A.1 Appendix:  A Quick Tour of the Balance Sheet

A.1:  Consolidated Balance Sheet (Example: Amazon, Jan 2011 10-K)

This statement provides the primary source of information relevant to assessing the capital resources that a company controls.   It shows the financial position -- assets, liabilities and stockholders' equity on a particular date.  The formal structure of the Balance sheet at a point in time is: 

Assets - Liabilities = Owners Equity

That is what resources are available less what obligations the entity has equals the owners’ residual claims.  That is, if you purchased this entity the balance sheet provides the set of resources you gain control over plus the set of obligations or liabilities that you have assumed.

The balance sheet results from classifying every transactions relative to the fundamental accounting equation.  That is, the balance sheet results from the following types of transactions: 

o   Assets increase, Assets decrease

o   Assets increase, Equities increase

o   Equities decrease, Equities increase

o   Equities decrease, Assets decrease

o   Assets and equities increase or decrease by the same amount

In each case the equality is maintained.  For example suppose Wal-Mart purchase inventory for cash to sell in their stores.  Inventory is an asset and so assets increase.  Cash is an asset that is decreased and thus the net effect is unchanged leaving the fundamental equation unchanged.  Other transactions may result in increasing the two sides of the above equation by the same amount.  For example, suppose Wal-Mart sell this inventory for cash at a higher price than what they paid for it.  Now the cash asset increases more than the inventory asset decreases which requires for equality to be restored by adding the difference (referred to as the profit) to the right hand side of the equation in retained earnings an owners’ equity account.

One could ask do any transactions exist that only have a single effect? 

The answer is no because the accounting equation is a binding constraint and therefore the accounting equation identifies the appropriate offset for every transaction.  In other words double entry accounting flows naturally from the accounting equation that defines the balance sheet.  For example, paying a cash dividend may appear to fall into a possible single effect category because cash is paid out.  So what is the offsetting entry?  The answer to this is that because cash is paid out to the owners this reduces owners’ equity and thus cash dividends reduce assets and reduce owners’ equity (retained earnings). 

Balance Sheet Classifications and Major Firm Decisions

In the balance sheet assets provide future services to the firm.  They are classified into Current and Non-Current Assets if their service potential is short term (either 1-year or one operating cycle if the latter is greater than 1-year).  The Operating cycle is defined as the time to purchase or manufacture inventory, sell the product and collect the cash.   The operating cycle is short for the case of perishables such as food, seafood, fruit and relatively short in consumer goods industries.  It is slower in capital goods industries and relatively long for products such as distilleries and wine.  As a result, in these industries the one operating period rule sometimes applies.

Non-current assets reflect investments the firm has made into capacity and related items so that their service potential to the firm extends over longer periods of time.   Similarly, Liabilities are classified into Current and Non-Current based upon the time of the obligation’s expected due date.  Obligations can arise from operations such as accounts payable, from investing activities and financing activities the entity is involved in.  Finally, the owners or stockholders’ equity part of the balance sheet results from transactions involving shareholders such as new equity financing or company purchases of their own stock (Treasury stock purchases) as well as activities not involving shareholders but the shareholders benefit from.  For example, income generating activities, foreign currency fluctuations, pension accounting and fair value accounting.  An example is provided below for Amazon.com.

Amazon present their balance sheet in a relatively simple form compared to most other companies.  They provide their additional details in separate support statements.  For example, suppose an analyst wanted to see what the above reported number for “Long Term Liabilities” $1561 (millions) consist of?

For Amazon this is in the support statement (“Other Long-Term Liabilities Summary (Detail) (USD $)”):

Further details are available about Amazon’s Long Term Debt including the weighted-average interest rate as follows:

Online, you can also drill down into Amazon’s lease obligations by selecting the statement “Long-Term Capital Lease Obligations (Detail) (USD $)”:

The Stockholders Equity is provided below to preserve links between the two balance sheets across time.

