The Balance Sheet

Nyoman Ardiantha Putera / 344132Muhammad Heickal Pradinanta / 350168

The Relationship between balance sheet and income statement

“Articulation means that the two statements are mathematically defined in such a way that net income is

equal to the change in owners’ equity”

ArticulationAccounting elements: assets, liabilities, owners’ equity, revenues, gains, expenses, and losses.

Income calculated from: revenues, gains, expenses, and losses.

Assets - Liabilities = Owners’ equity

Traditional Articulated Approachrevenue-expense

concerned with definition, recognition, and measurement of income

derived by matching

accounting rules governed income statement and balance sheet, income measurement rules burdens balance sheet.

concerned about stabilizing the fluctuating effect of income statements

asset-liability

concerned with measuring and reporting assets and liabilities

income statement as simply a way of classifying and reporting changes in net assets

unrealized holding gains and losses

Nonarticulated approach

Severe traditional articulated approach with a revenue-expense-based income statement and an asset-liability-based balance sheet

Definition of AssetsEstablishes what types of economic factors appear in

the balance sheet, elements to be recognized, measured, and reported in it

1. Committee on Terminology (1953, paragraph 26)emphasizes on legal property, includes deferred charges

2. APB (1970a, paragraph 132)emphasizes that assets are economic resources

3. FASB (1985, paragraph 25)emphasizes further evolution on “assets are economic resources”

Executory ContractsHow to account mutually unperformed executory contracts

no recognition is needed in financial statement because the exchange has not yet occurred (eg. employment contracts, long-term purchase agreement)

Recognition and Measurement of AssetsReviews how specific types of assets are measured. Using original acquisition cost (historical cost), historical cost less cumulative charges to income (book value), replacement cost, selling prices, net realizable value (selling price - disposal cost), and net realizable value - normal markups.

Recognition and Measurement of Assets (cont.)Receivables

carried at historical cost

adjusted for uncollectible amounts (estimate)

attributes measured using net realizable value

Recognition and Measurement of Assets (cont.)Investments Not Subject to Equity Accounting

1.Held to Maturity

uses effective rate of interest

2.Trading

uses fair value

3.Available for sale

uses fair value

Recognition and Measurement of Assets (cont.)Equity securities in an amount of 20% (significant influence) to 50% (majority) of the outstanding stock are valued using equity method

uses historical cost

investment increase after:

eliminating investor-investee transactions profit

reducing amortization and dividends paid

Recognition and Measurement of Assets (cont.)Inventories

Ending Inventory: (quantity on hand x quantity by the acquisition cost)

FIFO

LIFO

Weighted Average

Used Conservatism.

Recognition and Measurement of Assets (cont.)Self-Constructed Assets and Manufactured Inventories

variable (direct) costing

production cost charged under variable production costs, fixed costs charged as period costs.

full-absorption costing

assign all manufacturing costs, fixed and variable to the production costs.

requires the development of arbitrary overhead rates on assumed production levels

Recognition and Measurement of Assets (cont.)Impaired Assets

writedowns long-lived assets and possible related goodwill

decreased market value, significant physical change in the asset, declining cash flows from both current and prospective operations

Recognition and Measurement of Assets (cont.)Nonmonetary Exchanges of Similar Assets

APB Opinion No. 29: the sacrifice to obtain a new asset with a traded-in asset and possibly some cash (book value)

SFAS No. 153: amended APB Opinion No. 29.

commercial substance (fair value) new asset must have different cash flow

no commercial substance (book value) following the old asset

Recognition and Measurement of Assets (cont.)Intangible Assets

For example: A/R, FDI, capitalized lease rights, copyrights, patents, trademarks.

depreciation, depletion, amortization (book value)

Capitalizing Intangible Costs

“it makes sense to recognize intangible investments as assets when uncertainty of benefits considerably resolved”

- SFAS No. 86, Lev and Zarowin

Recognition and Measurement of Assets (cont.)Deferred Charges

1.prepaid costs

provide future benefits in the form of reduced future cash outflows (eg. prepaid insurance)

2.costs

deferred from expense recognition because income measurement rules (eg. startup costs)

LiabilitiesDefinition of Accounting liabilities:

1. Something represented by a credit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting

2. Economic obligations of an enterprise that are recognized and measured in conformity with GAAP

3. Liabilities are probable future sacrifices of economic benefits

Types of Accounting LiabilitiesContractual liabilities

Constructive obligations

Equitable obligations

Contingent liabilities

Deferred credits

first type represents prepaid revenues

second type arises from income rules that defer income statement recognition of the item

Recognition and Measurement of LiabilitiesThe general principle is the liabilities are measured at

the amount established in the exchange

For current liabilities, it represents the face value of the obligation to be settled.

