FSA 3 Analyzing Balance Sheets

A balance sheet sets out three things at a single moment in time: the resources a company controls (assets), the claims of outside parties against it (liabilities), and what remains for the owners once those claims are settled (equity). Because it is a snapshot rather than a flow, it answers questions about financial position rather than performance.

The complication for an analyst is that not every line is measured the same way. Many items sit at historical cost, the amount originally paid. Others are carried at fair value, the amount a seller would collect on disposing of an asset, or a payer would surrender to shift a liability, in an orderly market transaction. And some items of real economic value, such as a skilled workforce or a trusted brand built up over years, are never recognized at all. Reading the balance sheet well therefore means knowing which basis applies to each line and where the notes fill the gaps.

Two bodies set the rules. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS), while the Financial Accounting Standards Board (FASB) issues US GAAP. The two frameworks agree on a great deal but differ on specific points, and this module flags the main divergences as they arise. Because standards are revised over time, some detail can date.

At a high level, assets and liabilities are measured either at fair value or at amortized or historical cost. The notes to the financial statements are where a company explains the measurement basis it has applied to each category, which is exactly the information needed to judge whether two companies can be compared on a like basis. Once the bases are understood, the balance sheet supports assessments of liquidity (the ability to meet near-term obligations) and solvency (the ability to meet obligations over the longer term), usually through ratios that connect balance sheet figures to one another and to other statements.

An intangible asset is an identifiable non-monetary asset that has no physical form. The word identifiable does real work here: an asset qualifies if it can be separated from the company and sold on its own, or if it springs from contractual or legal rights. Patents, licenses, trademarks, copyrights, franchises, and customer lists all fit. The single large intangible that lacks separate identifiability is goodwill, produced only through acquisitions and taken up in the next section.

Measurement, useful life, and impairment

IFRS lets a company carry intangibles under a cost model or, where an active market for the asset exists, a revaluation model; both mirror the treatment allowed for property, plant, and equipment (PP&E). US GAAP permits the cost model alone. For every intangible, the company must first judge the asset’s useful life as either finite or indefinite, since that call drives everything that follows.

• An intangible with a finite useful life is amortized systematically over the best estimate of that life, and both the method and the life estimate are revisited at least once a year. Its impairment rules match those for PP&E.
• An intangible carrying an indefinite life is left unamortized; at least once a year the company rechecks that an indefinite assumption still holds and tests the asset for impairment.

Analysts tend to treat reported intangible values, and goodwill in particular, with some suspicion. A common response is to compute a tangible book value by stripping intangibles out of equity, while adding any related amortization or impairment back to pretax income. Assigning a blanket value of zero is not sensible, though; the better habit is to examine each listed intangible and decide case by case whether an adjustment is warranted. The note disclosures, covering useful lives, the rates and methods of amortization, and any impairment losses booked or later reversed, are what make that judgement possible.

Internally created versus acquired intangibles

Estimating the cost of an intangible a company builds for itself is hard and subjective, so the default under both IFRS and US GAAP is to expense internally created identifiable intangibles rather than record them as assets. IFRS, however, draws a line down the middle of an internal project. It requires the research phase (the search for new knowledge or products) to be separated from the development phase (design and testing of prototypes and models that follows). Research-phase costs must be expensed. Development-phase costs may be capitalized as an intangible asset, but only once specific conditions hold, such as demonstrating technological feasibility, showing that the finished asset can be used or sold, and confirming that the project can be completed.

US GAAP goes further, refusing capitalization for most internally developed intangibles and for research and development in general, so those outlays are expensed. Regardless of framework, several categories are expensed as incurred:

• brands, mastheads, publishing titles, and customer lists that a company generates internally;
• the costs of starting up operations;
• staff training;
• general and administrative overhead;
• promotion and advertising;
• the expenses of relocation and reorganization; and
• termination and redundancy costs.

Purchased intangibles are treated differently. When a company buys an intangible that carries contractual rights (a licensing agreement), other legal rights (a patent), or the ability to be separated and sold (a customer list), that intangible is capitalized and reported as a separately identifiable asset.

