In our previous articles, we discussed the impact that accounting estimates have on the income statement. However, it is not just the income statement that is subject to estimates, the balance sheet is as well. Balance sheet items will affect efficiency ratios (asset turnover), solvency ratios (debt to equity), and liquidity ratios (quick ratio).
As efficiency ratios are a part of some return ratios (RoA, RoE), return ratios will also be affected. Therefore, you need to understand the estimates that go into balance sheet accounts before using these ratios for analysis. We will start our discussions with the left side of the balance sheet: the assets.
Accounts receivable is usually a major component of working capital (as a current asset). It is generated through credit sales, and is diminished by collecting on the credit sales. As with all forms of financing, credit sales come with a risk of default on the part of the borrower.
Credit policies are determined by the expected losses from buyers relative to the additional profit generated from credit sales as opposed to cash sales. A large accounts receivable relative to sales (ART) is usually indicative of loose credit terms or difficulties with collection,
Accounts receivable is reported on the balance sheet as its net value, or gross AR minus Allowance For Doubtful Accounts (AFDA). AFDA is the expected noncollectable AR, its value is revised every reporting period. AFDA is the estimated value, and can be estimated from two methods: the sales method and the aging of accounts method.
- Sales method – AFDA is a percentage of the period’s credit sales (from income statement), based on historical data. This method is less accurate but simpler.
- Aging of accounts method – AFDA is a percentage of the period’s AR (from balance sheet), based on historical data. Depending on the age of the AR, the chance of default is different. This method is more accurate but more involved.
When buyers actually default on their accounts payable, both AR and AFDA will be written-off. Bad debt expense is used to adjust the AFDA back to the appropriate amount every period in the aging of accounts method.
Inventory is usually carried at historical cost (cost to manufacture or cost to acquire). However, there are several inventory cost methods when that inventory is sold, we discussed that in the expense recognition article. The different inventory cost methods will affect the balance sheet as well, and that would in turn affect the inventory turnover ratio and the current ratio. As a review, the three methods are:
- FIFO – Inventory sold first are the ones bought/made first
- AC – Inventory sold is the average of all inventory
- LIFO – Inventory sold first are the ones bought/made last (only in US GAAP)
Assuming a normal inflationary environment, using FIFO will result in the highest level of inventory, AC the second highest and LIFO the lowest.
Long Term Operating Assets
Long term operating assets are typically the largest part of the assets of a company. It is made up of tangible assets (land, buildings, equipment) and intangible assets (trademarks, patents). The assets are on the non-current part of the balance sheet, and should provide value to the company for multiple reporting periods (years).
When incurring the costs of a long term operating asset, all costs to acquire and prepare the asset for use should be capitalized. For example, the installation fees, taxes, calibration fees and shipping fees should be capitalized alongside the cost of the equipment itself. Some borrowing costs, such as the interest on the financing used to purchase the equipment can be capitalized as well. However, anything else, such as routine maintenance that does not improve the asset or lengthen its economic life must be expensed. Improperly capitalizing costs can delay expense recognition and artificially increase asset book value.
Depreciation was also mentioned in the expense recognition article, but it is also relevant here. The choice of depreciation methods will affect the net book value of the asset. The depreciation methods are:
- Straight line method – depreciate at constant rate
- Double declining balance method – depreciate at accelerated rate
- Units of production method – depreciate at actual rate of use
Which method results in the highest level of assets is not definitive, as it could be straight line or units of production. Similarly, either double declining balance or units of production could result in the lowest level of assets.
Assets can be impaired, if the higher of fair value less cost of disposal or value in use is lower than its net book value. Impairment of assets will lower asset levels, and is usually an undesirable signal for investors. New management may be more inclined to aggressively write-down assets, in order to start from a more favorable position.
Intangible assets are assets that lack physical substance and will provide future benefits for the owner. The identifiable intangible assets can be separated, sold, transferred or exchanged (patents, copyrights, customer lists, formulas, processes, databases). Goodwill, the premium that companies pay for acquisitions is considered a not identifiable intangible asset.
If the intangible asset is developed internally, it is typically not capitalized. For example, if a customer list was developed by a conference the company hosted, the cost of the conference will be expensed in that period. One exception to that rule is capitalizing the development portion of R&D costs, if the product is technically and commercially viable, and the company has the intention and the resources to complete the development.
If the intangible asset is bought, the costs are capitalized. For example, if a pharmaceutical company buys a patent for a new cancer drug, the cost of the patent will go on non-current assets as patent. The cost of the patent, like other definite life intangible assets, is then amortized over its economic life (usually using the straight line method). If the patent is determined to be worth less than its carrying value, it should be impaired. Definite life intangible assets are tested for impairment when indicated, while indefinitely life intangible assets are tested annually.