In a separate topic we will work through the details of the stockholders’ equity section of the balance sheet.  This is because this area is sufficiently complex that today it is expanded into the fourth primary statement referred to as the “Consolidated Statement of Stockholders’ Equity.”

Next, we consider some of the typical line items in a Consolidated Balance sheet. 

Elements of the Balance sheet

Current Assets

US GAAP requires listing in order of liquidity and it includes the following major categories:

Cash and Marketable Securities (Category:  Cash)

Cash and cash substitutes, relatively riskless and easily converted to cash.  Marketable securities are short term investments that are initially recorded at cost.  However, US GAAP (FAS 115) categorizes marketable securities into three categories; Trading, Available for Sale, Held to Maturity.  To categorize as “Held to Maturity” the firm must have ‘positive intent and ability’ to hold until maturity.  Marketable securities held for trading are common for financial institutions.  In addition, for all institutions there are some financial securities that are deemed to be Held-for-Trading irrespective of intent.  These are derivatives that do not qualify as a hedge under US GAAP. 

Finally, any security that is neither classified as “Trading” or “Held to Maturity,” are deemed to be “Available for Sale.”  The classification matters for how it is measured on the balance sheet relative to recognizing unrealized gains and losses.  In particular,

•       Held to maturity – These are measured on the balance sheet at amortized cost.

•       Trading securities – These securities are reported at fair (market) value with unrealized gains and losses reported in the accounting income statement (covered in a later topic).

•       Available for Sale – These securities are neither “Held-to-Maturity” or for “Trading.”  Available-for-Sale securities are reported at fair value with unrealized gains and losses reported in the Consolidated Statement of Stockholders’ Equity (covered in a later topic).

It is noted that accounting for financial assets reflects fair value accounting and is one of those rare examples of where the recognition of unrealized gains is permitted.  Of course the recognition of unrealized losses is common in both historical cost and fair value accounting.

Financial assets on today’s balance sheet can be very large.  The example below illustrates this for Apple (in millions):

The breakdown of this category for large firms is provided in their footnotes to the account:

The next set of account groupings fall into the category of working capital.  Working Capital measures the operating liquidity of a firm and results from managing a firm’s short term assets and liabilities that relate to the firm’s operations.  Major items include:

Accounts Receivable (Category:  Operating)

This records the outstanding balance from credit sales and is recorded at their net realizable value.  That is, an allowance is made for doubtful debts.

Again important details associated with the Accounts Receivable are provided in the footnotes to the accounts.

Inventory (Category:  Operating)

This records items that held for sale or used to manufacture products to be sold.  The measurement of inventory reflects the underlying cost flow assumption which under US GAAP can be FIFO (first-in, first-out), LIFO (last in, last out), weighted average cost or specific identification.  Under IFRS only FIFO the weighted average cost flow assumptions are permitted.  The cost flow assumption for accounting purposes can be different from the actual physical flow of inventory and in times of inflation the cost flow assumption makes a significant difference to net income measurement.  That is, LIFO reduces income but also reduces taxable income in times of inflation relative to FIFO.

Analysts look at the change in inventory over the period to check whether inventory is building up or running down.  When product is moving fast inventory declines as can be seen from Apple’s results below:

Prepaid Expenses (Category:  Operating)

Not all current assets are converted to cash.  Prepaid expenses represent one class that does not convert to cash but they do have service potential that will be consumed within the year.  Typically these are insurance, rent, property taxes and utilities.

Deferred Taxes (Category:  Operating)

This item can appear as a current asset in a balance sheet.  It arises because accounting net income and taxable income are different.  For example, in taxable income there can be effects from net loss carryovers from previous periods which are classified as assets when it is determined that there is a greater than 50% chance of being able to be used in future fiscal periods.   As a result, differences between accounting and taxable income can be classified as either “temporary” or “permanent.”  Deferred taxes arise from temporary differences in the recognition for taxable income and this can create either an asset or a liability on the balance sheet.

