comprise what is known as "mher comprehensive income." (:omprehcll.sivc income is equal ro ncr income plus other comprehensive income.

Proftssor's Note: It is easy to confuse the two terms "comprehensiue income" and '~laumuLtltedother comprehCllsiue income." Cumprehnzsiue income is tLll illcome meawre over a period o/time. It iI/eludes net illrome and other comprehensiue income fOr the period. AccumuLated other comprehensiue income does not include net income but is tI compollent u/stockhoLders' eqlli~), at tI point in time.

Under U.S. GAAP, the firm can repon comprehensive income in the income statement (below net income), in a separate statcment of comprehensive income, or in the statement of changes in stockholders' equity. Firms are not required ro report comprehensive income under IFRS.

LOS 53.i: Interpret balance sheets, common-size balance sheets, the statement of ch;Jnges in equity, and commonly used balance sheet ratios.

The statement of changes in stockholders' equity summarizes all transactions that increase or decrease the equity accounrs for the period. The statemenr includes transactions with shareholders, and a reconciliation of the beginning and ending balance of each equity account, including capital srock, additional paid-in-capital, retained earnings, and accumulated other comprehensive income. In addition, the components of accumulated other comprehensive income are disclosed (i.e., unrealized gains and losses from available-for-sale securities, cash flow hedging derivatives, foreign currency translation, and adjustments for minimum pension liability).

A statement of changes in stockholders' equity is illustrated in Figure 5.

Study Session H

CrossReference to CIA Institute Assigned Reading #33 - Understanding the Balance Sheet

Figure 5: Sample Statement of Changes in Stockholders' Equity

Common-Size Balance Sheets

As with the income statement, common-size balance sheets and rarios can facilitare analysis of a firm,

A common-size balance sheet expresses each balance sheer account as a percentage of total assers, This formar is known as Ilertical common-size analy.ris and allows the analyst

Commonly Used Balance Sheet Ratios

Liquidity rarios and solvency rarios are considered pure balance sheer ratios since both the nUl11craror and denominator are from the balance sheet. Liquidity ratios measure the hrm's abiliry to satisfy shon-term obligations when due. Solvency ratios measure the (Irm's ability to satisfY long-term obligations.

Liquidity ratios

The current ratio is the best known measure of liquidiry.

. currenI' assets current ratIO = ~-~~-~~-

current liabilities

Study Session ~

Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet

A current ratio of less than olle means that the I-irlll has negative workin[', capital and

may be eICillg a liquidity Lrisis. Working capital is1elJual to current assets minus current liabiliti<.:s.

The quiek ratio (acid tesl ratio) is a more conservative measure of liquidity because it excludes inventories and less liquiJ current asscts from the numerator.

The cash ratio is the most conservative measure of liquidity.

. cash -+ marketable securities cash r~lUo =

curreJ1[ liabilities

The Iligllt'r the liquidin' ratios, the more likely the firm will be able to pay its short-tlTll1 bills whell they are due. T'he ratios differ only in the assumed liquiJity of the currelll assets.

Solvency ratios

The following ratios measure hnancial risk and leverage. With all four ratios, the higher the ratio, the greater the leverage and the greater the risk.

The long-term debt-to-equity ratio measures long-term financing sources relative to the equity base.

tot~lliong-termdebt long-tum deht-lO-equity = .

total equity

The debt-to-equity ratio measures total debt relative to the equity base.

total debt debt-to-equity = .

total equity

The total debt ratio measures the extent to which assets arc flnanced by creditors.

. total debt total debt rauo = -----

total assets

The flnancial leverage ratio is a variation of the debt-to-equity ratio that is used as a component of the DuPont model.

total assets

fInancial leverage

total equity

Slud y Session 8

Cross-Reference to Cf;i\ Institute Assigned Reading #33 - Understanding the Balance Sheet

Usejitlllcss alld limitati01lS of I"fltio fl1lt1lysis

Even in forw~lrd-Iookillg"d"hcicnt markels" (whl'le securities prices rdlecr all available inI(Jrmation), flnancial ratios hased on backward-looking data provide useful information to analysts. Specifically, ratios provide the following:

Insights inro the flnanClal relationships that arc useful in forecasting future earnings and cash 1I0ws.

• Inforntation about thc financial AexibiJity of rhe firm.

•A means of evaluating n1Jnagemcnt's performance.

Financial ratios are nO[ without limitations:

•Ratios are not useful when viewed in isolation.

Comparisons with other companies are made more difficult because of different accou n ting methods. Some of the more com mon differences include in ven tory methods U;II'Oand LIFO), depreciation Illerhods (accelerated and straight-line). and lease auoullling (capital and operating).

•There may be difficulty in locating cOlllparable ratios when analyzing comp;lJlics that operate in mulriple industries.

•Conclusions cannot be made from viewing one set of ratios. Ratios must be viewed relarive to one another over rime, between companies or relative [() benchmark values.

]udgl1lenr is rel]nired. Determining the target or comp;1rison value for a ratio is difficult and may acrually be some range of acceptable values rather than a single target value.