THE FINANCIAL STATEMENTS
KEY FINANCIAL INDICATORS
ACCOUNTING ISSUES
WHAT-IF ... SENSITIVITY MODELS
TIMING MATTERS
JUSTIFYING INVESTMENT
SCORECARDS AND VALUE MANAGEMENT

Delving Deeper

Fixed Assets

Fixed assets are shown at Net Book Value (NBV) in the balance sheet – ie after accumulated depreciation. If I buy a machine for $20,000 and depreciate it at $4,000 per year, then after 2 years, the NBV would be: $12,000 ($20,000 – $4,000 depreciation each year).

The accounting system is essentially a system of record. It records transactions. Thus the balance sheet value does not purport to represent the current value – it shows the value after the proportionate allocation of cost. We can identify three broad types of fixed asset: tangibles, intangibles and financial.

Tangibles

A tangible fixed asset is an item that a firm owns and uses in the production of its income and which is not expected to be consumed or converted into cash any sooner than at least one year’s time. Buildings, real estate, equipment and furniture are good examples of fixed assets. Tangibles are sometimes collectively referred to as ‘plant’.

Intangibles

Intangible long-term assets are ‘non-monetary assets without physical substance’, such as trademarks and patents. Also included in “intangibles” are capitalized development expenses and goodwill.

Capitalized Development Expenses

Some companies (eg pharmaceuticals) need to invest in R&D for several years before a product comes to market. Since these costs do not relate to current revenues, it makes sense not to treat them as expenses in this year’s income statement. In fact, R&D appears to be more of an investment that will yield future revenues rather than an expense. For this reason, a proportion of R&D expenses (salaries, lab costs etc) may be capitalized – ie they become an asset on the balance sheet rather than an expense. The company’s auditors will seek to ensure that the expenses really are development expenses and that they are in line with normal industry practice.

Goodwill

When a company took over another company, the balance sheets of the acquiring and acquired companies would be added together. The problem was that the amount paid for a company rarely matched the balance sheet value. There was normally a premium paid. For instance, company X paid $500,000 for company Y. But company Y assets were only worth $300,000. When the company Y balance sheet was added to that of company X, the company X balance sheet no longer balanced. $300,000 of asset value has been added but $500,000 has gone out. So, a $200,000 entry would be made under Goodwill; it was essentially a balancing entry.

You may have noticed that I have been speaking in the past tense and that’s because things have changed. In the past, the difference in value would be lumped under goodwill and would be amortized, written off, over a period of, say, 20 years. Since the introduction of IFRS 3, however, this is no longer the case.

When a company is acquired, its intangible assets must be recognized separately from goodwill if:

  • they are identifiable
  • their cost, based on fair value, can be measured reliably

The fair value can be based on:

  • a quoted price in an active market
  • the amount the entity would have paid in an arm’s length transaction
  • a calculated value using earnings multiples, the relief from royalty method or discounted cash flows (more on these later)

In effect, this is the accounting community recognizing that in the modern world it is intangibles that often represent the bulk of the value in a takeover – and that valuing these assets may require additional expertise. Thus, consultancies such as Intangible Business have grown to provide valuations on intangibles such as brand. For some investors, the separate recognition of intangible assets is a good thing; it should expose the reason why a company has been acquired. However, in a review of IFRS, the IFRS Foundation stated:

“Other investors do not support the current practice of identifying additional intangible assets (for example, brands, customer relationships, etc) separately from goodwill, because it is highly subjective. They think that these intangible assets should be recognised only if there is a market for them.”

Once specific assets have been identified, then anything left would be regarded as goodwill and instead of being amortized, it is subject to annual ‘impairment tests’ and then discounted accordingly.

IFRS 3 brought accounting practices into line with the way that commercial organisations were thinking. Brand is, they argue, something that they will invest in through promotional activity and so should appear as assets and should not be amortized.

