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Module 3ModuleModuleModule 333 The Balance SheetThe Balance Sheet Omar ElKheshen – kheshen@gmail.com 1
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Learning Objectives By the end of this module you should understand: 1. The detailed structure of the balance sheet and the valuation problems surrounding fixed assets, inventories and debtors 2. The relationship between asset valuation and the measurement of profit 3. The impact of gearing on profits available for distribution to shareholders 4.4. Why a balance sheet must always balanceWhy a balance sheet must always balance 5. The significance, and construction, of the statement of cash flows Omar ElKheshen – kheshen@gmail.com 2
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Agenda 3.1 Introduction 3.2 The Anatomy of the Balance Sheet 3.3 Fixed Assets 3.4 Current Assets 3.5 Current Liabilities 33..66 Net Current Assets and Net AssetsNet Current Assets and Net Assets 3.7 Why Does a Balance Sheet always Balance? Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 3
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In module 2 we’ve seen that the measurement of a company’s profit (or loss) depends to a very large extent on the valuation of certain assets Valuation of assets like: Inventories Have a significant impact on profits Depreciable Fixed Assets We’ve also seen that there are 2 categories of assets with varying values: AssetsAssets Untransformed Means of Transformed means of Production production Land Work-in-progress Buildings Finished goods, which Plant and machinery have not yet been Raw materials released into the P/L account Omar ElKheshen – kheshen@gmail.com 4
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The following example shows how assets affect the profit and loss account Problem A new business purchases light fittings for its offices and warehouse for €1,000. During the first year it pays €100 to the local power utility company for energy consumed by these fittings. What are the accounting treatments for these transactions? Solution €€100100 energyenergy It has no future benefit consumption Expense in the P/L Account It provides future benefit €1,000 Light Fittings Fixed Asset in the Balance Sheet to the business Annual Depreciation Recognition of a loss in Cost Expense in the P/L Account value Cost of power of the light Annual Energy Costs Expense in the P/L Account fittings Omar ElKheshen – kheshen@gmail.com 5
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Agenda 3.1 Introduction 3.2 The Anatomy of the Balance Sheet 3.3 Fixed Assets 3.4 Current Assets 3.5 Current Liabilities 33..66 Net Current Assets and Net AssetsNet Current Assets and Net Assets 3.7 Why Does a Balance Sheet always Balance? Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 6
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We will use the balance sheet of the sole trader encountered in Module 1 to discuss the balance sheet comprehensively Balance sheet as at Action 7 Fixed assets Plant and equipment at cost € 12,000 Less: Depreciation 50 € 11,950 Current assets Inventories 5,500 Debtors 750 Cash 4,960 11,210 Less: Current liabilities Creditors 3,000 8,210 Net assets of the company 20,160 Represented by: Capital introduced 20,000 Profits earned € 160 Owners’ equity 20,160 Omar ElKheshen – kheshen@gmail.com 7
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Agenda 3.1 Introduction 3.2 The Anatomy of the Balance Sheet 3.3 Fixed Assets 3.4 Current Assets 3.5 Current Liabilities 33..66 Net Current Assets and Net AssetsNet Current Assets and Net Assets 3.7 Why Does a Balance Sheet always Balance? Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 8
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“Fixed assets” is the first item to be examined in the balance sheet Fixed Assets definition Assets that a company keeps for a long period of time, not for resale and to be used in the course of business Fixed Assets Land Buildings Plant and Fixed Assets not Equipment Owned by the Company Omar ElKheshen – kheshen@gmail.com 9
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To classify an asset as a fixed asset, we have to consider how the management intends to use it Classifying assets into fixed assets depends on: The intention of management as to how to use the asset NOT Its physical characteristics Example: Motor Vehicle can be treated in two different ways Fixed AssetFixed Asset Current AssetCurrent Asset Manufacturing Company Car Dealer Omar ElKheshen – kheshen@gmail.com 10
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Land is recorded at its acquisition cost together with legal fees and the cost of preparing the land for use Land A fixed asset that is not usually depreciated since it has an infinite life and thus does NOT normally diminish in value Expenditure related to the acquisition could be either: Capitalized in the B/S Or Written Off in the P/L Accountants record the asset at:Accountants record the asset at: Acquisition Cost Any expenditure not related to the acquisition of the asset + Legal Fees and making it operational + Preparation Expenditure Omar ElKheshen – kheshen@gmail.com 11
