Chapter 10: The Balance Sheet

Linking the balance sheet and income statement

Evolving definitions

Asset valuation

Liabilities and owners’ equities

Hybrid securities

Derivatives

Balance sheet classification issues

Two Types of Relationships between Balance Sheet & Income Statement

ArticulatedThe two statements are mathematically linkedNet income is equal to the change in owners’ equity for a period, assuming no capital transactions or prior period adjustments

NonarticulatedThe two statements are independently definedThe relationship between the balance sheet and the income statement is severed

Owners’ Equity

ContributedCapital

UnrealizedCapital

Adjustments

RetainedEarnings

OtherContributed

Capital

LegalCapital

IncomeStatementAccounts

PriorPeriod

Adjustments

Dividends

DR CR

Assets – Liabilities =

Debits Credits

GainsRevenues

Ordinary Extraordinary

LossesExpenses

Ordinary Extraordinary

Income Statement Accounts

Accounting Classification System

Rather simple

Complex transactions do not always fit neatly into one of the categories

Surprisingly, current accounting classification system is virtually unchanged since Pacioli’s time

Articulated System Alternatives

Revenue-Expense approachConcerned with the definition, recognition, and measurement of incomeResult is that balance sheet contains assets, liabilities and ambiguous debits and credits called deferred charges and deferred credits

Asset-Liability approachSFAC No. 6 defines comprehensive income as the change in the firm’s net assets from nonowner sourcesFocuses on the measurement of net assets

Definitions: Assets

Something represented by a debit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting ... Economic resources of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Assets also include certain deferred charges... Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Asset Definition Trend

Definitions of assets have evolved from a narrow legal orientation to a broader concept of economic resources.

As the definition has broadened, the boundary around what is and what is not an asset has become hazy and ambiguous.

Executory Contracts: Assets?

a contract unperformed by both parties.

A long-standing problem in accounting has been the question of how to account (if at all) for mutually unperformed executory contracts.

traditional accounting view is that no recognition is required in financial statements because a binding exchange has not yet occurred. The contract is prospective.

Recognition and Measurement

Assets and liabilities generally are initially recorded on the basis of events in which the enterprise acquires resources from other entities or incurs obligations to other entities.

The assets and liabilities are measured by the exchange prices at which the transfers take place.

Assets

Initially recognized when the transaction transferring control occursAt this point in time, a potential exists for future economic benefits Measured at the market value (exchange price) of the consideration exchanged or sacrificed to acquire the assets and place them in operating condition.

called historical acquisition costhowever, an asset should not be recorded in an amount greater than its cash equivalent purchase price.

Asset Valuation: A Lack of Additivity

original acquisition cost (historical cost)

historical cost less cumulative charges to income (book value)

replacement cost

selling prices

net realizable value

net realizable value less normal markups

Summary of Asset Measurement

Receivables Approximate net realizible value

Investments...APB 115Amortized historical cost or fair value

Investments...APB 18Unique accounting attribute(equity accounting)

InventoriesCost, replacement cost, NRVor NRV less mark-up

Summary of Asset Measurement

Self-constructed assetsFull-asbsorption for inventory;capitalize interest for noninventory

Assets subject todepreciation or depletion

Unique accounting attribute(book value)

Nonmonetary exchangesOf similar assets

Book value of old asset plus cash

Intangible assetsUnique accounting attribute(book value)

Summary of Asset Measurement

Deferred chargesUnique accounting attribute(book value)

Restructured receivables...modification of terms

Newly restructured future cash inflows discounted at original rate

Impaired assetsFair value if less than carryingvalue, assuming...

Definition: Liabilities

... not only items which constitute liabilities in the popular sense of debts or obligations ...but also credit balances to be accounted for which do not involve a debtor and creditor relation

economic obligations of an enterprise recognized and measured in conformity with GAAP

probable future sacrifices of economic benefits

Definition: Owners’ Equity (OE)

The owners’ residual interest in the net assets of the firm

Two types of owners’ equity transactions

Capital

Income-related

Definition: Hybrid Securities

Redeemable preferred stockTrust preferred stock

Company sells preferred stock to subsidiarySubsidiary sells bonds to parentParent takes interest tax deduction and eliminates debt in consolidation process

Securitizations involves the sale by a firm (called the transferor) of an asset or group of assets to another firm (called the transferee)is to keep debt off of its balance sheet

Definition: Derivatives

Financial instruments whose value is based upon other financial instruments, stock indexes or interest rates, or interest rate indexes

Two typesForward-based derivatives

Options-based derivatives

Types of Derivatives

Forward-based derivatives arise between two parties where one party will realize a gain and the other party will realize a loss due to a change in value of the factor underlying the instrument.

Option holders pay a specific “up front” price that gives them the right to buy (“call”) or sell (“put”) a specific quantity at a specific price of a standard commodity or a financial or equity instrument.

Balance Sheet Classification Issues

Current-noncurrent approach gives only a crude indication of a firm’s liquidity

There are five distinctly different types of accounting liabilities:

contractual,

constructive,

equitable,

contingent,

and deferred charges

Chapter 10: The Balance Sheet

Linking the balance sheet and income statement

Evolving definitions

Asset valuation

Liabilities and owners’ equities

Hybrid securities

Derivatives

Balance sheet classification issues