Financial Accounting Department of Accounting - Peder Fredslund Møller The balance sheet –...

Financial AccountingFinancial Accounting

Department of Accounting - Peder Fredslund Møller

The balance sheet – structure, purpose, basic concepts, methods of

appreciation• Which resources does a company recognize as assets?• What valuation does a company assign to these assets?• How does a company classify, or group, assets within the balance

sheet?• Which claims against a company’s assets appear on the balance sheet

as liabilities?• What valuations does a company use for these liabilities?• How does a company classify liabilities within the balance sheet?

Copyright 2000 by Harcourt Inc. All rights reserved.



Definitions

• DCAA, IAS(international) and CON(USA) – An asset:

• A resource

• that is controlled by the company

• that is a result of past events

• from which future economic benefits

are expected by a company



Economic Advantage

• A (service) potential, which directly or indirectly contributes to future positive payment effect for the company

– For example directly: Debt outstanding from sale of goods which will be paid =>future cash inflows

– For example indirectly: Future purchase of machines which reduces production costs, i.e. reduces future cash outflows

– For example indirectly : Purchase of machines which leads to production potential which again leads to increased sales, i.e. result in future cash inflows



Expectations

• It must be probable that the economic advantages, which a resource contains, will benefit the company in future accounting periods

• Probable is a valuation issue which depends on the information that are available at the time when the accounts are prepared

• See the American rule of thumb on the passive side in Stickney & Weil p. 52….probable = greater than 80 - 85% (internationally discussed)



Resource

• Physical substance is not decisive for whether an asset exists or not (but it is conductive!)

Patents and concessions can be assets, if they are expected to provide future earnings for a company and if they are controlled by a company.



Control• Control means that you have ”exclusive right” to the

advantage of the resource (public road is not an asset)• Legal ownership: often, but not decisive for whether an

asset exists or not

Leasing contracts that are drawn up so that they basically resemble a purchase agreement are treated as assets even though legal ownership remains with lessor:

leasing asset = right of use



Past transactions or exchange• Transaction: typically a purchase or production event, but also

discovery of e.g. minerals qualifies.

• Past: The balance sheet is a snapshot picture that shows the company’s resources and debt at a given point of time

• Transactions or events that are expected to occur in the future do not isolated produce existing assets.

• Example: the intent to buy inventory does not meet the definition of an asset.



The recognition criteria reliable value

• The purchase price or the value must be able to be measured with a high degree of precision.

• Estimates are often involved - it is not enough to solely disqualify an item from recognition.

• However, some times fair estimates cannot be made.



The recognition criteria reliable value

• Expected compensation expected to be received from a law suit for instance might meet the definition of an asset (and revenues) but it might fall on it not being possible to estimate the payments with a fairly degree of precision.

• The company might have paid expenses to build up a good reputation but the future economic advantages cannot be stated sufficiently reliably.



Accounting conventions filter out

• The conceptual frame work of IASB §91: In praxis contractual obligations, which are equivalent to assets

and which have not yet been met (e.g. the obligation to pay for goods ordered but not yet received), are usually not included as existing liabilities in the accounts.

Contractual obligations can however meet the definition of obligations, and if so and they have a net negative value, they are included as a net obligation, e.g. the net loss in relation to the obligation to buy oil is stated at a price that is higher than the estimated sales price of the company.



Valuation of assetsPurchase value

Cost price

Depreciated valueWritten down value

Replacement valueNet

realizable value

Present valueof cash flows.(utility value)

BOOKED VALUE

Written upvalue



Valuation of assetsGeneral rules concerning valuation:Operating activities related asset items: • Valued at the time of purchase at cost price,• and subsequently on the basis of cost price unless they have lowerrecovery value, which they then MUST written down at(recovery value = net value in terms of a sale or use of the asset, i.e. value at

”least worst option”).

For financial outstanding debts ”cost price” is perceived as present value of the promised payments, discounted the rate of interest that existed when outstanding debt arose (but companies often refrain from discounting if interest rate payments are not explicitly stated and the maturity period is short, i.e. debts are stated at nominal value)

• Fixed assets and inventory can be written up if they have higher recovery

value, inventory, however, max at replacement cost(this possibility, however, is not used much in praxis).



Valuation of assets (continued)

•“The trade portfolio” of securities and derivative financial instruments•Valued at market price (it is, however, unfortunately very unclear what “the trade portfolio” of assets includes)



Arguments in favor of cost valuation

• Necessity: Most often there is no obvious current value for real assets (in many cases an asset cannot be traded and if it can, purchase and sales prices are very different, very subjective and often far from value in use)

• Basic assumption: Cost price must reflect the owner’s expectation of possible earnings, and market forces implicate that only normal return from an investment can be expected.

• Intention: Companies shall repot at the time of the sale (and only there).



Provisions of law

• An operating activity is assumed to continue in the future, unless it is not/cannot be continued (going concern), DCAA § 13 =>the historical cost is assumed to represent a profitable investment)

• In the profit and loss account income is included as it is earned, DCAA § 49 (income is not recognized until at a ”decisive event confirms the profit”)



Provisions of law (continued..)

• Expenses in the profit and loss account are the costs that are directly associated with obtaining the revenues, DCAA § 29 (=matching: => profit is recognized by revenue recognition => costs are compiled until a sale occurs)



Definitions

• A liability item is a • present obligation of the company that has arisen

as a result of • past events and whose fulfillment is expected to

result in a • future outflow of the company’s resources



Definitions

• Obligation: A duty or responsibility to act or perform something in a specific way

• Typically legal obligation, but business standards, or the voluntary business practice of a company that will result in future payments may also meet the criterion for an obligation.



Definitions• Present:• In contrast to future. • E.g. a company decision by management to buy

assets in future is not a present obligation. • An obligation usually is not recognized until the

asset has been delivered or the company receives a pre payment from a customer.



Definitions

• Past event:• Debt resulting from previous transactions when a company

receives benefits or services and in return promises to perform something of value.

• E.g.: Borrowings result in an obligation to repay the loan.• E.g.: A company can also include the obligation to pay

discounts based on customers’ annual turnover as debt on the balance sheet. In this case the preceding sale is the transaction that causes the debt.



Definitions

• Future outflows of a company’s resources:• Typically an obligation to make a cash payment.• Could also be to transfer other assets e.g. when pre

payments from customers are received.



The recognition criterion reliable value

• Liabilities are recognized when it is probable that in the future outflow of a company’s resources will take place and the amount of money with which the obligation is settled can be stated reliably.

• Payment of damages expecting to result from an ongoing trial could e.g. meet the definition of a liability but it might fall on it not being possible to state the claim with acceptable certainty.

=> in that case the contingent liability should be disclosed in the notes, but in all other cases a provision must be made in the balance sheet.



Liability valuationOperating activity related liability items:• Amortized cost price (= nominal value if a company does not

do discounting)• Valuation is typically easier than for assets as most liability

items are made up of obligations to pay specific money amounts - but difficult/hard for provisions (they often involve a high degree of estimating which valuation of current value)

Liabilities in “the trade portfolio”• Market value

Classification: Short-term or long-term debt (1 year) and provisions (Note! EU-praxis differs/deviates from US-praxis)



Shareholders´ Equity

• Remember: Assets = Debt + Shareholders´ equity.

Shareholders´Equity is classified into• Subscribed Capital• Various capital reserves• Profit reservesMore details in chapter 12.

Copyright 2000 by Harcourt Inc. All rights reserved.

Financial Accounting Department of Accounting - Peder Fredslund Møller The balance sheet –...

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