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Chapter 10:
The Balance Sheet
Linking the balance
sheet and income
statement
Evolving definitions
Asset valuation
Liabilities and owners’
equities
Hybrid securities
Derivatives
Balance sheet
classification issues
Two Types of Relationships between
Balance Sheet & Income Statement
Articulated
The two statements are mathematically linked
Net income is equal to the change in owners’
equity for a period, assuming no capital
transactions or prior period adjustments
Nonarticulated
The two statements are independently defined
The relationship between the balance sheet and
the income statement is severed
Assets – Liabilities = Owners’ Equity
Contributed
Capital
Legal
Capital
Unrealized
Capital
Adjustments
Other
Contributed
Capital
Income
Statement
Accounts
DR
Retained
Earnings
Prior
Period
Adjustments
CR
Dividends
Income Statement Accounts
Debits
Expenses
Ordinary
Credits
Losses
Revenues
Extraordinary
Ordinary
Gains
Extraordinary
Accounting Classification System
Rather simple
Complex transactions do not always fit
neatly into one of the categories
Surprisingly, current accounting
classification system is virtually unchanged
since Pacioli’s time
Articulated System Alternatives
Revenue-Expense approach
Concerned with the definition, recognition, and
measurement of income
Result is that balance sheet contains assets, liabilities
and ambiguous debits and credits called deferred charges
and deferred credits
Asset-Liability approach
SFAC No. 6 defines comprehensive income as the
change in the firm’s net assets from nonowner sources
Focuses on the measurement of net assets
Definitions: Assets
Something represented by a debit balance that is or would
be properly carried forward upon a closing of books of
account according to the rules or principles of accounting
...
Economic resources of an enterprise that are recognized
and measured in conformity with generally accepted
accounting principles. Assets also include certain deferred
charges...
Assets are probable future economic benefits obtained or
controlled by a particular entity as a result of past
transactions or events.
Asset Definition Trend
Definitions of
assets have evolved
from a narrow legal
orientation to a
broader concept of
economic
resources.
As the definition
has broadened, the
boundary around
what is and what is
not an asset has
become hazy and
ambiguous.
Executory Contracts: Assets?
a contract unperformed by both parties.
A long-standing problem in accounting has been
the question of how to account (if at all) for
mutually unperformed executory contracts.
traditional accounting view is that no recognition
is required in financial statements because a
binding exchange has not yet occurred. The
contract is prospective.
Recognition and Measurement
Assets and liabilities generally are initially
recorded on the basis of events in which the
enterprise acquires resources from other
entities or incurs obligations to other
entities.
The assets and liabilities are measured by
the exchange prices at which the transfers
take place.
Assets
Initially recognized when the transaction
transferring control occurs
At this point in time, a potential exists for future
economic benefits
Measured at the market value (exchange price) of
the consideration exchanged or sacrificed to
acquire the assets and place them in operating
condition.
called historical acquisition cost
however, an asset should not be recorded in an amount
greater than its cash equivalent purchase price.
Asset Valuation: A Lack of Additivity
original acquisition cost (historical cost)
historical cost less cumulative charges to
income (book value)
replacement cost
selling prices
net realizable value
net realizable value less normal markups
Summary of Asset Measurement
Receivables
Approximate net realizible value
Investments...APB 115
Amortized historical cost
or fair value
Investments...APB 18
Unique accounting attribute
(equity accounting)
Inventories
Cost, replacement cost, NRV
or NRV less mark-up
Summary of Asset Measurement
Self-constructed assets
Full-asbsorption for inventory;
capitalize interest for noninventory
Assets subject to
depreciation or depletion
Unique accounting attribute
(book value)
Nonmonetary exchanges
Of similar assets
Book value of old asset plus cash
Intangible assets
Unique accounting attribute
(book value)
Summary of Asset Measurement
Deferred charges
Unique accounting attribute
(book value)
Restructured receivables
...modification of terms
Newly restructured future cash
inflows discounted at original rate
Impaired assets
Fair value if less than carrying
value, assuming...
Definition: Liabilities
... not only items which constitute liabilities in the
popular sense of debts or obligations ...but also
credit balances to be accounted for which do not
involve a debtor and creditor relation
economic obligations of an enterprise recognized
and measured in conformity with GAAP
probable future sacrifices of economic benefits
Definition: Owners’ Equity (OE)
The owners’ residual
interest in the net
assets of the firm
Two types of owners’
equity transactions
Capital
Income-related
Definition: Hybrid Securities
Redeemable preferred stock
Trust preferred stock
Company sells preferred stock to subsidiary
Subsidiary sells bonds to parent
Parent takes interest tax deduction and eliminates debt
in consolidation process
Securitizations
involves the sale by a firm (called the transferor) of an
asset or group of assets to another firm (called the
transferee)
is to keep debt off of its balance sheet
Definition: Derivatives
Financial instruments whose value is based
upon other financial instruments, stock
indexes or interest rates, or interest rate
indexes
Two types
Forward-based derivatives
Options-based derivatives
Types of Derivatives
Forward-based derivatives arise between two
parties where one party will realize a gain and the
other party will realize a loss due to a change in
value of the factor underlying the instrument.
Option holders pay a specific “up front” price that
gives them the right to buy (“call”) or sell (“put”)
a specific quantity at a specific price of a standard
commodity or a financial or equity instrument.
Balance Sheet Classification Issues
Current-noncurrent approach gives only a crude
indication of a firm’s liquidity
There are five distinctly different types of
accounting liabilities:
contractual,
constructive,
equitable,
contingent,
and deferred charges
Chapter 10:
The Balance Sheet
Linking the balance
sheet and income
statement
Evolving definitions
Asset valuation
Liabilities and owners’
equities
Hybrid securities
Derivatives
Balance sheet
classification issues