Chapter 4 - Assets, Liabilities & Financial Statement Analysis

Long-Term Assets

Assets are items a business owns. For accounting purposes, assets are categorized as current versus long term, and tangible versus intangible. Assets that are expected to be used by the business for more than one year are considered long-term assets. They are not intended for resale and are anticipated to help generate revenue for the business in the future. Some common long-term assets are computers and other office machines, buildings, vehicles, software, computer code, and copyrights. Although these are all considered long-term assets, some are tangible and some are intangible.

Tangible Assets

An asset is considered a tangible asset when it is an economic resource that has physical substance—it can be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, not be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets.

Businesses typically need many different types of these assets to meet their objectives. These assets differ from the company’s products. For example, the computers that Apple Inc. intends to sell are considered inventory (a short-term asset), whereas the computers Apple’s employees use for day-to-day operations are long-term assets. In Liam’s case, the new silk-screening machine would be considered a long-term tangible asset as he plans to use it over many years to help him generate revenue for his business. Long-term tangible assets are listed as noncurrent assets on a company’s balance sheet. Typically, these assets are listed under the category of Property, Plant, and Equipment (PP&E), but they may be referred to as fixed assets or plant assets.

Apple Inc. lists a total of $33,783,000,000 in total Property, Plant and Equipment (net) on its 2017 consolidated balance sheet (see Figure 11.2).2 As shown in the figure, this net total includes land and buildings, machinery, equipment and internal-use software, and leasehold improvements, resulting in a gross PP&E of $75,076,000,000—less accumulated depreciation and amortization of $41,293,000,000—to arrive at the net amount of $33,783,000,000.

Intangible Assets

Companies may have other long-term assets used in the operations of the business that they do not intend to sell, but that do not have physical substance; these assets still provide specific rights to the owner and are called intangible assets. These assets typically appear on the balance sheet following long-term tangible assets (see Figure 11.3.) Examples of intangible assets are patents, copyrights, franchises, licenses, goodwill, sometimes software, and trademarks (Table 11.1). Because the value of intangible assets is very subjective, it is usually not shown on the balance sheet until there is an event that indicates value objectively, such as the purchase of an intangible asset.

4.1 Capitalized Costs versus Expenses

When a business purchases a long-term asset (used for more than one year), it classifies the asset based on whether the asset is used in the business’s operations. If a long-term asset is used in the business operations, it will belong in property, plant, and equipment or intangible assets. In this situation the asset is typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life. 

Property, Plant, and Equipment (Fixed Assets)

Why are the costs of putting a long-term asset into service capitalized and written off as expenses (depreciated) over the economic life of the asset? Let’s return to Liam’s start-up business as an example. Liam plans to buy a silk-screening machine to help create clothing that he will sell. The machine is a long-term asset because it will be used in the business’s daily operation for many years. If the machine costs Liam $5,000 and it is expected to be used in his business for several years, generally accepted accounting principles (GAAP) require the allocation of the machine’s costs over its useful life, which is the period over which it will produce revenues. Overall, in determining a company’s financial performance, we would not expect that Liam should have an expense of $5,000 this year and $0 in expenses for this machine for future years in which it is being used. GAAP addressed this through the expense recognition (matching) principle, which states that expenses should be recorded in the same period with the revenues that the expense helped create. In Liam’s case, the $5,000 for this machine should be allocated over the years in which it helps to generate revenue for the business. Capitalizing the machine allows this to occur. As stated previously, to capitalize is to record a long-term asset on the balance sheet and expense its allocated costs on the income statement over the asset’s economic life. Therefore, when Liam purchases the machine, he will record it as an asset on the financial statements.

When capitalizing an asset, the total cost of acquiring the asset is included in the cost of the asset. This includes additional costs beyond the purchase price, such as shipping costs, taxes, assembly, and legal fees. For example, if a real estate broker is paid $8,000 as part of a transaction to purchase land for $100,000, the land would be recorded at a cost of $108,000.

Over time as the asset is used to generate revenue, Liam will need to depreciate the asset.

Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business believes it will use the asset to help generate revenue. 

Repair and Maintenance Costs of Property, Plant, and Equipment

Long-term assets may have additional costs associated with them over time. These additional costs may be capitalized or expensed based on the nature of the cost. For example, Walmart’s financial statements explain that major improvements are capitalized, while costs of normal repairs and maintenance are charged to expenses as incurred.