Reported figures show how material intangibles can be. SAP’s 2017 balance sheet carries EUR2,967 million of intangible assets, and its notes explain that all purchased intangibles other than goodwill have finite lives amortized over estimated useful lives ranging from 2 to 20 years. Apple’s 2017 balance sheet lists acquired intangible assets, net, at USD2,298 million, almost entirely definite-lived, with a remaining weighted-average amortization period of 3.4 years.

Goodwill appears only when one company buys another. In an acquisition, the purchase price is spread across all identifiable assets and liabilities acquired, each measured at fair value. Whatever the buyer pays above the fair value of those net identifiable assets is recorded as a single asset called goodwill.

Why would an acquirer pay a premium at all? Three reasons recur. First, valuable items never recorded by the target, such as its reputation, distribution network, and trained staff, still command a price. Second, past research and development may have produced value without meeting the test for a separately recognized asset. Third, the deal may deliver improved strategic position against rivals or synergies such as operating cost savings once the two businesses combine.

Accounting goodwill versus economic goodwill

The topic divides opinion. Proponents argue that goodwill is the present value of the excess returns a company is expected to earn, no different in principle from valuing any other asset by its future cash flows. Opponents counter that acquisition prices often rest on over-optimistic hopes, which later force write-offs. Analysts keep two ideas apart. Accounting goodwill is a bookkeeping figure that appears only after an acquisition and follows the standards. Economic goodwill reflects the actual economic performance of the business, is what matters to investors, and shows up in the share price rather than on the balance sheet. Some users would keep goodwill off the balance sheet entirely, since it cannot be sold apart from the company; others study it and its later impairments to grade management on past deals.

Recognition, impairment, and disclosure

Under both IFRS and US GAAP, goodwill from an acquisition is capitalized. It is never amortized; rather, it undergoes an impairment test no less than once a year. Should it be judged impaired, a loss is booked against that period’s income and trims earnings. That same loss reduces total assets, so a measure such as return on assets can actually rise in later periods on the smaller asset base. Importantly, a goodwill impairment is a non-cash item. The steps behind recognition are straightforward: determine the total cost to buy the target; measure the acquiree’s identifiable assets, liabilities, and contingent liabilities at fair value to get net identifiable assets; and record the excess of purchase cost over net identifiable assets as goodwill. Occasionally the net identifiable assets are worth more than the price paid, a bargain purchase, and the resulting gain is recognized in profit and loss when it arises. Companies must also disclose enough for users to gauge each combination, including the acquisition-date cost, the amounts recognized for major classes of assets and liabilities, and a narrative of the factors that constitute the recognized goodwill.

Because fair value estimation leans heavily on management judgement, and because goodwill and its impairments can distort comparisons between companies, analysts often adjust for it. Two adjustments are common: removing goodwill from the balance sheet data used to compute ratios, and removing goodwill impairment losses from the income data used to study operating trends. Comparing the price paid in a deal with the acquired company’s net assets and earnings prospects is another way to form a view on how the acquisition may play out.

Scale matters when reading goodwill. SAP’s 2017 balance sheet shows EUR21,274 million of goodwill, which is 50.1 percent of its total assets, while Apple’s goodwill of USD5,717 million is just 1.5 percent of its total assets. A figure as large as SAP’s, half of all assets, is the kind of concentration that would draw an analyst’s attention.

A financial instrument is a contract that creates a financial asset for one party and, at the same time, a financial liability or equity instrument for another. This section looks mainly at the asset side, meaning a company’s investments in the shares, notes, or bonds issued by other companies or by governments. The liability side, such as a company’s own notes and bonds payable, comes later. Some instruments serve as an asset in one situation and a liability in another, according to their terms and to market conditions; a derivative is the classic case, since its value comes from an underlying factor (a credit rating, an interest or exchange rate, or the price of a commodity or security) and it needs little or no money to enter.

Two measurement bases

A financial instrument is recognized once the company becomes a party to the contract. After that, measurement follows one of two routes: fair value or amortized cost. Amortized cost is the amount first recognized, less principal repaid, plus or minus any amortization of a discount or premium, and less any impairment. Where an asset is held at fair value, the standard also has to say what happens to the period’s change in value while the asset is still owned. Those unrealized changes, also called holding period gains and losses, can be recognized in one of two places: on the income statement as profit or loss, or in other comprehensive income, which bypasses the income statement. Gains and losses that are realized on an actual sale always run through the income statement.

