Agenda
 We will review the Balance Sheet
– The concept of Liquidity
– Valuation bases for assets and liabilities
(Historical Costing)
– Asset write-downs
 We will also review the Income Statement
– Revenue and expense recognition (accrual
accounting)
– Non-recurring (transitory) items
© 1999 by Robert F. Halsey
There are two concepts that guide the placement of
assets and liabilities on the balance sheet and the
amounts at which they are reported. These are liquidity
and historical costing. We will address each in turn.
© 1999 by Robert F. Halsey
Liquidity refers to cash. An asset is said to be “liquid”
if it can be sold and converted to cash quickly.
Assets are listed on the balance sheet in order of their
liquidity, or how quickly they are expected to be
converted to cash. For example, cash is listed first,
followed by investments in marketable securities,
accounts receivable, inventories, then property, plant
and equipment and other long-term assets.
Likewise, liabilities are listed in order of their maturity,
that is, how soon they will require the payment of cash.
Short-term debts are listed first, followed by long-term
liabilities, then stockholder’s equity.
© 1999 by Robert F. Halsey
Balance sheets are divided into two categories which
relate to liquidity and maturity: current and long-term.
Current assets are assets that are expected to be converted
to cash within one year of the balance sheet date. Current
liabilities are liabilities that are expected to be paid usually
within one year of the balance sheet date.
© 1999 by Robert F. Halsey
Examples of current assets are cash, investments in
marketable securities, accounts receivable, inventories
and prepaid expenses.
Examples of current liabilities are accounts payable,
taxes payable, accrued liabilities and the current portion
of long-term debt.
© 1999 by Robert F. Halsey
An important concept in the evaluation of the financial
condition of a company is the relation between the
dollar amount of current assets and current liabilities.
A large amount or current assets relative to current
liabilities indicates that the company can probably
withstand a decline in business activities and still meet
its contractual obligations.
© 1999 by Robert F. Halsey
Net working capital is defined as:
NWC = $current assets - $current liabilities.
We generally want this amount to be positive and
larger rather than smaller.
Since net working capital will generally be larger for
bigger companies than for smaller companies, it is not
very useful for comparisons between companies or
even for the same company over time if it has changed
significantly.
© 1999 by Robert F. Halsey
As a result, analysts often convert net working
capital to a ratio, called the current ratio, that is
defined as follows:
Current ratio =
Current Assets
Current liabilities
We generally want this ratio to be greater than 1.0
and larger rather than smaller.
© 1999 by Robert F. Halsey
The second concept governs the amount at which
assets and liabilities are reported on the balance sheet.
It is called Historical Costing.
Assets and liabilities are all initially recorded at their
cost, either their purchase price as in the case of assets
or, for liabilities, at their face amount (an exception is
long-term liabilities which we will cover in a later
chapter).
© 1999 by Robert F. Halsey
Once assets and liabilities have been recorded on the
balance sheet, they generally remain at their initial cost
and their carrying amount is not adjusted for
subsequent changes in their market values.
This means that if a company purchases inventory for
resale, it is reported on the balance sheet at its initial cost,
not at its retail selling price.
Also, if a parcel of land increases in value, that increase
is not reported on the balance sheet, nor is it reflected as
income, until the land is sold.
© 1999 by Robert F. Halsey
But, if the purpose of financial reporting is to provide
information that is useful to price a company’s
securities, wouldn’t current market values be more
relevant?
Yes - but allowing companies to report market values
on their balance sheets would introduce greater
subjectivity into the reporting process and render
them more susceptible to bias. This bias can arise
either from the inability of company managers to
measure accurately the market value of their assets, or
it might arise if managers intentionally manage the
reported values in order to mislead users of their
financial statements.
© 1999 by Robert F. Halsey
There is an inherent tradeoff in financial reporting
between relevance and reliability. The use of historical
costing is generally viewed as preferable by the
accounting profession since it is more objective and
verifiable (subject to audit).
You need to understand, however, that balance
sheets do not reflect market values and the price
of a company’s stock will usually be different
from the net book value of its stockholder’s
equity.
© 1999 by Robert F. Halsey
There are exceptions to the general principle of
historical costing which we will look at more
closely as the course progresses:
 Accounts Receivable are reported at net
realizable value (face value less expected
uncollectible accounts)
 Marketable short-term investments are
reported at market value
 Inventories and long-term assets are written
down to market value if there has been a
permanent decline.
© 1999 by Robert F. Halsey
The Income Statement
There are two possible ways to measure income and
expense. The first is to record income when cash is
received and expense when cash is paid.
This is called cash basis accounting.
Unfortunately, this method is not acceptable under
GAAP. Public companies are not permitted to prepare
their financial statements using cash basis accounting.
© 1999 by Robert F. Halsey
The second method, which is the only method
acceptable under GAAP, is called accrual accounting.
Accrual accounting focuses on increases and decreases
in all assets and liabilities to determine income and
expense instead of just focusing on cash.
There are two principles which comprise the
foundation for accrual accounting. They are the
revenue recognition principle and the matching
principle.
© 1999 by Robert F. Halsey
Under the revenue recognition principle, revenues
are reported when two conditions are met:
 The revenue has been realized or is realizable.