An amount spent is considered a current expense, or an amount charged in the current period, if the amount incurred did not help to extend the life of or improve the asset. For example, if a service company cleans and maintains Liam’s silk-screening machine every six months, that service does not extend the useful life of the machine beyond the original estimate, increase the capacity of the machine, or improve the quality of the silk-screening performed by the machine. Therefore, this maintenance would be expensed within the current period. In contrast, if Liam had the company upgrade the circuit board of the silk-screening machine, thereby increasing the machine’s future capabilities, this would be capitalized and depreciated over its useful life.

4.2 Depreciation Methods

In this section, we concentrate on the major characteristics of determining capitalized costs and some of the options for allocating these costs on an annual basis using the depreciation process. In the determination of capitalized costs, we do not consider just the initial cost of the asset; instead, we determine all of the costs necessary to place the asset into service. For example, if our company purchased a drill press for $22,000, and spent $2,500 on sales taxes and $800 for delivery and setup, the depreciation calculation would be based on a cost of $22,000 + $2,500 + $800, for a total cost of $25,300.

We also address some of the terminology used in depreciation determination that you want to familiarize yourself with. Finally, in terms of allocating the costs, there are alternatives that are available to the company. We will consider three of the most popular options, the straight-line method, the units-of-production method, and the double-declining-balance method.

Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

1. Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
2. At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation expenses incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s estimated useful life.

Recording the Initial Purchase of an Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation should be included. Costs outside of the purchase price may include shipping, taxes, installation, and modifications to the asset.

The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term account payable) is shown here.

Applying this to Liam’s silk-screening business, we learn that he purchased his silk-screening machine for $5,000 by paying $1,000 cash and the remainder in a note payable over five years. The journal entry to record the purchase is shown here.

Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.

The following items are important in determining and recording depreciation:

• Book value: the asset’s original cost less accumulated depreciation.
• Useful life: the length of time the asset will be productively used within operations.
• Salvage (residual) value: the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
• Depreciable base (cost): the depreciation expense over the asset’s useful life. For example, if we paid $50,000 for an asset and anticipated a salvage value of $10,000, the depreciable base is $40,000. We expect $40,000 in depreciation over the time period in which the asset was used, and then it would be sold for $10,000.

Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. The journal entry to record depreciation is shown here.

Depreciation expense is a common operating expense that appears on an income statement. Accumulated depreciation is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.

In this case, the asset’s book value is $20,000: the historical cost of $25,000 less the accumulated depreciation of $5,000.

It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.

Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate the allocation of depreciation expense: the straight-line method, the units-of-production method, and the double-declining-balance method. Assume that on January 1, 2019, Kenzie Company bought a printing press for $54,000. Kenzie pays shipping costs of $1,500 and setup costs of $2,500, assumes a useful life of five years or 960,000 pages. Based on experience, Kenzie Company anticipates a salvage value of $10,000.

Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. The Kenzie example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so the total cost would be $58,000, and after allowing for an anticipated salvage value of $10,000 in five years, the business could take $48,000 in depreciation over the machine’s economic life.

Straight-Line Depreciation

Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of $48,000 by the economic life of five years, giving an annual depreciation expense of $9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one:

After the journal entry in year one, the press would have a book value of $48,400. This is the original cost of $58,000 less the accumulated depreciation of $9,600. Here are the journal entry and information for year two:

Kenzie records an annual depreciation expense of $9,600. Each year, the accumulated depreciation balance increases by $9,600, and the press’s book value decreases by the same $9,600. At the end of five years, the asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of $48,000 (5 × $9,600) from the cost of $58,000.

Partial-Year Depreciation

A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of $58,000, a five-year useful life, and a salvage value of $10,000. The annual depreciation is $9,600 ($58,000 – 10,000/5). However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine months of the first year. The depreciation expense of the first year is $7,200 ($9,600 × 9/12). The company will depreciate the asset $9,600 for the next four years, but only $2,400 in the sixth year so that the total depreciation of the asset over its useful life is the depreciable amount of $48,000 ($7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

4.3 Special Issues in Accounting for Long-Term Assets

Sale of an Asset

When an asset is sold, the company must account for its depreciation up to the date of sale. This means the company may be required to record a depreciation entry before the sale of the asset to ensure it is current. After ensuring that the net book value of an asset is current, the company must determine if the asset has sold at a gain, at a loss, or at book value. We will look at examples of each accounting alternative using the Kenzie Company data.

