Module 2
Understanding the Balance Sheet
Part 1
Learning Objective
1.
Describe and construct the balance sheet and understand how it can be used for analysis. (p. 1)
In Module 1, we introduced the four financial statements—the balance sheet, the income statement, the cash flow statement, and the statement of stockholders’ equity. In this module and the
next, we turn our attention to how the balance sheet and income statement are prepared.
Reporting Financial Condition
The balance sheet reports on a company’s financial condition and is divided into three components:
assets, liabilities, and stockholders’ equity. It provides us with information about the resources
available to management and the claims against those resources by creditors and shareholders.
At the end of August 2011, Walgreens reports total assets of $27,454 million, total liabilities of
$12,607 million, and equity of $14,847 million. Drawing on the accounting equation, Walgreens’
balance sheet is summarized as follows ($ million).
Assets
=
Liabilities
+
Equity
$27,454
=
$12,607
+
$14,847
LO1 Describe
and construct the
balance sheet and
understand how
it can be used for
analysis.
The balance sheet is prepared at a point in time. It is a snapshot of the financial condition of the company at that instant. For Walgreens, the above balance sheet amounts were reported at the close of
business on August 31, 2011. Balance sheet accounts carry over from one period to the next; that is,
the ending balance from one period becomes the beginning balance for the next period.
Walgreens’ 2011 and 2010 balance sheets are shown in Exhibit 2.1. These balance sheets report the assets and the liabilities and shareholders’ equity amounts as of August 31, the company’s
fiscal year-end. Walgreens had $27,454 million in assets at the end of August 31, 2011, with the
same amount reported in liabilities and shareholders’ equity. Companies report their audited financial results on a yearly basis.1 Many companies use the calendar year as their fiscal year. Other
companies prefer to prepare their yearly report at a time when business activity is at a low level.
Walgreens is an example of the latter reporting.
Assets
An asset is a resource that is expected to provide a company with future economic benefits. When
a company incurs a cost to acquire future benefits, we say that cost is capitalized and an asset is
recorded. An asset must possess two characteristics to be reported on the balance sheet:
1. It must be owned or controlled by the company.
2. It must possess expected future benefits that can be measured in monetary units.
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Companies also report quarterly financial statements, and these are reviewed by the independent accountant, but not
audited.
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Module 2: Part 1 | Understanding the Balance Sheet
The first requirement, that the asset must be owned or controlled by the company, implies that the
company has legal title to the asset or has the unrestricted right to use the asset. This requirement
presumes that the cost to acquire the asset has been incurred, either by paying cash, by trading
other assets, or by assuming an obligation to make future payments.
The second requirement indicates that the company expects to receive some future benefit
from ownership of the asset. Benefits can be the expected cash receipts from selling the asset or
from selling products produced by the asset. Benefits can also refer to the receipt of other noncash
assets, such as accounts receivable or the reduction of a liability (e.g. when assets are given up to
settle debts). It also requires that a monetary value can be assigned to the asset.
Companies acquire assets to yield a return for their shareholders. Assets are expected to produce revenues, either directly (e.g. inventory that is sold) or indirectly (e.g. a manufacturing plant
that produces inventories for sale). To create shareholder value, assets must yield income that is in
excess of the cost of the funds utilized to acquire the assets.
EXHIBIT 2.1
Walgreens’ Balance Sheet
Walgreen Co. and Subsidiaries
Consolidated Balance Sheets at
August 31, 2011 and 2010
($ millions)
Assets used up or
converted to cash
within one year
Assets not used
up or converted
to cash in one
year
Liabilities requiring
payment within one
year
Liabilities not
requiring payment
within one year
Current
Assets
Noncurrent
Assets
Current
Liabilities
Noncurrent
Liabilities
Shareholders’
Equity
Assets
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2011
2010
$ 1,556
2,497
8,044
225
$ 1,880
2,450
7,378
214
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property and equipment at cost, less accumulated
depreciation and amortization . . . . . . . . . . . . . . . . . . . .
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . .
12,322
11,922
11,526
11,184
2,017
1,589
1,887
1,282
Total noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . .
