Student Study Notes - Chapter 4

The Purpose of the Balance Sheet

  • Business owners prepare balance sheets to better understand the value of a business and how well its assets have been utilized to produce wealth for the business’s owners. For an example of why this is important, see Go Figure! in the text.
  • The type of information contained on a business’s balance sheet is of critical importance to several different groups including:
  • Owners
  • Investors
  • Lenders
  • Creditors
  • Managers

Owners

  • The balance sheet, prepared at the end of each defined accounting period, lets the owners of the business know about the amount of that business which they actually “own”.
  • A lien is the legal right to hold another’s property to satisfy a debt. A bank’s lien is similar to a business’s liabilities. These liabilities must be subtracted from the value of the business before its owners can determine the amount of their own equity (free and clear ownership). The balance sheet is designed to show the amount of a business owner’s free and clear ownership.

Investors

  • Investors seek to maximize the return on investment (ROI) (see Chapter 1) they receive. When a business’s balance sheet from one accounting period is compared to its balance sheet covering another time period, investors can measure their return on investment. For an example of this, see Go Figure!in the text.
  • Investors must have the information contained in a balance sheet if they are to accurately compute their annual returns on investment (ROI).

Lenders

  • Lenders are most concerned about a business’s ability to repay its debts. For a comparison of two hotels’ abilities to repay their debts, see Go Figure! in the text.
  • Lenders read the balance sheet of a business in an effort to better understand the financial strength (and thus the repayment ability) of that business.

Creditors

  • Business creditors, much like lenders, are concerned about repayment. It would not be unreasonable for vendors to ask to see their customer’s respective balance sheets before a decision was made regarding the wisdom of extending credit to them. The balance sheet is the financial document that most accurately indicates the long-term ability of a business to repay a vendor who has extended credit to that business.

Managers

  • Managers most often are more interested in the information found on the income statement than that found on the balance sheet. However, they too must be able to read and analyze their own balance sheets to determine items such as the current financial balances of cash, accounts receivable, inventories, and accounts payable, and other accounts that have a direct impact on operations.
  • Those who operate a business must consistently have sufficient cash on hand to pay their employees, their vendors, and the taxes owed by the business. The balance sheet indicates to management the amount of cash available to them on the day the balance sheet is prepared.
  • Managers must be able to read a balance sheet to determine the total amount of accounts receivable owed to the business on the date it is prepared. Excessively large amounts of accounts receivable (which are not identified on the income statement) could be telltale signs that:
  • Too much credit has been extended
  • Credit collection efforts may need to be reviewed and improved if necessary
  • Cash reserves could become insufficient to meet the short term needs of your business

Limitations of the Balance Sheet

  • The balance sheet is important because it reveals, at a fixed point in time, the amount of wealththat a company possesses. In this case, wealth is defined as the current value of all a company’s assets minus all of the company’s obligations.
  • No single approach to valuing assets is used by accountants in the preparation of the balance sheet. Knowledgeable readers of a balance sheet recognize that accountants utilize a variety of evaluation approaches, each of which may make the most sense for specific asset types based upon circumstances and available information.
  • It is also important to note that balance sheets have been criticized because of the company assets they do not value. Consider the fact that, of all the assets listed on the balance sheet, none take into account the relative value, or worth, of a restaurant or hotel’s staff, including its managers.

Balance Sheet Formats

  • A balance sheet represents an accountant’s systematic method of documenting the value of a business’s assets, liabilities and owner’s equity on a specific date.
  • There are two basic methods accountants use to display the information on a balance sheet.
  • When using the account format those preparing the balance sheet list the assets of a company on the left side of the report and the liabilities and owner’s equity accounts on the right side (see Figure 4.1).
  • When using the reportformat those preparing the balance sheet list the assets of a company first and then the liabilities and owner’s equity accounts (vertically), and present the totals in such a manner as to prove to the reader that assets equals liabilities plus owners equity (see Figure 4.2).
  • In both type formats, the date on which the balance sheet was prepared is clearly identified.

Balance Sheet Content

  • The Accounting formula is stated as Assets = Liabilities + Owner’s Equity, and the purpose of a balance sheet is to tell its readers as much as possible about each of these three accounting formula components.