Recall that Kenzie’s press has a depreciable base of $48,000 and an economic life of five years. If Kenzie sells the press at the end of the third year, the company would have taken three years of depreciation amounting to $28,800 ($9,600 × 3 years). With an original cost of $58,000, and after subtracting the accumulated depreciation of $28,800, the press would have a book value of $29,200. If the company sells the press for $31,000, it would realize a gain of $1,800, as shown.

The journal entry to record the sale is shown here.

If Kenzie sells the printing press for $27,100, what would the journal entries be? The book value of the press is $29,200, so Kenzie would be selling the press at a loss. The journal entry to record the sale is shown here.

What if Kenzie sells the press at exactly book value? In this case, the company will realize neither a gain nor a loss. Here is the journal entry to record the sale.

4.4 Identify and Describe Current Liabilities

To assist in understanding current liabilities, assume that you own a landscaping company that provides landscaping maintenance services to clients. As is common for landscaping companies in your area, you require clients to pay an initial deposit of 25% for services before you begin working on their property. Asking a customer to pay for services before you have provided them creates a current liability transaction for your business. As you’ve learned, liabilities require a future disbursement of assets or services resulting from a prior business activity or transaction. For companies to make more informed decisions, liabilities need to be classified into two specific categories: current liabilities and noncurrent (or long-term) liabilities. The differentiating factor between current and long-term is when the liability is due.

Fundamentals of Current Liabilities

A current liability is a debt or obligation due within a company’s standard operating period, typically a year. Noncurrent liabilities are long-term obligations with payment typically due in a subsequent operating period.

Current vs. Noncurrent Liabilities

Examples of Current Liabilities

Common current liabilities include accounts payable, unearned revenues, the current portion of a note payable, and taxes payable. Each of these liabilities is current because it results from a past business activity, with a disbursement or payment due within a period of less than a year.

Accounts Payable

Accounts payable accounts for financial obligations owed to suppliers after purchasing products or services on credit. An account payable is usually a less formal arrangement than a promissory note for a current note payable. An invoice from the supplier (such as the one shown in Figure 12.2) detailing the purchase, credit terms, invoice date, and shipping arrangements will suffice for this contractual relationship. In many cases, accounts payable agreements do not include interest payments, unlike notes payable.

For example, assume the owner of a clothing boutique purchases hangers from a manufacturer on credit. The organizations may establish an ongoing purchase agreement, which includes purchase details (such as hanger prices and quantities), credit terms (2/10, n/60), an invoice date, and shipping charges (free on board (FOB) shipping) for each order.

Unearned Revenue

Unearned revenue, also known as deferred revenue, is a customer’s advance payment for a product or service that has yet to be provided by the company. Some common unearned revenue situations include subscription services, gift cards, advance ticket sales, lawyer retainer fees, and deposits for services. Under accrual accounting, a company does not record revenue as earned until it has provided a product or service. Until the customer is provided with the obligated product or service, a liability exists, and the amount paid in advance is recognized in the Unearned Revenue account. As soon as the company provides all, or a portion, of the product or service, the value is then recognized as earned revenue.

For example, assume that a landscaping company provides services to clients. The company requires advance payment before rendering service. The customer’s advance payment for landscaping is recognized in the Unearned Service Revenue account, which is a liability. Once the company has finished the client’s landscaping, it may recognize all of the advance payment as earned revenue in the Service Revenue account. If the landscaping company provides part of the landscaping services within the operating period, it may recognize the value of the work completed at that time.

Notes Payable

A note payable is a debt to a lender with specific repayment terms, which can include principal and interest. A note payable has written contractual terms that make it available to sell to another party. The principal on a note refers to the initial borrowed amount, not including interest. In addition to repayment of principal, interest may accrue. Interest is a monetary incentive to the lender, which justifies loan risk.

Interest is an expense that you might pay for the use of someone else’s money. For example, if you have a credit card and you owe a balance at the end of the month it will typically charge you a percentage, such as 1.5% a month (which is the same as 18% annually) on the balance that you owe. Assuming that you owe $400, your interest charge for the month would be $400 × 1.5%, or $6.00. To pay your balance due on your monthly statement would require $406 (the $400 balance due plus the $6 interest expense).