Deferred taxes in the “current” part of the balance sheet reconciles the differences for the current accounting period between the reported tax expense and the cash paid for taxes to the IRS. 

Apple Example:

Again it is in the footnotes to the accounts that spell out the differences as illustrated for Apple below.

Non-Current Assets

Property, Plant and Equipment (PPE) (Category:  Investing)

These items represent the firm’s capacity to provide service for more than one year.  These items are depreciated over time and management has much discretion with respect to their choice of depreciation methods.  Briefly the three major types are referred to as straight line, accelerated and units of production.

Noncurrent assets are cleverly defined as anything not classified as a current asset. The main line items in this section are long-term investments; property, plant, and equipment (PP&E); and goodwill and other intangible assets.

The relative size of PPE depends upon the firm’s business model and it is instructive to illustrate this for Apple versus Intel.  Intel produces chips and there products whereas Apple focuses upon interface and excels at interface with the human user.  Such differences will appear both in Item 1 of the 10-K as well as their respective balance sheets:

Example:  Apple versus Intel

The graph reveals the relative small size of PPE to other Balance Sheet items for Apple.  Now compare this to the large relative size of PPE for Intel.  This is consistent with its business model:

Leases (Category:  Investing)

Under both US GAAP and IFRS leases are recognized as an asset if the firm bears substantially all the risks and rewards of ownership of the leased property.  This is classified as a capital lease.  We will return to leases in more detail in the Liability side of the Balance Sheet.

Deferred Taxes (Category:  Operating)

This item can appear as a non-current asset in a balance sheet.  It arises from net loss carryovers which are classified as assets when it is determined that there is a greater than 50% chance of being able to be used in future fiscal periods.   Refer to the discussion in the Current section for additional information on this category.

Pensions (Category:  Operating)

Pension accounting will be discussed in more detail later in the Consolidated Stockholders’ Equity topic.

Long-Term Investments  (Category:  Investing)

These items represent investments that are expected to be held for longer terms than one year. These items will include a number of different measurement bases ranging from fair value to historical costs.  Additional details are provided in the notes to the financial statements.

Intangible Assets (Category:  Investing)

These items represent nonmonetary assets without physical substance.  To be recognized on the Balance sheet there should be probable future economic benefits and costs should be reliably measured.  Goodwill is only recognized in a business combination and research costs associated with Research and Development (R&D) are expensed for most industries. 

January 1, 2002 the Financial Accounting Standards Board (FASB) eliminated the “pooling method” of accounting which meant that goodwill and intangibles are no longer amortized.  Instead under fair value accounting they are placed on the Balance Sheet but subjected to annual tests for impairment. 

Impairment under US GAAP has a technical meaning.  It is the downward revaluation of a fixed asset below its historical cost and impairment write downs cannot be subsequently recovered via upward revaluation even if the asset has subsequently recovered in value.   This is a major current difference between US GAAP and IFRS.  IFRS permits recovery of prior impairments (up to the original historical cost) if the value has subsequently recovered.  It is noted that neither system allows unrealized gains to be recognized unlike the earlier cases that involved financial assets.

A Classic Example of Accounting for Goodwill

The worst takeover in US Corporate History was the Time Warner/AOL merger.  At the time of the merger, even though financial analysts made upbeat comments, technology had changed and the merger made little sense given that AOL’s user base relied entirely upon dial up web services.  Further, AOL had no ability to provide the new trends of delivery via cable and other high speed delivery methods because other entities controlled these outlets. However, at the time of the merger typical reporting was as illustrated below:

That’s AOL folks… 

 January 10, 2000: 5:26 p.m. ET

Internet leader and entertainment firm to join forces; new company worth $350B

By Staff Writer Tom Johnson 

NEW YORK (CNNfn) - In a stunning development, America Online Inc. announced plans to acquire Time Warner Inc. for roughly $182 billion in stock and debt Monday, creating a digital media powerhouse with the potential to reach every American in one form or another.