How financial assets are classified

IFRS sorts financial assets into three measurement categories, and US GAAP has close counterparts.

• Amortized cost. Used under IFRS when the asset’s cash flows arrive on fixed dates and are made up only of principal and interest, and the intent under the business model is to keep the asset until it matures. A long-term bond bought to hold to maturity fits here: its market value moves with interest rates, but it stays on the books at amortized cost. Loans and notes receivable also belong here. US GAAP calls this category held-to-maturity.
• Fair value through other comprehensive income (FVOCI). Used under IFRS when the business model is both to collect contractual cash flows and to sell the asset; it applies to debt with cash flows of solely principal and interest, and also to equity investments when the company makes an irrevocable election at purchase. The US GAAP relative is available-for-sale, but it covers debt securities only and is not allowed for equity investments.
• Fair value through profit or loss (FVPL). The default under IFRS for assets that fit neither of the other two, plus any asset the company irrevocably elects into this category at purchase. Under US GAAP, all equity securities (other than holdings large enough to give significant influence) are measured this way, as are debt securities designated as trading, meaning bought to sell rather than to hold for interest and principal.

Disclosures put these categories to work. SAP’s 2017 balance sheet reports other financial assets of EUR990 million (current) and EUR1,155 million (non-current); its notes identify loans and other financial receivables of EUR793 million as the largest current piece and EUR827 million of available-for-sale equity investments as the largest non-current piece. Apple reports USD53,892 million of short-term marketable securities and USD194,714 million of long-term marketable securities; together, marketable securities exceed 66 percent of its USD375.3 billion of total assets, and with cash and cash equivalents the figure is around 72 percent. Apple’s notes show these are mostly fixed-income instruments from the US government and its agencies (USD60,237 million) alongside corporate issuers, commercial paper included (USD153,451 million); the company labels them available for sale, carries them at fair value, and routes unrealized gains and losses through other comprehensive income.

Any liability that is not current is non-current, or long-term. Both SAP and Apple report a non-current portion of unearned revenue (deferred income for SAP, deferred revenue for Apple), representing amounts collected for goods and services expected to be delivered more than 12 months out. Two common long-term liabilities deserve a closer look: financial liabilities such as loans and bonds, and deferred tax liabilities.

Long-term financial liabilities

The typical long-term financial liabilities are loans (bank borrowings) and notes or bonds payable (fixed-income securities sold to investors). As a rule these are carried at amortized cost, and by maturity the amortized cost, the carrying amount, has converged on the face value.

Two short cases make the point. If a company issues USD10,000,000 of bonds at par, they are reported as a USD10 million liability from issue right through to maturity, with no change in carrying amount. If instead it issues the same USD10,000,000 of bonds at 97.50 percent of par, a discount, the liability starts at USD9,750,000; over the bond’s life the USD250,000 discount is amortized so that the carrying amount reaches USD10,000,000 at maturity. A bond sold at a premium works the same way in reverse. Some liabilities are instead carried at fair value: those held for trading, derivatives sitting in a liability position, and certain non-derivative instruments, for instance ones hedged using derivatives. SAP reports EUR5,034 million of financial liabilities, mostly bonds payable, and Apple reports USD97,207 million of long-term debt made up of floating- and fixed-rate notes spread across a range of maturities.

Deferred tax liabilities

Deferred tax liabilities come from temporary timing differences between income measured for tax purposes and income measured for the financial statements. They arise when taxable income, and so the tax actually payable, is below reported pretax income and its associated tax expense in a period; formally, they are the income taxes payable in future periods on taxable temporary differences. The gap between the smaller taxes payable and the larger income tax expense becomes the deferred tax liability. The everyday cause is using accelerated depreciation for tax while using straight-line depreciation for reporting, which pushes taxable income below accounting income early on. Deferred tax liabilities can also arise when income is taxed only later, for instance profits of a subsidiary that have not yet been distributed. SAP reports EUR240 million of deferred tax liabilities; Apple shows no separate line, but its notes reveal that most of its USD40,415 million of other non-current liabilities is deferred tax, totaling USD31,504 million.