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Accountants take a conservative position and write off expenditure unless it is clearly related to the acquisition of the asset Problem Solution A retail grocery company purchased an urban site on which it proposes to Land Fixed Asset 1 locate a new supermarket within the next six months. The land cost €3.5 million, legal and survey fees cost 2 Legal fees Capitalized to €250,000 and a promotional program B/S announcing the impending development involving billboards,development involving billboards, PromotionalPromotional Written off toWritten off to 33 P/L account handbills and local media advertising Program will cost another €250 000. How much of this expenditure should be treated as a fixed asset? Omar ElKheshen – kheshen@gmail.com 12
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Accountants are unhappy with the cost convention in relation to some assets, including land That’s because: The acquisition cost is usually different from the current market value 2 Alternative Treatments: 1 2 To continue to record acquisition cost To revalue the land from time to and to publish market value inand to publish market value in time, amend the book valuetime, amend the book value parenthesis (acquisition cost less depreciation to date) accordingly and add/subtract the incremental change to the shareholders’ equity in the company Should not be recorded in P/L Omar ElKheshen – kheshen@gmail.com 13
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Market value is usually much greater than acquisition costs Example A company’s land was revalued at the balance sheet date at €20,000. The land was purchased five years ago for €5,000 and has not been revalued until now. Treatment 1: Balance sheet extract Treatment 2: Balance sheet extract Profits of the company are unaffected by this revaluation Omar ElKheshen – kheshen@gmail.com 14
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Not all accountants prefer using treatment 2 Some do prefer treatment 2 Some don’t prefer treatment 2 Argument: Argument: They believe that land value gains will The actual gain of €15,000 has not yet remain positive been realized They don’t wait until the sale of theThey don’t wait until the sale of the There is no intention to sell the landThere is no intention to sell the land land to recognize these gains in the foreseeable future Omar ElKheshen – kheshen@gmail.com 15
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The accounting treatment for buildings and plant & equipment differs from that of land Buildings Plant and Equipment 2 Accounting Treatments: Accounting Treatment: Either: Combined with Land Depreciating asset One Amount in the B/S As discussed in Module 2 Or: The slower depreciation rate,The slower depreciation rate, Depreciating asset the smaller the impact of depreciation on profits Since they have a finite life The write-off cost is usually slow Omar ElKheshen – kheshen@gmail.com 16
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Many companies operate fixed assets they do not legally own – they do so under a leasing or rental arrangement A company chooses to lease some assets, for a number of reasons: 1 Avoiding a substantial cash outflow at the beginning 2 Spreading relatively small cash outflows over asset’s life 33 Replacing the leased asset with an up-to-date model without recording a loss/gain on sale of the old modelloss/gain on sale of the old model 4 Saving further cash outflow as asset’s maintenance costs are covered by the lease agreement 5 Lease payments are an allowable charge against profits before the calculation of taxation Omar ElKheshen – kheshen@gmail.com
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There are 2 types of leases, each has its own accounting treatment Finance Lease Operating Lease A lease in which ownership will revert A lease in which ownership remains Definition to the lessee at the end of the lease with the lessor Balance Sheet Capitalized Not capitalized Treatment Both the capital and interest elements Only the interest element is charged of the operating lease payments are while the capital portion is deducted Accounting Treatment charged in the P/L account from the lease obligation amount in the B/S Long-term lease (finance lease) contract is in effect a purchase transaction and should be recorded in the balance sheet Omar ElKheshen – kheshen@gmail.com 18
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The effect of recording the leased asset in the balance sheet can be seen from the following example Example Two shipping firms, Dee Ltd and Don Ltd have identical balance sheets. Each firm decides to acquire a new tanker costing €10m. Dee Ltd will purchase its tanker with a loan from the bank and Don Ltd will lease its tanker. Balance Sheet of Both Before Lease Agreement: Omar ElKheshen – kheshen@gmail.com 19
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Assets leased (finance lease) are shown in the balance sheet under ‘fixed assets’ and the future lease payments under ‘creditors’ The respective balance sheets will look like this after the acquisition: This treatment relates company’s earnings in an accounting period with the underlying assets which gave rise to the earnings Omar ElKheshen – kheshen@gmail.com
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