 With dominating positions in the music, publishing, news, entertainment, cable and Internet industries, the combined company, called AOL Time Warner, will boast unrivaled assets among other media and online companies.

 The merger, the largest deal in history, combines the nation’s top internet service provider with the world’s top media conglomerate. The deal also validates the Internet’s role as a leader in the new world economy, while redefining what the next generation of digital-based leaders will look like.

    "Together, they represent an unprecedented powerhouse,” said Scott Ehrens, a media analyst with Bear Stearns. "If their mantra is content, this alliance is unbeatable. Now they have this great platform they can cross-fertilize with content and redistribute.”

 Source:  CNN Money  

Two years later the new accounting standards required the impairment of goodwill which resulted in the largest write-down:

What AOL Time Warner's $54 Billion Loss Means

By Frank Pellegrini Thursday, Apr. 25, 2002

Sticking out of AOL Time Warner's rather humdrum earnings report Wednesday was a very gaudy number: A one-time loss of $54 billion. It's the largest spill of red ink, dollar for dollar, in U.S. corporate history and nearly two-thirds of the company's current stock-market value. (It's also, as a lot of news outlets have noted, more than the annual GDP of Ecuador, but that's hardly relevant here.) All for something called "goodwill impairment."

Source Time Business

Liabilities

Current Liabilities

This is the set of obligations that will fall due within one year or one operating cycle.  This provides the other side of the working capital or operating cycle.  The operating cycle is the time to purchase, manufacture or provide the inventory or service, sell the product or service for cash or on account.  Some major line items are:

Accounts Payable (Category:  Operating)

These items are short-term obligations arising from credit extended to a firm’s suppliers.  The length of time extended by suppliers typically represents the tradeoff between providing incentives for quick payments and disincentives (penalty interest) for slow payment.

Notes Payable (Category:  Operating and Financing)

These are short term promissory notes issued to suppliers and financial institutions. 

For example, Notes Payable is not a big deal to an Apple who is sitting on globules of cash.  However, notes payable is a big deal to a Coca-Cola who recently completed acquisitions that resulted from a major strategy shift.

Example:

Again as an analyst you must consult the footnotes to the Balance Sheet to get at the additional detail associated with specific balance sheet line items:

Current Maturities of Long-Term Debt (Category:  Financing)

These items are the long-term debt outstanding that falls due during the current year.  As a result, it includes the face value of debt that matures during the current year.

Accrued Liabilities (Category:  Operating)

This item results from accrual accounting.  These items arise from the recognition of expenses prior to the actual cash being paid.  The credit part of the entry creates an accrued liability.

Unearned Revenue or Deferred Credits (Category:  Operating)

This item results from accrual accounting.  It arises when a firm is paid in advance for services or product before delivery.  This is one of the most interesting areas of the balance sheet for an analyst to review.

Why?

First this is a nice liability to have!  It is “unearned revenue” that has an obligation to deliver services or products.   However, when delivered this becomes Sales Revenue.  Unearned revenue is typical in the technology sector because a product can be a bundle of goods and services.  From an analyst perspective when forecasting next quarter’s earnings and revenue large amounts of unearned revenue imply that a firm may be more likely to meet consensus forecasts because it has the additional flexibility of being able to convert its unearned into earned revenue. 

For example, a simple to understand “old economy” product such as produced by Coca Cola result in no unearned revenue.  But for the case of technology stocks such as Apple, Microsoft and Google unearned revenue may provide powerful signals to analysts.

For the case of Microsoft and Apple these very strong deferred revenue numbers provide each stock with a lot of flexibility for meeting quarterly revenues.  The efforts required to generate the initial sale have already been performed and to be recognized as accounting revenue the remaining services or product must be delivered.  That is, it does not require generating future sales. 

For both of these companies their subsequent 10-Q’s resulted in strong announced results:

Microsoft News Center

News Press Release

Microsoft Reports Record Revenue of $20.9 Billion in Second Quarter

Strong business demand and holiday sales drive record revenue and EPS.