15,132
14,353
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$27,454
$26,275
Liabilities and Shareholders’ Equity
Short-term borrowings
Trade accounts payable
Accrued expenses and other liabilities
Income taxes
$    13
4,810
3,075
185
$    12
4,585
2,763
73
8,083
2,396
343
1,785
7,433
2,389
318
1,735
4,524
—
80
834
(34)
18,877
16
(4,926)
4,442
—
80
684
(87)
16,848
(24)
(3,101)
Total current liabilities
Long-term debt
Deferred income taxes
Other noncurrent liabilities
Total noncurrent liabilities
Preferred stock; none issued
Common stock
Paid-in capital
Employee stock loan receivable
Retained earnings
Accumulated other comprehensive income (loss)
Treasury stock, at cost
Total shareholders’ equity
Total liabilities and shareholders’ equity
14,847
14,400
$27,454
$26,275
Current Assets In the United States, the assets section of a balance sheet is presented in order
of liquidity, which refers to the ease of converting noncash assets into cash. The most liquid assets
are called current assets. Current assets are assets expected to be converted into cash or used in
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Module 2: Part 1 | Understanding the Balance Sheet
operations within the next year, or within the next operating cycle. Some typical examples of current assets include the following accounts, which are listed in order of their liquidity:
■
Cash—currency, bank deposits, certificates of deposit, and other cash equivalents;
■
Marketable securities—short-term investments that can be quickly sold to raise cash;
■
Accounts receivable—amounts due to the company from customers arising from the sale of
products or services on credit;
■
Inventory—goods purchased or produced for sale to customers;
■
Prepaid expenses—costs paid in advance for rent, insurance, or other services.
FYI
Cash
equivalents are shortterm, highly liquid
investments that mature
in three months or
less and can be easily
converted to cash.
The amount of current assets is an important measure of liquidity. Companies require a
degree of liquidity to effectively operate on a daily basis. However, current assets are expensive
to hold—they must be insured, monitored, financed, and so forth—and they typically generate
returns that are less than those from noncurrent assets. As a result, companies seek to maintain
just enough current assets to cover liquidity needs, but not so much so as to reduce income
unnecessarily.
Noncurrent Assets The second section of the asset side of the balance sheet reports noncurrent (long-term) assets. Noncurrent assets include the following asset accounts:
■
■
■
Long-term financial investments—investments in debt securities or shares of other firms
that management does not intend to sell in the near future;
Property, plant, and equipment (PPE)—includes land, factory buildings, warehouses, office buildings, machinery, office equipment, and other items used in the operations of the
company;
Intangible and other assets—includes patents, trademarks, franchise rights, goodwill, and
other items that provide future benefits, but do not possess physical substance.
Noncurrent assets are listed after current assets because they are not expected to expire or be converted into cash within one year.
Measuring Assets Assets that are intended to be used, such as inventory and property, plant,
and equipment, are reported on the balance sheet at their historical cost (with adjustments for
depreciation in some cases). Historical cost refers to the original acquisition cost. The use of
historical cost to report asset values has the advantage of reliability. Historical costs are reliable
because the acquisition cost (the amount of cash paid to purchase the asset) can be objectively
determined and accurately measured. The disadvantage of historical costs is that some assets can
be significantly undervalued on the balance sheet. For example, the land in Anaheim, California,
on which Disneyland was built more than 50 years ago, was purchased for a mere fraction of its
current market value.
Some assets, such as marketable securities, are reported at current market value or fair value.
The market value of these assets can be easily obtained from online price quotes or from reliable sources such as The Wall Street Journal. Reporting certain assets at fair value increases the
relevance of the information presented in the balance sheet. Relevance refers to how useful the
information is to those who use the financial statements for decision making. For example, marketable securities are intended to be sold for cash when cash is needed by the company to pay its
obligations. Therefore, the most relevant value for marketable securities is the amount of cash that
the company expects to receive when the securities are sold.
Only those asset values that can be accurately measured are reported on the balance sheet. For
this reason, some of a company’s most important assets are often not reflected among the reported
assets of the company. For example, the well-recognized Walgreens logo does not appear as an
asset on the company’s balance sheet. The image of Mickey Mouse and that of the Aflac Duck are
also absent from The Walt Disney Company’s and Aflac Incorporated’s balance sheets. Each of
these items is referred to as an unrecognized intangible asset. These intangible assets and the Coke
FYI
Excluded
assets often relate
to self-developed,
knowledgebased assets, like
organizational
effectiveness and
technology. This is one
reason that knowledgebased industries are so
difficult to analyze. Yet,
excluded assets are
presumably reflected in
company market values.
This fact can explain
why the firm’s market
capitalization (its share
price multiplied by the
number of shares) is
often greater than the
book value shown on
the balance sheet.
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Module 2: Part 1 | Understanding the Balance Sheet
bottle silhouette, the Kleenex name, an excellent management team, or a well-designed supply
chain, are measured and reported on the balance sheet only when they are purchased from a third
party. As a result, internally created intangible assets, such as the Mickey Mouse image, are not
reported on a balance sheet, even though many of these internally created intangible assets are of
enormous value.