That means that either cash has been received or is in
the form of an account receivable. Notice, therefore,
that revenue can be reported even though no cash is
received.
 The revenue has been earned. This means that the
company has performed everything that it is required
to do as part of the sale. Revenue cannot be reported,
for example, if the customer has a right of return
privilege or if the company has future obligations
relating to the sael.
© 1999 by Robert F. Halsey
The matching principle requires all expenses
that have been incurred to generate revenues during
the period to be recognized in the same period in
which we recognize the revenue.
The order is this - we first decide what revenues to
recognize using the revenue recognition principle
(when it is earned and realized or realizable). Next,
we recognize all expenses that have been incurred in
order to generate that revenue.
Expenses are , therefore, matched against the revenues
they help to generate in the period that the revenues are
recognized
© 1999 by Robert F. Halsey
An example of the matching principle is depreciation.
When a long-term asset is purchased, its cost is
recorded on the balance sheet as an asset (since it will
provide future benefits).
We, then, recognize as expense a portion of the asset’s
cost each period to match against the revenue
produced by the asset over its useful life (the cost is
transferred from the balance sheet into the income
statement as depreciation expense).
The objective is to spread the cost out over the period
of time during which the asset is expected to produce
revenues.
© 1999 by Robert F. Halsey
Let’s look at some examples relating to revenue and
expense recognition.
Annual reports contain a description of the company’s
revenue recognition policies.
Here is an example from Colgate-Palmolive’s
annual report:
Revenues are reported at the time of product shipment. At
that point, Colgate-Palmolive has fulfilled its obligation to
its customer and the revenue has been earned.
© 1999 by Robert F. Halsey
Sometimes, however, cash is received prior to delivery
of the product (or performance of a service).
Since the revenue has not yet been earned, we must
record a liability called deferred revenues to reflect our
obligation to deliver the product in the future
This is accomplished with the following journal entry:
Cash
xxx
Unearned income
xxx
Cash is increased to reflect the inflow and a liability
(unearned income) is reflected on the balance sheet to
reflect the obligation to provide the product in the future.
No revenue or profit is recorded until it is earned.
© 1999 by Robert F. Halsey
When the product is delivered in the future, the liability
is reduced and earned income is reported in the income
statement equal to the proportion of the product that has
been delivered.
A simple example of this is in the magazine publishing
industry. When subscriptions are received, firms make
an entry like the one we just discussed since no revenue
has been earned. As magazines are shipped, a portion of
the liability is reduced with each shipment and revenues
are reported in the income statement.
© 1999 by Robert F. Halsey
This can be seen the the following note from the annual
report of Time-Warner, the publisher of Time magazine:
Revenues and Costs
Publishing and Music
The unearned portion of paid magazine subscriptions is
deferred until magazines are delivered to subscribers.
Upon each delivery, a proportionate share of the gross
subscription price is included in revenues.
Reported revenues, therefore, are a proportion of the
subscriptions received, where the proportion is equal to
the number of magazines delivered compared to the
number purchased with the subscription.
© 1999 by Robert F. Halsey
Revenue recognition issues also arise when firms
utilize contracts that extend over multiple reporting
periods. They must, then, estimate the proportion of the
total revenue that should be recognized in each period.
This is typically accomplished through the use of the
percentage-of-completion method. Basically, revenue
is recognized in proportion to the amount of costs
incurred to date in performance of the contract
compared with the total costs that are expected to be
incurred in order to meet the requirements of the
contract.
© 1999 by Robert F. Halsey
For example, assume a company has a contract for
$10 million to build a bridge and expects that the
project will cost $8 million. If it incurs costs of $2
million during the year on the project, it will report
revenues of $2.5 million ($10 million * $2 million /
$8 million).
© 1999 by Robert F. Halsey
Here is an example of the percentage-of-completion
method utilized by Johnson Controls to recognize
revenue on its long-term contracts:
© 1999 by Robert F. Halsey
Let’s also take a look at some issues relating to
expense recognition.
Under normal circumstances, the cost of fixed assets is
reported on the balance sheet less an allowance for
depreciation. Their cost is, thus, recognized gradually
in the income statement as the asset is used up.
© 1999 by Robert F. Halsey
Sometimes, however, the asset becomes “impaired.”
This means that its expected cash flows are
significantly less than originally expected such that it
is not likely that the original cost of the asset can be
recovered.
In this case, the carrying amount of the asset must be
written down and that write-down reflected as an
additional one-time expense in the income statement.
© 1999 by Robert F. Halsey
Take a look, for example, at the notes from the annual
report of Bethlehem Steel:
© 1999 by Robert F. Halsey
The write-down to which the company refers is further
described in note “B”:
This write-down related to the closure of a mill whose
expected earnings and cash flows had declined significantly.
© 1999 by Robert F. Halsey
As a second example of expense recognition,
sometimes expenses are recognized in advance of their
payment. This is called an “accrual.”
For example, we accrue for employee compensation
earned during the period to match against reported
revenues even though the payment might not be
made until the next payroll period.