But what about internally generated intangibles, that is assets developed organically and not acquired through takeover. IFRS 3 allows these to be evaluated and recognized as assets if:

  • the asset is identifiable
  • future economic benefits are probable
  • the company has the intent and ability to complete the asset

However, it specifically excludes research expenditure and brands, along with customer lists.

Thus brands only appear on the Balance Sheet if they were acquired. Thus you will not see the brand of Coca Cola on their balance sheet. This may seem a little incongruous. After all, most people acknowledge that Coca Cola is one of the top 5 brands in the world and yet Coca Cola is not the on the balance sheet whereas a tiny bottling plant that it takes over could be. It also means that acquisitive companies could have more attractive balance sheets than organically-grown companies. There are two primary reasons why a company’s own brand does not appear:

  • no transaction – the primary purpose of the accounts is to record transactions. If you buy a company, there is a transaction. If you build a brand yourself, there is no transaction. The balance sheet does not purport to represent the value of the organization.
  • caution and conservatism – accountants err on the side of caution. If organically grown brands were allowed in the balance sheet, how could they be valued. Sure, there are lots of marketing consultancies that will offer to do this for you but each will come up with a different value and the process will never approach the level of consistency and transparency that an accountant demands. When a brand is acquired, there is at least a market transaction to provide an indication of value.

Financial Assets

Typical financial assets are:

  • equity in joint ventures – for example the stakes of Sony and Ericsson in Sony Ericsson (before Ericsson sold its share to Sony)
  • long-term customer financing – large companies will often provide long-term loans for customers. It is usually easier and cheaper for a large corporation to gain finance than, for instance, a start-up company in a developing country.
  • deferred tax assets – a company may incur tax losses and be able to ‘carry forward’ losses to reduce taxable income in future years

Current Assets

Current assets are assets that can be converted into cash easily or are likely to be converted into cash within one year. Cash is the term used to cover all ‘money’, not just folding bills and coins. Shares in publicly-traded companies fall under current assets, as do prepayments – payments made before value has been received by a company. For example, a company may pay for a service contract in advance in order to obtain a discount. Start-ups often have to deal pro forma – in other words, they pay for the goods when they place the order. The other major types of current asset are: inventory and accounts receivable.

Inventory

Inventory (sometimes called stock) offers lots of fun for (creative) accountants. As mentioned earlier, there are 3 broad types of inventory – raw materials, work-in-progress / work-in-process and finished goods. Each category brings its own challenges and opportunities for interpretation. Take raw materials, as you make sales, you remove items from inventory and add new ones that you buy. But did you sell the items you bought last year for $1 or your most recent purchases, bought at $2? This affects profitability. The LIFO method (Last In First Out) is common in the USA and Japan but not allowed under IFRS regulations. Assuming inflation and / or higher prices for more recently-purchased goods, LIFO usually lowers reported profitability and so defers taxes. FIFO (First in First Out) is the opposite and will lead to increased profits (because lower priced old stock is used) and a higher value for stock on the balance sheet (because the higher priced, most recently-purchased items remain).

Moving to WiP, the major potential difficulty should be immediately apparent – how do you value a part-finished product? For simple items adding up the cost of the components. But judgement plays a greater part where there is substantial ‘working’ or bespoke processes involved. Finally, would you value a finished good produced several months ago that might be subject to deterioration or changes in fashion in the same way as a brand-new item.

For a purely services company, ‘inventory’ may not make much sense. However, there can still be work-in-progress or even ‘finished goods’. For example, unbilled consulting work or an unpublished report. These are assets of the business and should be recorded in the balance sheet.

My focus is not so much on the accounting techniques – that is not the purpose of this program; rather it is to alert you to the need to look behind the bare numbers. For example, you may be responsible for producing a business and financial plan for an acquired business. If this is the case, you need to be aware of some of the pitfalls that can be hidden in the financial statements. Many financial analysts actually believe the footnotes to be the most important part of an annual report.