REDMOND, Wash. — Jan. 19, 2012 — Microsoft Corp. today announced quarterly revenue of $20.89 billion for the quarter ended Dec. 31, 2011, a 5% increase from the prior year period. Operating income, net income, and diluted earnings per share for the quarter were $7.99 billion, $6.62 billion, and $0.78 per share, compared with $8.17 billion, $6.63 billion and $0.77 per share, respectively, in the prior year period. Prior year results include recognition of $224 million of deferred revenue related to the Office 2010 technology guarantee program.

Apple Press Information

Apple Reports First Quarter Results

Highest Quarterly Revenue and Earnings Ever

All-Time Record iPhone, iPad and Mac Sales

CUPERTINO, California—January 24, 2012—Apple® today announced financial results for its fiscal 2012 first quarter which spanned 14 weeks and ended December 31, 2011. The Company posted record quarterly revenue of $46.33 billion and record quarterly net profit of $13.06 billion, or $13.87 per diluted share. These results compare to revenue of $26.74 billion and net quarterly profit of $6 billion, or $6.43 per diluted share, in the year-ago quarter. Gross margin was 44.7 percent compared to 38.5 percent in the year-ago quarter. International sales accounted for 58 percent of the quarter’s revenue.

This can be contrasted to Google.  Their quarterly results were not so strong relative to analyst forecasts:

Bloomberg

Google Quarterly Earnings Miss Hands 99% Losses to Bullish Options Traders

 By Nikolaj Gammeltoft and Jeff Kearns - Jan 20, 2012 4:32 PM ET

Google Inc. (GOOG) options traders who made bullish bets before the company’s quarterly report yesterday suffered the U.S. derivatives market’s biggest losses today after the search-engine operator missed analysts’ projections.

Google calls posted 10 of the 12 biggest declines among all contracts traded on U.S. exchanges as of 4 p.m. New York time, with each tumbling more than 99 percent, according to data compiled by Bloomberg. Shares of the Mountain View, California- based company tumbled 8.4 percent, the most since December 2008. January $595 calls, which expire today, retreated 99.98 percent for the biggest drop.

It is interesting to contrast Google’s unearned revenues for the previous quarter.  Google’s deferred revenues are substantially lower than for an Apple or a Microsoft and thus Google has less flexibility to meet analyst expectations:

Missing the sell side analyst forecasts is costly not only to option traders betting on Google but to the stock in general.

 Deferred Income Taxes (Category:  Operating)

This item results from temporary differences in the recognition of revenue and expense for taxable income relative to reported income.  The item is governed by FAS 109 and it arises from differences when calculating taxable and accounting income.  It is noted that no legal obligation exists for deferred taxes but the items included in deferred taxes are only those items which are judged to give rise to temporary differences between taxable and accounting incomes.  Permanent differences are not included in Deferred Taxes.

Long Term Debt (Category:  Financing)

These items are all financial obligations with maturities in excess of one year.  Long term debt is the residual portion of long term debt that does not fall due within the next year.  This latter debt is labeled:

                Current Maturities of Long-Term Debt

The balance sheet numbers represent aggregate numbers and companies are required to provide additional financing details in the footnotes to the consolidated balance sheet (plus other places) as illustrated for Coca-Cola below:

Capital Lease Obligations (Category:  Financing)

These items arise from the credit entry arising under both US GAAP and IFRS when leases are recognized as an asset.  That is, if the firm bears substantially all the risks and rewards of ownership of the leased property this is classified as a capital lease and both an asset and liability are recorded on the balance sheet.  A lease liability and lease asset is recognized if any one of four conditions are met:

•       Lease transfers ownership, contains a “bargain” purchase option, lease life >= 75% life of asset, lease payments have a PV of 90% or more of the fair property value

Otherwise it is treated as an operating lease which has no balance sheet liability implications.  However, US GAAP does require footnote disclosure of leases and so an analyst can estimate what the Asset and Liability implications would be if it was treated as a Capital Lease.  This is important if comparing three types of firms.  Firm A owns capacity, Firm B leases the same capacity structured as an operating lease and Firm C leases the same capacity structured as a capital lease.  Economically Firms A, B, and C all have the same capacity but the accounting is very different for Firm B versus A and C.  For the case of B no capacity is recorded on the balance sheet whereas capacity is recorded for A and B.  As a result, analysts by referring to the footnote information reassess B’s operating lease as a capital lease to ensure compatibility if the lease is significant.

