Classification And Elements Of Balance Sheet

I have been receiving many emails request for a post explains complete classification and elements of Balance Sheet in more details. Here I am bringing “Classification and Elements of Balance Sheet” post series. This post is designed to help you to understand the structure of the balance sheet and its related elements. Please note, for faster page load, these post series will be completed through some posts.

Balance sheet accounts are generally classified to facilitate readability and analysis. The three major classifications include assets, liabilities, and shareholders’ equity. Assets and liabilities are divided into two categories: current and non-current. The purpose of this separation is to help the reader recognize the difference between assets and liabilities that will be consumed or satisfied in the upcoming year (current assets) and assets and liabilities that will influence the organization’s operations for many years to come (non-current).

Equity is divided according to a different rule. Shareholders’ equity is usually separated according to how it is developed. Is the equity generated from shareholder contributions or is it generated by the firm’s operations? When the equity develops from investor contributions, it is called contributed capital. When it emerges from the company’s day-to-day operations, it is called earned capital and is combined over time in an account called retained earnings.

 

Elements Of The Balance Sheet

These sub-classifications support what might be viewed as an aggregate approach to balance sheet analysis. For example, the current ratio requires the sum of current assets and the sum of current liabilities to enable its computation. Although aggregated financial information of this nature is a necessity, the balance sheet often includes multiple elements within a group. The understanding of each element enhances one’s understanding of the sub-classification, its associated group, and ratios in which it is a component.

Let’s start with current asset first….

 

Current Assets

Specific current assets include cash, short-term investments, accounts receivable, merchandise inventories, raw material inventories and other current assets. They represent a company’s resources that will ordinarily be consumed during the upcoming fiscal year. As shown, current assets are essential when evaluating a company’s liquidity position.

 

Cash And Cash Equivalents

Cash in the balance sheet, and for the purpose of reporting cash in the statement of cash flows, includes cash on hand, cash in savings and checking accounts, and cash invested in highly liquid short-term instruments with original maturities of three months or less. Highly liquid instruments include high-grade commercial paper, money market funds, or government agency securities, each with original maturities of 90 days or less.

Investments in these instruments are referred to as “cash equivalents” and are combined with cash. Companies take advantage of cash equivalents by exchanging excess cash for highly liquid investments. This maintains the company’s liquid position and converts cash into an earning asset.

 

Short-Term Investments Including Current Maturities Of Long-Term Investments

The balance sheet account short-term investments includes a company’s investment in the stocks and bonds of other companies. These are investment opportunities that appeal to a company for the short term or investments that were once classified as long term but will mature in the upcoming year. Although it might appear that stock and bond investments can be held for an extended period of time, what controls this classification
is management’s intent.

Specific accounting rules require management to classify many investments into one of three groups:

  1. Trading
  2. Available For Sale (AFS)
  3. Held To Maturity (HTM)

 

If an investment is classified as trading, it is management’s intent to hold the investment for a very short period (generally a few weeks to a few months). These investments are shown on the balance sheet at their current market value with all “unrealized gains and losses” (based on changes in market value) reported in the “income statement“.

Market value can be determined at the end of the reporting period by the closing price of a share of stock or bond on one of the major exchanges. If an investment is classified as available for sale, it is management’s intent to hold the investment for more than a few weeks or months. AFS investments can be classified as a current asset or as a long-term investment in the balance sheet. AFS investments, similar to trading investments, are again adjusted to their fair market values. However, changes in market values are reported in stockholders’ equity (as a part of other comprehensive income, defined shortly), not in the income statement. The logic that underlies this accounting treatment is tied closely to the holding period of the investment. Since management intends to hold the investment for a longer period of time, all changes in market values can be reported in equity until the investment is liquidated. This way gains and losses can offset each other over time and in the end can reduce reported earnings volatility.