We make one more observation about interest: interest rates are typically quoted in annual terms. For example, if you borrowed money to buy a car, your interest expense might be quoted as 9%. Note that this is an annual rate. If you are making monthly payments, the monthly charge for interest would be 9% divided by twelve, or 0.75% a month. For example, if you borrowed $20,000, and made sixty equal monthly payments, your monthly payment would be $415.17, and your interest expense component of the $415.17 payment would be $150.00. The formula to calculate interest on either an annual or partial-year basis is:

Interest = Principal (amount borrowed) x Interest Rate x Period of Time

In our example this would be

$20,000 x 9% x (¹/₁₂) = $150

The good news is that for a loan such as our car loan or even a home loan, the loan is typically what is called fully amortizing. At this point, you just need to know that in our case the amount that you owe would go from a balance due of $20,000 down to $0 after the twentieth payment and the part of your $415.17 monthly payment allocated to interest would be less each month. For example, your last (sixtieth) payment would only incur $3.09 in interest, with the remaining payment covering the last of the principal owed. See Figure 13.7 for an exhibit that demonstrates this concept.

4.5 Analyze, Journalize, and Report Current Liabilities

To illustrate current liability entries, we use transaction information from Sierra Sports (see Figure 12.6). Sierra Sports owns and operates a sporting goods store in the Southwest specializing in sports apparel and equipment. The company engages in regular business activities with suppliers, creditors, customers, and employees.

Accounts Payable

On August 1, Sierra Sports purchased $12,000 of soccer equipment from a manufacturer (supplier) on credit. In the current transaction, credit terms are 2/10, n/30, the invoice date is August 1, and shipping charges are FOB shipping points (which is included in the purchase cost).

Credit terms of 2/10, n/30 signal the payment terms and discount. Therefore, 2/10, n/30 means Sierra Sports has ten days to pay its balance due to receive a 2% discount, otherwise Sierra Sports has net thirty days—in this case August 31—to pay in full but not receive a discount. Sierra Sports would make the following journal entry on August 1.

The merchandise is purchased from the supplier on credit. In this case, Accounts Payable would increase (a credit) for the full amount due. Inventory, the asset account, would increase (a debit) for the purchase price of the merchandise.

If Sierra Sports pays the full amount owed on August 10, it qualifies for the discount, and the following entry would occur.

Assume that the payment to the manufacturer occurs within the discount period of ten days (2/10, n/30) and is recognized in the entry. Accounts Payable decreases (debit) for the original amount due, Inventory decreases (credit) for the discount amount of $240 ($12,000 × 2%), and Cash decreases (credit) for the remaining balance due after discount. Note that Inventory is decreased in this entry because the value of the merchandise (soccer equipment) is reduced. 

In another possible scenario, Sierra Sports remitted payment outside of the discount window on August 28, but inside of thirty days. In this case, they did not qualify for the discount—and assuming that they made no returns—they paid the full, undiscounted balance of $12,000.

If this occurred, both Accounts Payable and Cash decreased by $12,000. Inventory is not affected in this instance because the full cost of the merchandise was paid.

Unearned Revenue

Sierra Sports has contracted with a local youth football league to provide all uniforms for participating teams. The league pays for the uniforms in advance, and Sierra Sports provides the customized uniforms shortly after purchase. The following situation shows the journal entry for the initial purchase with cash. Assume the league pays Sierra Sports for twenty uniforms (cost per uniform is $30, for a total of $600) on April 3.

Sierra Sports would see an increase to Cash (debit) for the payment made from the football league. The revenue from the sale of the uniforms is $600 (20 uniforms × $30 per uniform). Unearned Uniform Revenue accounts reflect the prepayment from the league, which cannot be recognized as earned revenue until the uniforms are provided. Unearned Uniform Revenue is a current liability account that increases (credit) with the increase in outstanding product debt.

Sierra provides the uniforms on May 6 and records the following entry.

Now that Sierra has provided all of the uniforms, the unearned revenue can be recognized as earned. This satisfies the revenue recognition principle. Therefore, Unearned Uniform Revenue would decrease (debit), and Uniform Revenue would increase (credit) for the total amount.

In another scenario using the same cost information, assume that on April 3, the league contracted for the production of the uniforms on credit with terms 5/10, n/30. They signed a contract for the production of the uniforms, so an account receivable was created for Sierra, as shown.

Sierra and the league have worked out credit terms and a discount agreement. As such, the league can delay cash payment for ten days and receive a discount, or for thirty days with no discount assessed. Instead of cash increasing for Sierra, Accounts Receivable increases (debit) for the amount the football league owes.

The league pays for the uniforms on April 15, and Sierra provides all uniforms on May 6. The following entry shows the payment on credit.

The football league made payment outside of the discount period, since April 15 is more than ten days from the invoice date. Thus, they do not receive the 5% discount. Cash increases (debit) for the $600 paid by the football league, and Accounts Receivable decreases (credit).