Liabilities and Equity
Liabilities and equity represent the sources of capital to the company that are used to finance the
acquisition of assets. Liabilities represent the firm’s obligations for borrowed funds from lenders or
bond investors, as well as obligations to pay suppliers, employees, tax authorities, and other parties.
These obligations can be interest-bearing or non-interest-bearing. Equity represents capital that has
been invested by the shareholders, either directly via the purchase of stock, or indirectly in the form
of earnings that are reinvested in the business and not paid out as dividends (retained earnings). We
discuss liabilities and equity in this section.
The liabilities and equity sections of Walgreens’ balance sheets for 2011 and 2010 are reproduced in the lower section of Exhibit 2.1. Walgreens reports $12,607 million of total liabilities and
$14,847 million of equity as of its 2011 fiscal year-end. The total of liabilities and equity equals
$27,454—the same as the total assets—because the shareholders have the residual claim on the
company.
A liability is a probable future economic sacrifice resulting from a current or past event. The
economic sacrifice can be a future cash payment to a creditor, or it can be an obligation to deliver
goods or services to a customer at a future date. A liability must be reported in the balance sheet
when each of the following three conditions is met:
1. The future sacrifice is probable.
2. The amount of the obligation is known or can be reasonably estimated.
3. The transaction or event that caused the obligation has occurred.
When conditions 1 and 2 are satisfied, but the transaction that caused the obligation has not occurred,
the obligation is called an executory contract and no liability is reported. An example of such an
obligation is a purchase order. When a company signs an agreement to purchase materials from a
supplier, it commits to making a future cash payment of a known amount. However, the obligation
to pay for the materials is not considered a liability until the materials are delivered. Therefore, even
though the company is contractually obligated to make the cash payment to the supplier, a liability
is not recorded on the balance sheet. However, information about purchase commitments and other
executory contracts is useful to investors and creditors, and the obligations, if material, should be
disclosed in the footnotes to the financial statements. In its annual report, Walgreens reports open
inventory purchase orders of $1,736 million at the end of fiscal year 2011.
Current Liabilities Liabilities on the balance sheet are listed according to maturity. Obligations that are due within one year or within one operating cycle are called current liabilities.
Some examples of common current liabilities include:
■
■
■
■
■
Accounts payable—amounts owed to suppliers for goods and services purchased on credit.
Accrued liabilities—obligations for expenses that have been recorded but not yet paid.
Examples include accrued compensation payable (wages earned by employees but not yet
paid), accrued interest payable (interest on debt that has not been paid), and accrued taxes
(taxes due).
Short-term borrowings—short-term debt payable to banks or other creditors.
Deferred (unearned) revenues—an obligation created when the company accepts payment
in advance for goods or services it will deliver in the future. Sometimes also called advances
from customers or customer deposits.
Current maturities of long-term debt—the current portion of long-term debt that is due to
be paid within one year.
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Noncurrent Liabilities Noncurrent liabilities are obligations to be paid after one year. Examples of noncurrent liabilities include:
■
■
Long-term debt—amounts borrowed from creditors that are scheduled to be repaid more
than one year in the future. Any portion of long-term debt that is due within one year is reclassified as a current liability called current maturities of long-term debt.
Other long-term liabilities—various obligations, such as warranty and deferred compensation liabilities and long-term tax liabilities, that will be satisfied at least a year in the future.
Detailed information about a company’s noncurrent liabilities, such as payment schedules,
interest rates, and restrictive covenants, are provided in the footnotes to the financial statements.
FYI
Borrowings
are often titled Notes
Payable. When a
company borrows
money it normally signs
a promissory note
agreeing to pay the
money back—hence,
the title notes payable.
B U SIN ESS IN SIGH T
How Much Debt Is Reasonable? In August 2011, Walgreens reports total assets of $27,454
million, liabilities of $12,607 ($8,083 current 1 $4,524 non-current) million, and equity of $14,847 million.
This means that Walgreens finances 46% of its assets with borrowed funds and 54% with shareholder
investment. Liabilities represent claims for fixed amounts, while shareholders’ equity represents a flexible claim (because shareholders have a residual claim). Companies must monitor their financing sources
and amounts because borrowing too much increases risk, and investors must recognize that companies
may have substantial obligations (like Walgreens’ inventory purchase commitment) that do not appear
on the balance sheet.
