Balance Sheet Analysis Part 1: Assets

  1. INTRODUCTION

The balance sheet shows the ending balances of a company’s asset, liabilities, and equity accounts at a specific time.  For example, the balance sheet may be as of calendar year-end, December 31, and will show the ending balances of those accounts as of that date.  The balance sheet must balance per the accounting equation:  Assets = Liabilities + Shareholder’s Equity.

The presentation of the typical balance sheet begins with a presentation of a company’s assets.  Assets are resources of the company which are expected to provide future economic benefits to the company.  The balance sheet further separates assets into current assets and noncurrent (long-term assets).  Current assets are those assets whose economic benefits are expected to be fully realized within one year from the balance sheet date (or within the company’s operating cycle).  Noncurrent assets are those assets with expected economic benefits in excess of one year.

  1. CURRENT ASSETS

2.1.  Cash and Equivalents

The first item of monetary value on the balance sheet is cash and equivalents.  This category includes cash balances at financial institutions and highly liquid, short-term financial securities.  Because of the short time to maturity for such financial securities, the value of these securities should not deviate materially from their cash value due to interest rate fluctuations.  Such securities are thus considered equivalent to cash.

Investors, however, should still read the relevant footnote disclosures to understand the securities which the companies consider as cash equivalents.  For example, during the financial crisis many companies had to recognize losses on auction-rate securities, despite the securities being classified as cash-equivalentsi.

2.2.  Receivables

2.2.1.  Accounts Receivable

Often a company will sell a good or service and at the time of sale receive from the customer a promise of future payment.  When such a transaction occurs, the selling firm recognizes the sale and increases an asset account known as accounts receivable.

Under both U.S. GAAP and IFRS, accounts receivable must be recorded at net realizable value, meaning the company must estimate the amount of uncollectible receivables.  The company established a contra-account to accounts receivable, allowance for bad debts, and will adjust this account accordingly in each accounting period.  When a specific receivable is considered uncollectible and must be “written off”, the company will debit the allowance account and credit the specific receivable.  The allowance account, in other words, is a “reserve” for future uncollectible receivables.

2.2.2.  Trade Notes Receivable

A seller may extent longer-term credit to the buyer in the form of a note (a formal financing agreement) which entitles the seller to interest over the term of the agreement.  When such an arrangement exists, the seller recognizes the sale and records an offsetting increase to trade notes receivable.  Like accounts receivable, companies must establish an allowance for uncollectible notes.  With trade notes receivable, the company will record periodic interest income and appropriate reductions to trade notes receivable.

2.2.3.  Receivables Securitization

Many companies regularly sell or borrow against their trade receivables. A simple sale of receivables at a discount to a bank or commercial finance company is known as factoring.  A company, however, may elect to retain ownership of the trade receivables and instead borrow against them.  Current accounting guidelines (both U.S. GAAP and IFRS) distinguish between a sale and borrowing based on whether the transferor has surrendered control over the receivables.  If control has been surrendered, the receivables transfer can be treated as a sale, and any gain or loss must be recognized in earnings.  If control has not been surrendered, the transaction is accounted for as a collateralized borrowing, and the company must record a liability for the amount of the borrowing.

Companies may also engage in a securitization of its receivables.  The securitization process begins when the company forms a special purpose entity (SPE), which is an entity (trust or corporation) that is legally distinct from the company and formed for the sole purpose of the securitization transaction.  The SPE then issues debt securities, using the receivables as collateral, and the proceeds from the issuance of these securities are then remitted to the transferor company.   The company, however, must consolidate the SPE if the company retains any involvement or risk in the receivables.

2.3.  Inventories

2.3.1.  Inventory Cost Flow Assumptions

Inventories are goods that a company holds to sell to customers as part of the company’s normal business operations.  Companies often purchase the same inventory item at different prices.  Thus, companies must make an assumption, for accounting purposes, of which items are being sold.  Under current U.S. GAAP, companies can choose among three methods for allocating inventory costs to costs of goods sold:  weighted-average; first-in, first-out (FIFO); or last-in, first-out (LIFO)ii.  Under IFRS, however, only the weighted-average of FIFO methods are allowed; the LIFO method is not permitted under IFRS.