When the company provides the uniforms on May 6, Unearned Uniform Revenue decreases (debit) and Uniform Revenue increases (credit) for $600.

4.6 Record Transactions Incurred in Preparing Payroll

Have you ever looked at your paycheck and wondered where all the money went? Well, it did not disappear; the money was used to contribute required and optional financial payments to various entities.

Payroll can be one of the largest expenses and potential liabilities for a business. Payroll liabilities include employee salaries and wages, and deductions for taxes, benefits, and employer contributions. In this section, we explain these elements of payroll and the required journal entries.

Employee Compensation and Deductions

As an employee working in a business, you receive compensation for your work. This pay could be a monthly salary or hourly wages paid periodically. The amount earned by the employee before any reductions in pay occur is considered gross income (pay). These reductions include involuntary and voluntary deductions. The remaining balance after deductions is considered net income (pay), or take-home-pay. The take-home-pay is what employees receive and deposit in their bank accounts.

Involuntary Deductions

Involuntary deductions are withholdings that neither the employer nor the employee have control over and are required by law.

Federal, state, and local income taxes are considered involuntary deductions. 

While not a common occurrence, local income tax withholding is applied to those living or working within a jurisdiction to cover schooling, social services, park maintenance, and law enforcement. If local income taxes are withheld, these remain current liabilities until paid.

Various countries and states may have additional involuntary deductions that they impose during a payroll process. 

Involuntary deductions may also include child support payments, federal tax levies, court-ordered wage garnishments, and bankruptcy judgments. All involuntary deductions are an employer’s liability until they are paid.

Voluntary Deductions

In addition to involuntary deductions, employers may withhold certain voluntary deductions from employee wages. Voluntary deductions are not required to be removed from employee pay unless the employee designates reduction of these amounts. Voluntary deductions may include, but are not limited to, health-care coverage, life insurance, retirement contributions, charitable contributions, pension funds, and union dues. Employees can cover the full cost of these benefits or they may cost-share with the employer.

As with involuntary deductions, voluntary deductions are held as a current liability until paid. When payroll is disbursed, journal entries are required.

4.7 Long-Term Liabilities

Businesses have several ways to secure financing and, in practice, will use a combination of these methods to finance the business. As you’ve learned, net income does not necessarily mean cash. In some cases, in the long-run, profitable operations will provide businesses with sufficient cash to finance current operations and to invest in new opportunities. However, situations might arise where the cash flow generated is insufficient to cover future anticipated expenses or expansion, and the company might need to secure additional funding.

If the extra amount needed is somewhat temporary or small, a short-term source, such as a loan, might be appropriate. When additional long-term funding needs arise, a business can choose to sell stock in the company (equity-based financing) or obtain a long-term liability (debt-based financing), such as a loan that is spread over a period longer than a year.

Types of Long-Term Funding

If a company needs additional funding for a major expenditure, such as expansion, the source of funding would typically be repaid over several years, or in the case of equity-based financing, over an indefinite period of time. With equity-based financing, the company sells an interest in the company’s ownership by issuing shares of the company’s common stock. This financing option is equity financing.

Debt as an option for financing is an important source of funding for businesses. If a company chooses a debt-based option, the business can borrow money on an intermediate (typically 2–4 years) or long-term (longer than four years) basis from lenders. When a company chooses a loan, the business signs what is known as a note, and a legal relationship called a note payable is created between the borrower and the lender. The document lists the conditions of the financial arrangement, a fixed predetermined interest rate (or, if the agreement allows, a variable interest rate), the amount borrowed, the borrowing costs to be charged, and the timing of the payments. For individuals a student loan, car loan, or a mortgage can all be types of notes payable. Figure 13.2 shows a sample promissory note that might be used for a simple, relatively intermediate-term loan. If we were considering a loan that would be repaid over a several-year period the document might be a little more complicated.

The note payable creates an obligation for the borrower to repay the lender on a specified date. To demonstrate the mechanics of a loan, a note payable is created for the borrower when the loan is initiated. This example assumes the loan will be paid in full by the maturity or due date. Typically, over the life of the loan, payments will be composed of both principal and interest components. The principal component paid typically reduces the amount that the borrower owes the lender. For example, assume that a company borrowed $10,000 from a lender under the following terms: a five-year life, an annual interest rate of 10%, and five annual payments at the end of the year.