Therefore, any changes in market value would be reported in stockholders’ equity as a part of accumulated other comprehensive income. Long-term investments classified as HTM are debt investments that management intends to hold until they mature. This investment is generally carried at cost with no adjustment being made for changes in market value. Since management intends to hold the investment until the bonds mature, future changes in market value over the investment’s holding period are irrelevant. Should management change its investment strategy at some point forward, certain investments might need to be reclassified and would then be influenced by other accounting rules.

Companies that actively seek to acquire additional shares of ownership in a particular company may, over time, acquire enough voting shares to gain significant influence over that company. When this occurs, the investing company can influence dividend payouts and other management decisions of the company. As a result, the investor company must employ the equity method of accounting, a departure from cost or fair-value accounting.

The equity method requires the investor company to periodically adjust the carrying value of the investment based on its percent ownership of the investee company’s profits and losses, as well as the investee company’s dividend distributions. For example: the recognition of a percentage ownership in a company’s profits increases the carrying value of the investment (and vice versa for a company’s losses). Dividend distributions by the investee company decrease the carrying value of the investment for the investor company because dividends reduce investee equity. The logic behind the equity method of accounting is in the name. If you own 40 percent of a company’s common shares, then you essentially own 40 percent of the company or, conversely, have a 40 percent equity interest in the net assets of that company. As the investee company’s position changes over time, so should the carrying value of the investment by the investor company.

Generally, the threshold for application of the equity method of accounting is 20 to 50 percent of a company’s voting shares. When a company’s investment increases beyond the 50 percent threshold, the investor company is required to account for the investment under consolidation rules. Here, two or more companies’ performances are merged and reported as one. They are still separate legal entities, but they are accounted for as if they were one.

 

Accounts Receivables

Current assets, in addition to cash and short-term investments, will generally include amounts due from other companies or individuals. These amounts are identified as “accounts receivable” in the balance sheet and correspond to the sale of merchandise or services on credit. The granting of credit is a business decision made by the company to enhance sales revenue. Without this purchase alternative, many individuals or firms would shop elsewhere.

A company may reports accounts receivable at its net realizable value. Net realizable value represents the amount of cash that it expects to collect from customers paying their receivable balance. The difference between gross accounts receivable and the net realizable value is identified as a company’s allowance for bad debts. The benefit of reporting net realizable value is that users can rely on this information to represent the approximate cash collections of receivables.

 

Merchandise (Finished Goods) Inventories

A company’s inventory of goods is most likely the largest component of current assets but also the most illiquid. Inventories can be acquired from other manufacturers and then resold. Inventory can be manufactured and sold by a single company as well. When they are manufactured and sold by the same company the balance sheet may report three inventory accounts: raw materials, work in progress, and finished goods inventory. General Motors Corporation is an example of a company that would utilize three inventory accounts in its accounting system. Obviously, it can have an automobile at any stage of completion, from the raw material to the work in progress, to the finished good that remains unsold.

From a reporting perspective, merchandise inventories must be stated at the Lower-of-Cost or Market (LCM). This approach requires companies to restate the value of their inventories when a permanent decline in the market value of specific inventory holdings has taken place. For this reason, companies must periodically review the carrying value of their inventory and recognize any losses on inventory write-downs in the period in which the decline takes place. The LCM is tied very closely to the conservatism principle in accounting. Inventory write-downs are common in the technology area as new technologies emerge. For example: a company could acquire digital cameras at a cost of $700 but a breakthrough in the industry might make the camera unmarketable even at the company’s acquisition cost. If this occurs, a company would be required to reduce the inventory value on the books and recognize a loss on inventory carrying value for the period.

Another somewhat unique accounting convention allows corporations great flexibility when they determine the value of their inventory at the close of the reporting period. For this reason, financial statement users must be knowledgeable of various inventory valuation approaches. For example: most companies utilize some type of cost-flow assumption when valuing inventory. Examples of cost-flow assumptions include First-In First-out (FIFO), Last-In First-Out (LIFO), and Average Cost. To illustrate, let’s consider a simple example of goods purchased and goods sold.