Why a Balance Sheet Balances - Dr. Dopson’s Stuff Theory

  • Dr. Lea Dopson, a hospitality managerial accounting professor and one of the authors of your textbook, has developed “Dr. Dopson’s Stuff Theory” to explain why a balance sheet balances (see Figure 4.3).
  • Dr. Dopson’s Stuff Theory is simple. For all the stuff (assets) you have in your life, you got it from either:
  • Borrowing money that you have to repay such as through credit cards or loans (liabilities) or
  • Acquiring the stuff through others such as your parents, siblings, or friends (investors’ equity) or paying for the stuff yourself through money you earned (retained earnings equity)
  • You are reporting your stuff and how you GOT (past tense) your stuff. In this sense, the list of your stuff balances with how you got it. This is why a balance sheet balances!
  • This same concept applies to businesses when preparing their balance sheets. All assets (stuff) must equal liabilities plus owners’ equity (how they got their stuff).

Components of the Balance Sheet

  • The balance sheet is often subdivided into components under the broad headings of Assets, Liabilities, and Owners’ Equity.
  • These subclassifications have been created by accountants to make information more easily accessible to readers of the balance sheet and to allow for more rapid identification of specific types of information for decision making.

Assets

Current Assets

  • Current Assetsare those which may reasonably be expected to be sold or turned into cash within one year (or one operating season).
  • Liquidity is defined as the ease in which current assets can be converted to cash in a short period of time (less than 12 months).
  • Current assets, typically listed on the balance sheet in order of their liquidity, include:
  • Cash
  • Marketable securities
  • Accounts receivable (net receivables)
  • Inventories
  • Prepaid expenses
  • For purposes of preparing a balance sheet, the term cash refers to the cash held in cash banks, money held in checking or savings accounts, electronic fund transfers from payment card companies, and certificates of deposit (CDs).
  • Marketable securities include those investments such as stocks and bonds that can readily be bought sold and thus are easily converted to cash. These are stocks and bonds the business purchases from other companies. These are not to be confused with a company’s stocks that are listed on its balance sheet as owners’ equity.
  • Accounts receivable represent the amount of money owed to a business by others (such as customers). Net receivables (the term net means that something has been subtracted out) are those monies owed to the business after subtracting any amounts that may not be collectable (doubtful accounts).
  • In the hospitality industry, inventories will include the value of food, beverages and supplies used by a restaurant, as well as sheets, towels and the in-room replacement items (hangers, blow dryers, coffee makers and the like) used by a hotel.
  • Prepaid expenses are best understood as items that will be used within a year’s time, but which must be completely paid for at the time of purchase.
  • The order of liquidity for current assets is easily explained:
  • Cash is listed first because it is already cash.
  • Marketable securities are less liquid than cash, but can be readily sold for cash.
  • Net receivables can be collected from others (customers), but not as easily as converting marketable securities to cash.
  • Inventories must be made ready for sale to customers and the money must be collected. There is no guarantee that payment for all inventories will be collected in full, and thus some may end up being reported as receivables.
  • Prepaid expenses are the least liquid current asset because once paid, refunds for this money are very difficult (if not impossible) to receive. For an illustration of prepaid expenses, see Go Figure! in the text.
  • Those prepaid expenses that will be of value or benefit to the business for more than one year (for example a three year pre-paid insurance policy) should be listed on the balance sheet as “Other Assets.”

Non Current (Fixed) Assets

  • Non Current (Fixed) Assetsconsist of those assets which management intends to keep for a period longer than one year, and typically include investments, property and equipment (land, building, furnishings and equipment, less accumulated depreciation), and other assets (see Figures 4.1 and 4.2).
  • Included in this group are investments made by the business which management intends to retain for a period of time longer than one year, unlike marketable securities, which can be readily sold and converted to cash within one year.
  • Investments are typically one of three types:
  • Securities (stocks and bonds) acquired for a specific purpose, such as a restaurant company that purchases a significant amount of stock in a smaller company with the intent of influencing the operations of the smaller company.
  • Assets owned by a business but not currently used by it. An example would be vacant land owned by a restaurant company that is going to build (but has not yet built) a restaurant on the site.
  • Special funds that have a specific purpose. The most common of these is a sinking fund, inwhich monies are reserved and invested for use in the future.
  • Investments are valued on the balance sheet at their fair market value. Fair market value is most often defined as the price at which an item would change hands between a buyer and a seller without any compulsion to buy or sell.
  • Property and Equipment, which includes land, building, furnishings and equipment, usually make up a significant portion of the total value of a hospitality business and are another form of non-current asset. These are listed on the balance sheet at their original cost less their accumulated depreciation (see Chapter 2).
  • Other assets are a non-current asset group that includes items that are mostly intangible. This includes the value of goodwill (the difference between the purchase price of an item and its fair market value). Goodwill is an asset that is amortized (systematically reduced in value) over the period of time in which it will be of benefit to the business.
  • Other items in this category may include the cash surrender value of life insurance policies taken out on certain company executives, deferred charges such as loan fees that are amortized over the life of the loan, and restricted cash that is set aside for a specific (restricted) purpose.
  • The techniques of depreciation and amortization used by a business should be prepared and shown in the Notes to Financial Statements that should be attached to the balance sheet.
  • As previously noted it can be difficult to accurately assess the value of a business’s assets. The following approaches to evaluation are typically used by hospitality accountants when they seek to establish the value of a company’s assets:

Asset TypeWorth Established By

CashCurrent value

Marketable securitiesFair market value or amortized cost

Accounts receivableEstimated future value

InventoriesThe lesser of current value or price paid

InvestmentsFair market value or amortized cost

Property and equipmentPrice paid adjusted for allowed depreciation.

Liabilities

  • Current liabilities are defined as those obligations of the business that will be repaid within a year. The most important sub-classifications of current liabilities include notes payable, income taxes payable, and accounts payable.
  • In the hospitality industry, current liabilities typically consist of payables resulting from the purchase of food, beverages, products, services and labor.
  • Current period payments utilized for the reduction of long-term debt are also considered a current liability.
  • Guest’s pre-paid deposits (such as those required by a hotel that reserves a ballroom for a wedding to be held several months in the future) are also listed as a current liability (because these monies are held by the business but have not been earned at the time the hotel accepts the deposit).
  • Dividends that have been declared but not yet paid and income taxes that are due but not yet paid will also be included in this liability classification.
  • Long-term liabilities are those obligations of the business that will not be completely paid within the current year. Typical examples include long-term debt, mortgages, lease obligations, and deferred incomes taxes resulting from the depreciation methodology used by the business.

Owner’s Equity

  • While the liabilities section of the balance sheet identifies non-owner (external) claims against the business’s assets, the owners’ equity portion identifies the asset claims of the business’s owners.
  • For corporations, common stock is the balance sheet entry that represents the number of shares of stock issued (owned) multiplied by the par value (the value of the stock recorded in the company’s books).
  • Common stock is valued at its historical cost regardless of its current selling price. Initially, most companies designate a stated or par value for the stock they issue and as each share is sold, an amount equal to the par value is reported in the common stock section of the balance sheet.
  • Differences between the selling price and par value are reported in the paid in capital portion of the balance sheet.
  • Some companies also issue preferred stock that pays its stockholders (owners) a fixed dividend. When more than one type of stock is issued by a company, the value of each type should be listed separately on the balance sheet.
  • Retained earningsare the final entry on the owners’ equity portion of the balance sheet. Retained earnings refer simply to the accumulated account of profits over the life of the business that have not been distributed as dividends. If net losses have occurred, the entry amount in this section may be a negative number.
  • When a company is organized as a sole proprietorship, the balance sheet reflects that single ownership (see Figure 4.6). When a partnership operates the business, each partner’s share is listed on the balance sheet (see Figure 4.7).

Balance Sheet Analysis

  • After the balance sheet has been prepared, managerial accountants use a variety of methods to analyze the information it contains. Three of the most common types of analysis are:
  • Vertical (common-size) analysis
  • Horizontal (comparative) analysis
  • Ratio analysis

Vertical Analysis of Balance Sheets

  • Income statements can be analyzed using vertical and horizontal techniques. In very similar ways, the balance sheet can be reviewed using these same techniques.
  • When using vertical analysis on a balance sheet, the business’s Total Assets take on a value of 100%. Total Liabilities and Owners’ Equity also take a value 100% (see Figure 4.8).
  • When utilizing vertical analysis, individual asset categories are expressed as a percentage (fraction) of Total Assets. Individual liability and owner’s equity classifications are expressed as a percentage of Total Liabilities and Owner’s Equity.
  • Each percentage computed is a percent of a “common” number, which is why this type analysis is sometimes referred to as common-size analysis.
  • Vertical analysis of the balance sheet may be used to compare a unit’s percentages with industry averages, other units in a corporation, or percentages from prior periods.

Horizontal Analysis of Balance Sheets

  • A second popular method of evaluating balance sheet information is the horizontal analysis method.
  • As was true with the income statement, a horizontal analysis of a balance sheet requires at least two different sets of data. Because of this “comparison” approach the horizontal analysis technique is also called a comparative analysis.
  • Managers who use horizontal analysis to evaluate the balance sheet may be concerned with comparisons such as their:
  • Current period results vs. prior period results (see Figure 4.9)
  • Current period results vs. budgeted (planned) results
  • Current period results vs. the results of similar business units
  • Current period results vs. industry averages

Determining Variance