Stockholders’ Equity Equity reflects capital provided by the owners of the company. It is
often referred to as a residual interest. That is, stockholders have a claim on any assets that are not
needed to meet the company’s obligations to creditors. The following are examples of items that
are typically included in stockholders’ equity:
■
■
■
■
■
Common stock—the capital received from the primary owners of the company. Total common stock is divided into shares. One share of common stock represents the smallest fractional unit of ownership of a company.2
Additional paid-in capital—amounts received from the primary owners in addition to the
par value or stated value of the common stock.
Treasury stock—the amount paid for its own common stock that the company has reacquired, which reduces contributed capital.
Retained earnings—the accumulated earnings that have not been distributed to stockholders
as dividends.
Accumulated other comprehensive income or loss—accumulated changes in equity that are
not reported in the income statement.
Contributed
Capital
Earned
Capital
The equity section of a balance sheet consists of two basic components: contributed capital
and earned capital. Contributed capital is the net funding that a company has received from issuing and reacquiring its equity shares. That is, the funds received from issuing shares less any
funds paid to repurchase such shares. In 2011, Walgreens’ equity section reports $14,847 million
in equity. Its contributed capital is a negative $4,046 million ($80 million in common stock plus
$834 million in [additional] paid-in capital minus $34 million in an employee stock loan receivable and minus $4,926 million in treasury stock). The negative balance indicates that Walgreens
has returned more cash to its shareholders (by buying its own stock) than it has received in cash
from its shareholder capital contributions.
Earned capital is the cumulative net income (and losses) retained by the company (not paid out
to shareholders as dividends). Earned capital typically includes retained earnings and accumulated
2
Many companies’ common shares have a par value, but that value has little economic significance. For instance, Walgreens’ shares have a par value of $.078125 per share, while the market price of the stock is about $35 at the time of this
writing. In most cases, the sum of common stock (at par) and additional paid-in capital represents the value of stockholders’ contributions to the business in exchange for shares.
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Module 2: Part 1 | Understanding the Balance Sheet
other comprehensive income or loss. Walgreens’ earned capital is $18,893 million ($18,877 million in retained earnings plus $16 million in accumulated other comprehensive income).
Retained Earnings There is an important relation for retained earnings that reconciles its beginning and ending balances as follows:
Beginning retained earnings
1 Net income (or  Net loss)
 Dividends
 Ending retained earnings
FYI
This relation is useful to remember, even though there are other items that sometimes impact retained earnings. We revisit this relation after our discussion of the income statement and show how
it links the balance sheet and income statement.
Equity is a
term used to describe
owners’ claims on
the company. For
corporations, the terms
shareholders’ equity
and stockholders’
equity are also used
to describe owners’
claims. We use all three
terms interchangeably.
Analyzing and Recording Transactions for the Balance Sheet
The balance sheet is the foundation of the accounting system. Every event, or transaction, that is
recorded in the accounting system must be recorded so that the following accounting equation is
maintained:
Assets 5 Liabilities 1 Equity
We use this fundamental relation to help us assess the financial impact of transactions. This is our
“step 1” when we encounter a transaction. Our “steps 2 and 3” are to journalize those financial impacts and then post them to individual accounts to emphasize the linkage from entries to accounts
(steps 2 and 3 are explained later in this module).
Balance Sheet
Balance Sheet
Statement of Equity
Transaction
Statement of Cash Flows
Income Statement
A
N
A
L
Y
Z
E
Balance Sheet
Balance Sheet
Transaction
Cash
Asset
Noncash
Assets
=
Liabilities
J
O
U
R
N
A
L
I
Z
E
Income Statement
Contrib.
Capital
=
Earned
Capital
Revenues
-
Expenses
Cash
Asset
=
Net
Income
=
(2) Purchased $950 in
supplies with $250 cash
and $700 on account
1
(2)
250
Cash
Noncash
Assets
950
Supplies
=
=
Liabilities
Income Statement
Contrib.
Capital
Earned
Capital
Revenues
700
-
Accounts
Payable
Supplies ( A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash ( A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts Payable ( L) . . . . . . . . . . . . . . . . . . . . . . . . .
-
Expenses
=
Cash
Asset
Transaction
Net
Income
A
N
A
L
Y
Z
E
=
J
O
U
R
N
A
L
I
Z
E
950
250
700
(2) Purchased $950 in
supplies with $250 cash
and $700 on account
1
(2)
250
Cash
Noncash
Assets
950
Supplies
=
=
Liabilities
Income Statement
Contrib.
Capital
Earned
Capital
Revenues
700
-
Expenses
-
Accounts
Payable
Supplies ( A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash ( A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts Payable ( L) . . . . . . . . . . . . . . . . . . . . . . . . .