Under the weighted-average method, costs of goods sold for a period is merely the weighted-average of the cost of goods available for sale (beginning inventory plus inventory purchases) applied to the units sold during a period.  A company would calculate the average unit cost by dividing the cost of goods available for sale by the number of units available for sale.

The FIFO method assumes that the oldest units purchased are the first units sold.  Companies using this method determine cost of goods sold by taking from older inventory “layers”.  During periods of rising inventory costs, FIFO firms are likely to show lower cost of goods sold (reflecting the older, lower costs) and higher profits than those firms using other methods.  The converse is true when inventory costs are falling.  During periods of rising prices, FIFO firms thus have “phantom profits”, meaning that a portion of profits is a holding gain on the inventory.  Given the moderate rates of inflation experienced by the U.S. in the last several decades, phantom profits are no longer a persistent issue.  However, some countries outside the U.S. experience much higher rates of inflation, and investors should be aware of the possibility of skewed profits of companies operating in such countries.  Ending inventory balances for FIFO firms, however, more closely approximate replacement costs as they represent the most recent inventory purchases.

The LIFO method assumes that the most recently purchased units are the first units sold.  During periods of changing inventory prices, LIFO cost of goods sold will more closely approximate current replacement cost.  However, ending inventory values on the balance sheet will likely be understated or overstated under LIFO accounting, because the method leaves older costs in inventory.  Companies which use LIFO accounting must use LIFO accounting for tax purposes.

Regardless of the inventory valuation method used, companies must value inventory at the lower of cost or market.  If the fair market value of the inventory is less than its carrying amount, the company must recognize the impairment on the income statement.  For some inventory-intensive companies, such as retailers, inventory impairments may be an ongoing charge.  Under IFRS, companies can reverse (“write-up) inventory impairments; however, under U.S. GAAP, impairments are permanent and can thus understate inventory replacement costs when fair value increases.

2.3.2.  Special Considerations for LIFO Accounting

A LIFO firm will have a buildup of inventory “LIFO layers” when the firm purchases more inventory than it sells in a period.  If the company sells these layers in a subsequent period (known as a LIFO liquidation) – cost of goods sold exceeds inventory purchases in the period – the company will likely report skewed profits in the reporting period as the company is matching current sales with older inventory costs.

U.S. GAAP requires companies to disclose the difference between inventory valued under FIFO and inventory valued under LIFO.  The difference in inventory values between the two methods is known as the LIFO reserve.  Investors can use this disclosure to adjust inventory values to more closely approximate replacement costs.  I discuss LIFO adjustments in a subsequent article.

2.3.3.  Inventory Costing for Manufacturing Companies

Manufactures will own inventory at various stages of production.  The three categories of inventory for manufacturers are: raw materials, work-in-process, and finished goods.  Manufacturers must allocate into inventory any costs (labor and overhead) which can be attributed to production.  Thus, a unique feature of manufacturing firms is that many costs which would be accounted for as direct expenses on the income statement are “capitalized” into inventory and will not be expensed until the products are sold (as cost of goods sold).  Investors should be aware of the financial statements impact of manufacturers’ inventory costing: when physical inventory is rising, more costs are absorbed into inventory and income will be higher; when physical inventory is decreasing, the company recognizes previous costs capitalized into inventory and thus income will be lower.

  1. LONG-LIVED ASSETS

Long-term assets are those resources of the company which are expected to provide economic benefits beyond one period (one year or the company’s operating cycle).  Long-term assets can be either tangible assets such as property, plant and equipment, or intangible assets such patents, trademarks, copyrights, or goodwill.  Accounting rules for long-term assets requires companies to make determinations regarding capitalization (which costs to include in the asset’s carrying value), allocation (how to recognize the asset’s cost as an expense), and impairment (how and when to recognize a deterioration in the asset’s fair value).

3.1.  Asset Capitalization

The carrying value of the asset will reflect (a) all costs necessary to acquire the asset and make it ready for use and (b) allocated portion of shared costs incurred in acquiring multiple assets.

3.1.1.  Capitalized Interest

Companies must capitalize interest on borrowings used to construct an asset.  These interest costs are thus a component of the asset’s carrying value and are expensed as depreciation rather than interest expense

[iii].  The interest, however, need not be specific to an asset.  Interest which could have been avoided had the expenditures for the asset not been made – called “avoidable interest” – must be capitalized into the cost of the asset.