For noncurrent obligation, the measurement represents a Present value calculation based on current interest rates.

Recognition and Measurement of Liabilities (Cont.)Notes Payable With Below Market Rates of Interest

APB Opinion No.21: it must be discounted

The real economic value of the transaction is measured at imputed market prices

Recognition and Measurement of Liabilities (Cont.)Bonds Payable

Recorded at the net proceeds of the transaction

net proceeds = present value of future interest payments and principal repayment, discounted at the market rate of interest less costs

Recognition and Measurement of Liabilities (Cont.)Convertible Bonds

the investors are willing to pay a price for conversion option and the price is paid in the form of lower interest rates

The policies are used to account for convertible bonds:

1.Treat convertible debt as conventional debt until conversion

2.segregate the amount of the debt as the price paid for the conversion privilege and to add to contributed capital

Recognition and Measurement of Liabilities (Cont.)Debt with Stock Warrants

APB Opinion No. 14: a value be assigned to detachable stock warrants that can accompany the issue of debt.

This policy is inconsistent

The little difference is the amount of being paid in the transaction for the right to acquire stock

Recognition and Measurement of Liabilities (Cont.)Hybrid Securities

Redeemable preferred stock

has nonvoting power

fixed dividend

callable by the issuer

Trust preferred stock

First issued by Texaco in 1993

Company sells preferred stock to subsidiary

The subsidiary sells bonds to the parent

Securitizations

Involves the sale by a firm (transferor) of an asset or group of assets to another firm (transferee)

raising the issue of whether the transferor has relinquished all rights in the assets.

Owners’ EquityThe stockholders’ residual interest in the net assets of the firm

Stockholders equity includes:

Contributed capital

Legal capital; represent the limited liability of stockholders

Other capital; stock premiums,donated capital,etc.

Earned capital (Retained earnings)

Owners’ equity transaction:

Capital Transaction

Income-related transaction

Recognition and Measurement of Owners’ EquityTreasury stock

Seen as a method of signaling future prospects to stockholders

Methods can be used to account for treasury stock:

The cost method

The par value method

Stock dividends

ARB No.43:

Large stock dividends (over 25%)

Small stock dividends (less 20%)

Two purposes:

give shareholders evidence of their interest in retained earnings

lower the price of the shares with the stock dividend serving as a stock split

Financial InstrumentsContracts involving a financial asset of one entity and a financial liability (or equity) of another entity

Example: Representing ownership of the asset

Derivatives

Financial instruments whose value is based on other financial instruments, stock indexes or interest rates, interest rate indexes, or some asset.

Types of Derivatives1.Forward-Based Derivatives

a.One party realizes a gain and other party realizes a loss

b.involve foreign currencies, debt contracts

2.Option-Based Derivatives

a.Gives the buyer (owner) the right to buy or sell a specific price of a standard commodity or a financial instrument.

b.for example call options for stocks, convertible bonds, and convertible preferred stock

FASB pronouncements on Derivatives

SFAS No. 133

valuing derivatives at fair value

SFAS No. 138

clarifying amendments for a few implementation difficulties in SFAS No. 133

SFAS No. 149

amends SFAS No.133, requires contract handled uniformly to improve comparability

SFAS No. 156

technical standards dealing with the servicing of financial assets and liabilities including securitizations

SFAS No. 159

allows exceptions relative to fair value measurement of certain financial instruments

Classification in The Balance SheetTwo classifications:

Current and noncurrent approach

Current defined as firm’s operating cycle or one year,whichever is longer

Also make liquidity ranking

Only gives a crude indication of a firm’s liquidity

Monetary and nonmonetary system

Thank You