© 1999 by Robert F. Halsey
An expense that has become increasingly more
common relates to restructuring activities. When
companies restructure their operations, that activity
might involve the closure of facilities and the severance
of employees.
As facilities are closed, their loss in value is usually
reflected in an asset write-down similar to the writedown taken by Bethlehem Steel.
© 1999 by Robert F. Halsey
The expenses related to severance of employees is
usually reflected as an accrual in which an expense is
recorded for the anticipated costs of the severance and
a liability is recorded for the anticipated payment.
Let’s take a look at the notes to the DuPont annual
report which detail the costs involved in its worldwide restructuring program:
© 1999 by Robert F. Halsey
This is the note
relating to DuPont’s
restructuring
program which cost
the company $577
million.
Most of the charge
($310 million)
related to
anticipated
severance of
employees
© 1999 by Robert F. Halsey
The remaining portion ($267 million) related to asset
write-downs
© 1999 by Robert F. Halsey
Transitory Items
Up to this point, we have considered income statements
of the following form:
Sales
- Operating expenses
= Profit
Some operating expenses, however, are one-time
occurrences. The FASB felt that inclusion of these
expenses with other operating expenses might mislead
users of financial statements
© 1999 by Robert F. Halsey
Remember, one of the purposes of financial reporting
is to provide information that is useful to investors
and creditors in predicting the amount, timing and
uncertainty of future cash flows.
If these “transitory items” were included with other
operating expenses, estimation of future operating
expenses, and thus net profit, would be more difficult.
© 1999 by Robert F. Halsey
As a result, the FASB reformatted the income statement
to require certain transitory (non-recurring) items to be
reported separately. The following is the format we
employ today:
+
=
=
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Income from Continuing Operations
Discontinued Operations
Extraordinary Items
Changes in Accounting Principles
Net Profit
© 1999 by Robert F. Halsey
Discontinued items relate to segments of a company
that it intends to sell. Once a company has decided to
divest itself of these operations, their sales and
operating expenses are taken out of the income
statement and the net profit or loss for these
discontinued operations is reported separately on the
income statement below income from continuing
operations.
Only the net profit (loss) is reported together with
the gain or loss on the sale of the business segment.
© 1999 by Robert F. Halsey
Here is the income statement of Venator Group, Inc which
owns retail athletic stores like Foot Locker.
The Company reported a loss of $139
million relating to discontinued
operations, $26 million in operating
losses and a $113 million loss on
their sale.
© 1999 by Robert F. Halsey
Additional details about these operations are found in the
notes to the annual report. The discontinued operations
related to the International General Merchandise which lost
$9 million during the year and the Specialty Footwear
segment which lost $17 million.
© 1999 by Robert F. Halsey
Companies are also required to separate expenses
called extraordinary items. These are defined as
extraordinary if they are both “unusual” and
“infrequent”.
In practice, extraordinary items usually relate to gains
or losses on the retirement of long-term debt (we will
cover this topic in detail in a later chapter).
Let’s take a look at an example of an extraordinary
item form the annual report of Du Pont:
© 1999 by Robert F. Halsey
Notice the extraordinary loss
of $201 million relating to Early
Extinguishment of Debt
© 1999 by Robert F. Halsey
This loss is more fully described in the notes to the
company’s annual report:
During the year, the company repaid long-term debt
before its scheduled maturity. The amount paid to
repay the indebtedness was greater than the amount
reported on its balance sheet, hence the loss. We will
cover the accounting for debt repayment in the
chapter on long-term liabilities.
© 1999 by Robert F. Halsey
The third “transitory item” reported below income
from continuing operations are Changes in
Accounting Principle.
Here is an example of the disclosure relating to a $21
million after-tax charge reported by Boston Scientific:
© 1999 by Robert F. Halsey
And here is the way it appeared
in the company’s income statement
© 1999 by Robert F. Halsey
A couple of closing remarks about transitory items:
 You should scrutinize these vary carefully to
understand their cause. The object is to discern
whether they convey information about the remaining
core operations that will help you to forecast their
future cash flows.
 You should understand that not all transitory
items are separated and reported below income from
continuing operations. Gains and losses on sales of
assets are a common example. If the assets are not a
part of discontinued operation, they are reported in
income form continuing operations. You, then, need
to closely examine the notes to the financial
statements for information relating to the sale.
© 1999 by Robert F. Halsey
Here is the income
statement of the
Wrigley company,
the chewing gum
maker. Notice the
gain on the sale of
their factory.
Usually, gains and
losses on assets
sales are not
disclosed in a
separate line of the
income statement.
© 1999 by Robert F. Halsey
Changes in Estimates and Errors
 When a company changes the estimates used in
preparing its financial statements (like the useful life
of a fixed asset), no retroactive application or
cumulative effect recognized. It merely uses the new
estimates prospectively. This is different from the
change is accounting principle discussed above.
 If a company makes an error in the preparation of its
financial statements (like failing to count some
inventory), it merely corrects the mistake if the annual
report has not yet been issued. Otherwise, it treats the
error as an adjustment to opening balance of retained
earnings (called a prior period adjustment).
© 1999 by Robert F. Halsey
The End
© 1999 by Robert F. Halsey