3.1.2.  Acquired Intangible Assets

Separately identifiable intangible assets (patents, brands, copyrights, etc.) which are acquired through a business acquisition must be capitalized at their estimated fair valueiv.  Intangible assets which cannot be separately identified and valued are collectively known as goodwill.  Goodwill is the excess of the acquisition price over the fair value of the acquired company’s tangible and intangible assets.

3.1.3.  Internally Developed Intangible Assets

Under both U.S. GAAP and IFRS, research and development costs must be expensed as incurred.  Under U.S. GAAP, companies developing software for sale or lease will expense costs only until technological feasibility has been reached, at which point subsequent costs must be capitalized.  For software developed for internal use, U.S. GAAP requires companies to expense development cost until the completion and use of the software is probable; all costs thereafter must be capitalized.  While U.S. GAAP requires such criteria only for software development, IFRS applies similar capitalization to all internally developed intangiblesv.

3.2.  Asset Cost Allocation

3.2.1.  Depreciation

Depreciation is the systematic expensing of the capitalized costs of tangible assets, such as property and equipmentvi.  Companies have several methods to choose from when calculating depreciation expense.  Regardless of the method used, the company must determine the useful life of each asset, which is the estimated number of years for which the asset is used in operations.  The company must also estimate the asset’s salvage value, i.e., the expected worth of the asset once it can no longer be used in operations.  The difference between the asset’s capitalized cost and its salvage value is the asset’s depreciable base.

The most widely used method of depreciation is the straight-line method.  Under the straight-line method, the company calculates depreciation by dividing the asset’s depreciable based by the asset’s useful life.  This method of depreciation leads to an equal amount of depreciation expense in each year of the asset’s useful life.  Investors should recognize two conceptual flaws with straight-line depreciation.  First, an asset is likely to be less efficient in later years of its use than in earlier years of its use, and yet the straight-line method recognizes the same rate of depreciation in each year.  Secondly, return on assets (net income divided by the book value of the asset) is higher in the later years of the asset’s use than in the earlier years.  Thus, the straight-line method leads to an increasing rate of return on an aging asset.

Companies can also use accelerated depreciation methods, which recognize greater depreciation in the early years of the asset’s use.  The two most widely used methods of accelerated depreciation are the double-declining balance method and the sum-of-the-years-digits methods.

Under the double-declining balance method, the depreciation is twice the rate recognized under the straight-line method.  The company calculates the period’s depreciation expense by applying the depreciation rate to beginning net book value of the asset.  Because the depreciation rate is applied to a decreasing net asset value, greater depreciation is recognized in the early years of the asset’s life than in its later yearsvii.

The other popular method of depreciation is the sum-of-the-years digits method.  With this method, an asset’s depreciation rate is a declining fraction of the total sum of the years of the asset’s depreciable life.  For example, five years of depreciation would sum to: 1 + 2 + 3 + 4 + 5 = 15.  The first year’s depreciation expense would be 5/15th of the asset’s depreciation base, the second year’s depreciation expense would be 4/15th of the asset’s depreciation base, etc.

In certain industries, companies may depreciate assets based on production activity.  One such method is the units of production method.  The units of production method allocates an asset’s depreciable base based on the expected number of units which the asset will produce.

3.2.2.  Amortization

Amortization is the systematic allocation of the capitalized cost of identifiable, limited-life intangible assets.  Goodwill, although recorded as an intangible asset, is not amortized but rather tested annually for impairment.

3.2.3.  Depletion

Depletion is the allocation of the capitalized cost of natural resources.  This allocation is based on the rate of extraction or rate of production of the resource.  Depletion is thus an activity-based cost allocation method – the more extraction or production, the greater the depletion expense.

3.3.  Asset Impairment

3.3.1.  Tangible and Amortizable Intangible Assets

Under U.S. GAAP, assets must be carried on the books at the lower of depreciated cost or market value.  When the company considers a long-lived asset impaired, the company must reduce the asset’s carrying value to its fair value, with the new value depreciated over its remaining useful life.  The company should undertake an impairment review whenever external events raise the possibility that an asset’s carrying amount (book value) may not be recoverable.  Under U.S. GAAP, an asset is impaired when the asset’s undiscounted expected future cash flows are lower than the asset’s current carrying value.  IFRS, however, utilizes discounted cash flows of the asset when considering impairment.  Because discounted cash flows will be lower than undiscounted cash flows, IFRS accounting will likely lead to more frequent asset impairments.