Example:

Assume Royal Bali Cemerlang buys a specific type of shovel three times a year from the same manufacturer. The first purchase of 30,000 shovels cost Royal Bali Cemerlang $11 each. The second purchase of 50,000 shovels cost $12 each, and the final purchase of 20,000 shovels cost $13 each. This suggests that Royal Bali Cemerlang had 100,000 shovels available to sell throughout the year and a total cost of $1,190,000 (30,000 x $11, 50,000 x $12, and 20,000 x $13).

If Royal Bali Cemerlang sells 80,000 shovels during the year, what value would it report in the income statement as cost of goods sold (COGS), and “what value would it report in the balance sheet as merchandise inventory at the close of the year?Note: 20,000 shovels remain at year-end, but what is their value?

Some companies might use a specific identification approach and use the price paid for each remaining unit as the determining factor to establish value. Although this valuation approach seems quite logical at first, a system of this nature can be very expensive for a company to operate. Therefore, most companies prefer to use a product’s cost flow as a means to valuation rather than physical flow. What this means is that a company views inventory as layers of cost that fluctuate over time. As each inventory unit is sold, even though the specific unit might have an $11, $12, or $13 cost (remember, the same model of shovel was purchased at three different prices), individual unit cost is not relevant for valuation.

Let’s now consider Royal Bali Cemerlang example and assume it chooses a First In First Out (FIFO) cost flow. Its cost of shovels sold would be reported at $930,000 (30,000 shovels at $11 plus 50,000 shovels at $12). In this instance, the earlier costs incurred flow through the income statement, while a more current replacement cost is reported in the balance sheet. Thus, having $1,190,000 of shovels available to sell would leave the inventory of shovels in the balance sheet reported at $260,000 (20,000 units at $13, or $1,190,000 – $930,000).

If Royal Bali Cemerlang chooses aLast In First Out (LIFO)” cost flow rather than FIFO, cost of goods sold would be reported at $970,000 (20,000 at $13, 50,000 at $12, plus 10,000 at $11). In this instance, the more recent costs of shovels flow through the income statement, with the earlier shovel costs reported in the balance sheet. Having $1,190,000 of inventory available to sell would leave inventory in the balance sheet reported at $220,000 (20,000 units at $11). In other words, the remaining 20,000 units of cost would come from the first purchase of the year.

If Royal Bali Cemerlang used anAverage” cost approach the balance sheet would report merchandise inventory at $238,000 (20,000 units x $11.90 per unit average cost). Average cost is calculated by dividing the total cost of goods available to sell by the number of units available to sell. According to the example, cost of goods available to sell is $1,190,000 and would be divided by 100,000 units, or shovels available to sell. The average cost method is simpler to use than FIFO or LIFO and is said to be a compromise between the two cost-flow assumptions.

This example illustrates how particular layers of inventory cost leave the balance sheet and pass through the income statement as part of Cost Of Goods Sold (COGS), while other layers of cost remain and constitute end-of-year inventory. Determining what layers of cost leave the balance sheet and what layers remain is tied directly to the cost-flow approach chosen by a company’s management. Cost-flow assumptions must be disclosed in the notes to the financial statements to help users understand the resulting differences in reported income when comparing multiple companies. Differences in net income can amount to millions or billions of dollars, depending on a company’s chosen method of inventory valuation. In practice, many companies choose the LIFO approach because, during periods of increasing prices, the higher costs transfer to the income statement, thus creating lower reported profits. This reduces a company’s tax obligation to the government tax institution. Please note: this LIFO approach is not allowed anymore by the GAAP with the recent statement.

Read also part of this “Classification and Element Of Balance Sheet” post series are:

  • Stockholders’ Equity (Contributed Capital, Earned Capital, Comprehensive Income, Treasury Stock)
  • Classification Of The Long-term Liabilities/Debt
  • Classification Of Current Liabilities
  • Classification Of Fixed Asset (Non-current Asset)
  •