=
Net
Income
=
950
250
700
Purchased supplies for $950.
Terms: $250 down, remainder due in 60 days.
Purchased supplies for $950.
Terms: $250 down, remainder due in 60 days.
P
O
S
T
Step 1: Analyze
each transaction
from source
documents
Supplies ( A)
(2)
Accounts Payable ( L)
950
Step 2: Journalize
each transaction
from the FSET
analysis
700
(2)
Cash ( A)
250
(2)
Step 3: Post
journal
information to
ledger accounts
Financial Statement Effects Template To analyze the financial impacts of transactions,
we employ the following financial statement effects template (FSET).
Balance Sheet
Transaction
Cash
Asset
1
Noncash
Assets
=
=
LiabilContrib.
1
1
ities
Capital
Income Statement
Earned
Capital
Revenues
-
Expenses
=
Net
Income
=
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Module 2: Part 1 |
Understanding the Balance Sheet
The template accomplishes several things. First and foremost, it captures the transaction that must
be recorded in the accounting system. But accounting is not just recording financial data; it is
also the reporting of information that is useful to financial statement readers. So, the template
also depicts the effects of the transaction on the four financial statements: balance sheet, income
statement, statement of stockholders’ equity, and statement of cash flows. For the balance sheet,
we differentiate between cash and noncash assets so as to identify the cash effects of transactions.
Likewise, equity is separated into the contributed and earned capital components (the latter includes retained earnings as its major element). Finally, income statement effects are separated into
revenues, expenses, and net income (the updating of retained earnings is denoted with an arrow
line running from net income to earned capital). This template provides a convenient means to
represent financial accounting transactions and events in a simple, concise manner for analyzing,
journalizing, and posting.
The Account An account is a mechanism for accumulating the effects of an organization’s
transactions and events. For instance, an account labeled “Merchandise Inventory” allows a retailer’s accounting system to accumulate information about the receipts of inventory from suppliers and the delivery of inventory to customers.
Before a transaction is recorded, we first analyze the effect of the transaction on the accounting equation by asking the following questions:
■
■
What accounts are affected by the transaction?
What is the direction and magnitude of each effect?
To maintain the equality of the accounting equation, each transaction must affect (at least) two
accounts. For example, a transaction might increase assets and increase equity by equal amounts.
Another transaction might increase one asset and decrease another asset, while yet another might
decrease an asset and decrease a liability. These dual effects are what constitute the double-entry
accounting system.
The account is a record of increases and decreases for each important asset, liability, equity,
revenue, or expense item. The chart of accounts is a listing of the titles (and identification codes)
of all accounts for a company.3 Account titles are commonly grouped into five categories: assets,
liabilities, equity, revenues, and expenses. The accounts for Natural Beauty Supply, Inc. (introduced below), follow:
Assets
110 Cash
120 Accounts Receivable
130 Other Receivables
140 Inventory
150 Prepaid Insurance
160 Security Deposit
170 Fixtures and Equipment
175 Accumulated Depreciation—Fixtures and
Equipment
liabilities
210 Accounts Payable
220 Interest Payable
230 Wages Payable
240 Taxes Payable
250 Unearned Revenue
260 Notes Payable
equity
310 Common Stock
320 Retained Earnings
revenues and income
410 Sales Revenue
420 Interest Revenue
expenses
510 Cost of Goods Sold
520 Wages Expense
530 Rent Expense
540 Advertising Expense
550 Depreciation Expense—Fixtures and
Equipment
560 Insurance Expense
570 Interest Expense
580 Tax Expense
3
Accounting systems at large organizations have much more detail in their account structures than we use here. The account structure’s detail allows management to accumulate information by responsibility center or by product line or by
customer.
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Each transaction entered in the template must maintain the equality of the accounting equation,
and the accounts cited must correspond to those in its chart of accounts.
Summary
Describe and construct the balance sheet and understand how it can be used for analysis. (p. 1)
■
■
■
■
■
LO1
Assets, which reflect investment activities, are reported (in order of their liquidity) as current assets
(expected to be used typically within a year) and long-term (or plant) assets.
Assets are reported at their historical cost and not at market values (with few exceptions) and are
restricted to those that can be reliably measured.
Not all assets are reported on the balance sheet; a company’s intellectual capital, often one of its more
valuable assets, is one example.
For an asset to be recorded, it must be owned or controlled by the company and carry future economic
benefits.
Liabilities and equity are the sources of company financing; ordered by maturity dates.
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