Accounts Receivable

This is money owed by debtors. Where a provision has been made for doubtful debtors, it should be subtracted from accounts receivable. Underestimating the value of doubtful debtors will make the company look more attractive.

Current Liabilities

Current liabilities are amounts owed and due for repayment by the company within a year, for example:

  • accounts payable (money owed to creditors)
  • accruals – amounts owed at the end of the period but not yet recorded. An energy bill may only arrive after the end of the period for energy already used. The cost of the energy used should be placed in the period to which it relates and so an accrual is made. Thus an accrual represents the value of an invoice that we have yet to receive for expenses relating to current trading.
  • short-term loans
  • declared dividends – a dividend becomes an actual liability on the date of declaration
  • tax payable in the coming year

It is normal to place current liabilities next to current assets on the balance sheet, allowing one to see the net current position.

Net Current Position

The net current position is the difference between current assets and current liabilities. This is an indication of the company’s ability to pay its way in the short-term. Beware of comparing the net current position of a company in one industry or market with that in another. Context is everything as we shall see when we consider working capital.

We now have the top half of the modern balance sheet.

fixed assets + (current assets less current liabilities)

The financing of the top half is revealed in the items in the bottom half.

Investors’ / Shareholders’ / Owners’ Funds

This portion of the balance sheet contains capital received from investors in exchange for stock (paid-in capital) and retained earnings. Retained earnings are the net earnings not paid out in dividends ie ‘retained’ by the company. The retained earnings figure is recorded under shareholders’ equity on the balance sheet and is a cumulative figure – ie the figure from the current period is added to the previous figure on the balance sheet. The retained earnings figure represents the total profits made by the company and yet to be returned to the owners (the investors).

Treasury Stock

Treasury stock refers to shares a company has issued and reacquired either through share repurchase programs or donations. A company is most likely to buy back their shares if management believes that the stock is undervalued. Pitney Bowes Chairman and CEO, Michael J. Critelli said in 1997:

“Our goal is to maximize the return on our stockholders’ investment in Pitney Bowes. We feel one of the strongest ways to signal our belief in the continued growth and profitability of Pitney Bowes is to proactively repurchase shares …”.

In 2012 there was $4.5bn of treasury stock on the Pitney Bowes balance sheet.

The effect of treasury stock is that cash and total equity go down by the same amount. Treasury stock is a negative entry under owners’ funds. The repurchased shares can either be retired (in some US states this is compulsory) or the company can hold them with the intention of reselling them to raise cash when the stock price rises.

Long Term Liabilities

Amounts owed by the company and not payable within a year. For instance:

  • notes and bond loans – to raise money a company may issue a bond. In return for cash the company agrees to pay the bond holder a rate of interest for a period of time until the bond is redeemed and the bondholder’s money is returned. The company is thus acting like a bank – and hopefully paying less in interest than it would to a bank (or obtaining funds that it could not otherwise obtain)
  • long-term loans – when a long-term loan becomes payable within the next year, it will be shifted to current liabilities, usually with some indication that it was a long-term debt.

Gearing

This ratio measures shareholders’ equity against debt. If you have a mortgage, then you have personal experience of gearing. Let’s say your house cost $200,000 and you invested $50,000 of your own money and took a mortgage of $150,000. At 75% of your home’s total value, your mortgage means that you are highly geared. Gearing is sometimes referred to as leverage. The loan acts like a lever to increase power of your equity. It can enable you to invest in new equipment, brand building or increased distribution. If the return that you make is greater than the cost of the debt, then the loan makes sense. However, the interest payments associated with high leverage can be dangerous. If interest rates rise, they may outstrip your returns. In addition, if there is a downturn in market conditions and sales fall, you may be unable to meet interest payments. This can lead to lenders seeking legal remedies and possibly liquidating the firm’s assets. This, of course, would not happen where the company is funded solely by shareholders’ equity.