For example, Krispy Kreme current footnote disclosure is as follows which classifies leases into Capital and Operating:

Postretirement Benefits Other Than Pensions (PRB) (Category:  Operating)

There are two general types of pensions, Defined Benefits and Defined Contributions.  The latter is common today and has straightforward accounting implications (Debit Pension Expense and Credit  Cash or Payables). 

For the case of defined benefits things are not straightforward.  SFAS 158 (US GAAP) 2006 extended the reporting of defined benefit plans to communicating the funded status of defined benefit pension plans as opposed to a detailed pension footnotes.   That is, under SFAS 158, company “defined benefit” pension plans must recognize the difference between the projected $ benefit obligation and the fair value of the plan’s assets as either an asset or a liability. 

Old economy companies can have significant defined benefit obligations.  For example, DuPont the oldest company in the Dow Jones 30 stocks reports as follows as “Other Accrued Liabilities:

And further as “Other Liabilities”:

That is, significant defined benefit obligations exist that are lumped into the above “Other” categories on the Balance Sheet.   It is interesting to observe as a side note that DuPont also include their Deferred Revenues in Other Accrued Liabilities.

Commitments and Contingencies (Category:  Operating)

This line item can appear on a balance sheet without an amount beside.  It is itemized to direct a reader’s attention to the disclosures included in the notes to the financial statements.  Items include non-cancellable leases or other non-cancellable contracts which are disclosed even if no amount is due at the time of the Balance Sheet.

For example, consider the following for Krispy Kreme

Commitments and contingencies is listed with a blank beside it.  However, in the footnote information the following additional information is disclosed:

The Company also is engaged in various legal proceedings arising in the normal course of business. The Company maintains customary insurance policies against certain kinds of such claims and suits, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts.

Non-Controlling Interests (Category:  Financing)

This arises when the parent controls less than 100% of the subsidiary and it gives rise to a line item now described as “Non-controlling Interest.”  This represents a name change from the traditional label “Minority Interest” resulting from FAS 160 to emphasize a parent’s substantive control over a subsidiary rather than a simple ownership percentage to better reflect the underlying economic and accounting concepts.

Finally we present a summary of Stockholders’ Equity accounts below but return to these items in more detail in the section on the Consolidated Statement of Stockholders’ Equity.”

Stockholders’ Equity

The residual ownership rights in the company are presented in the this last section of the Balance sheet.  This represents the residual claims against the Assets net of Liabilities.  These residual owners bear the risks and rewards of from the firm. 

Common Stock (Category:  Financing)

The amount listed here is based upon the par or partly paid value of the shares issued.  This usually bears no relationship to the market value of the stock as it is based upon the legal par value.

Additional Paid-In Capital (Category:  Financing)

The amount listed here measures the amount by which the original sales price of the shares exceeded the par amount.

Retained Earnings (Category:  Operating)

This account contains the record of cumulative earnings from the firm since its inception net of dividends paid.  

Accumulated Other Comprehensive Income (Category:  Operating)

This amount comes from the Statement of Stockholders’ Equity.  It largely includes the results from four items:

Unrealized gains and losses in the market value of investments for-sale securities.

Excess of additional pension liability over unrecognized prior service cost

Gains and losses from derivatives

Foreign currency translations

Other Equity Accounts (Category:  Financing)

This can contain preferred stockholder claims which are usually paid a fixed dividend relative to some face or par amount.