When the company has identified that as asset’s value has been impaired, the company must calculate the new, lower value using an accepted valuation technique – such as present value of cash flows.  The impairment is thus the difference between the asset’s carrying value and the lower calculated value.  The company would record the impairment by debiting an expense account – such as impairment loss – and crediting the appropriate asset account.  The impairment expense would be shown on the income statement as a component of operating income.  Under U.S. GAAP, an asset’s impairment cannot be later reversed.  Under IFRS, however, asset impairments may be reversed under certain circumstances.

3.3.2.  Indefinite-Lived Intangible Assets

For indefinite-lived intangible assets, such as acquired goodwill, U.S. GAAP requires the company to test such assets for impairment at least annually.  Companies are permitted to use qualitative considerations when testing for impairment of such assets, but ultimately quantitative methods must be used before an impairment is recognized.  Like amortizable assets, U.S. GAAP does not permit a company to reverse an impairment.

3.4.  Asset Revaluations Under IFRS

IFRS is less conservative than U.S. GAAP in regards to asset carrying values.  This is because IFRS allows for both the reversal of prior impairments and the revaluation of asset valuesviii.

3.4.1.  Reversals of Prior Impairments

IFRS allows for the reversal of prior asset impairments – for both tangible and intangible assets – if the asset’s fair value has appreciated substantially above its current depreciated carrying value.  However, the asset’s “written-up” value cannot exceed the asset’s depreciated historical costs; i.e., only the impairment can be reversed through the recognition of a gain.  The gain will be recognized on the income statement, and future depreciation will be based on the asset’s increased carrying value.

3.4.2.  Revaluation Model

Under IFRS, companies account for long-term asset using either the cost method or the revaluation method.  The cost method is similar to the method of asset accounting under U.S. GAAP; the asset is carried at historical cost less accumulated depreciation (unless impaired).

Under the revaluation model, a company can revalue assets periodically, increasing or decreasing the asset’s carrying value.  The company would use the asset’s revalued carrying amount when calculating subsequent depreciation.  If a company elects to use the revaluation model, the company must use the revaluation model for all assets within the asset class.  The gains or losses from these asset revaluations are recorded directly in owner’s equity, through an account called revaluation surplus.  These gains or losses are distinct from impairment reversals, which flow through the income statement.  Since market prices seldom exist for operating assets, the asset valuations may be subjective assessments from company management.

SOURCES

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer.

Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

 

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International Financial  

                  Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

 

Subramanyam, K.R. Financial Statement Analysis, 11th ed. New York: McGraw-Hill, 2014.

 

i Auction-rate securities are debt instruments whose interest rates reset regularly via auction.  During the financial crisis, these instruments became highly illiquid.

ii For uniquely identifiable goods, companies may use the specific identification method.  This method is the only inventory costing method which matches the actual physical flow of inventory.

iii When the asset is constructed for sale to a customer, the interest is capitalized into inventory and the expense recognized at the time of sale as cost of goods sold.

iv This is consistent with acquisition-method accounting, FASB ASC 805 (U.S. GAAP), IFRS 3

v ASC 985-20-25, ASC 350-40-25 (U.S. GAAP); IAS 38 (IFRS)

vi Land is not depreciated as its useful life is considered infinite; however, land may be written-down through an impairment.

vii For example, an asset with a total cost of $1,000 and an estimated useful life of 5 years would recognize depreciation at 40% (2 x 1/5) per year.  Assume salvage value is $100.  In year 1, depreciation expense would be .4 x 1,000 = 400; In year 2, depreciation expense would be .4 x 600 = 240; In year 3, depreciation expense would be .4 x 360 = 144; In year 4, depreciation would be .4 x 216 = 86; In year 5, the beginning book value of the asset would be 216 – 86 = 130.  Depreciation expense in this year would thus be 30 (130 book value minus 100 salvage value), since the asset cannot be depreciated below the asset’s salvage value.

viii IAS 26 and IAS 16

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

Are your investment returns falling short?

Learn about the money management industry and key performance constraints in investment management with our e-book.

Complete the form below and a copy of the e-book will be emailed to you.