Under these terms, the annual payment would be $2,637.97. The first year’s payment would be allocated to an interest expense of $1,000, and the remaining amount of the payment would go to reduce the amount borrowed (principal) by $1,637.97. After the first year’s payment, the company would owe a remaining balance of $8,362.03 ($10,000 – $1637.97.) Typical long-term loans have other characteristics. For example, most long-term notes are held by one entity, meaning one party provides all of the financing. If a company bought heavy-duty equipment from Caterpillar, it would be common for the seller of the equipment to also have a division that would provide the financing for the transaction. An additional characteristic of a long-term loan is that in many, if not most, situations, the initial creator of the loan will hold it and receive and process payments until it matures.

Fundamentals of Interest Calculation

Since interest is paid on long-term liabilities, we now need to examine the process of calculating interest. Interest can be calculated in several ways, some more common than others. For our purposes, we will explore interest calculations using the simple method and the compounded method. Regardless of the method involved, there are three components that we need when calculating interest:

1. Amount of money borrowed (called the principal).
2. Interest rate for the time frame of the loan. Note that interest rates are usually stated in annual terms (e.g., 8% per year). if the timeframe is excluded, an annual rate should be assumed. Pay particular attention to how often the interest is to be paid because this will affect the rate used in the calculation:
   Interest rate = Annual rate ÷ Payments per period
   For example, if the rate on a bond is 6% per year but the interest is paid semi-annually, the rate used in the interest calculation should be 3% because the interest applies to a 6-month timeframe (6% ÷ 2). Similarly, if the rate on a bond is 8% per year but the interest is paid quarterly, the rate used in the interest calculation should be 2% (8%  ÷ 4).
3. Time period for which we are calculating the interest,

Let’s explore simple interest first. We use the following formula to calculate interest in dollars:

Interest in $ = Principal x Interest Rate x Time 

Principal is the amount of money invested or borrowed, interest rate is the interest rate paid or earned, and time is the length of time the principal is borrowed or invested. Consider a bank deposit of $100 that remains in the account for three years, earning 6% per year with the bank paying simple interest. In this calculation, the interest rate is 6% a year, paid once at the end of the year. Using the interest rate formula from above, the interest rate remains 6% (6% ÷ 1). Using 6% interest per year earned on a $100 principal provides the following results in the first three years (Figure 13.5):

• Year 1: The $100 in the bank earns 6% interest, and at the end of the year, the bank pays $6.00 in interest, making the amount in the bank account $106 ($100 principal + $6 interest).
• Year 2: Assuming we do not withdraw the interest, the $106 in the bank earns 6% interest on the principal ($100), and at the end of the year, the bank pays $6 in interest, making the total amount $112.
• Year 3: Again, assuming we do not withdraw the interest, $112 in the bank earns 6% interest on the principal ($100), and at the end of the year, the bank pays $6 in interest, making the total amount $118.

With simple interest, the amount paid is always based on the principal, not on any interest earned.

Another method commonly used for calculating interest involves compound interest. Compound interest means that the interest earned also earns interest. Figure 13.6 shows the same deposit with compounded interest.

In this case, investing $100 today in a bank that pays 6% per year for three years with compound interest will produce $119.10 at the end of the three years, instead of $118.00, which was earned with simple interest.

At this point, we need to provide an assumption we make in this chapter. Since financial institutions typically cannot deal in fractions of a cent, in calculations such as the above, we will round the final answer to the nearest cent, if necessary. For example, the final cash total at the end of the third year in the above example would be $119.1016. However, we rounded the answer to the nearest cent for convenience. In the case of a car or home loan, the rounding can lead to a higher or lower adjustment in your final payment. For example, you might finance a car loan by borrowing $20,000 for 48 months with monthly payments of $469.70 for the first 47 months and $469.74 for the final payment.

Pricing of Long-Term Notes Payable

When a consumer borrows money, they can expect to not only repay the amount borrowed, but also to pay interest on the amount borrowed. When they make periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. In these timed payments, part of what they pay is interest. The amount borrowed that is still due is often called the principal. After they have made their final payment, they no longer owe anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan. A fully amortized loan is fully paid by the end of the maturity period.

In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank. They will repay the loan with five equal payments at the end of the year for the next five years. The bank’s required interest rate is an annual rate of 12%.

Interest rates are typically quoted in annual terms. Since their interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that they owe. As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan.

After each payment in a fully amortizing loan, the principal is reduced, which means that since the five payment amounts are equal, the portion allocated to interest is reduced each year, and the amount allocated to principal reduction increases an equal amount.

We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan. An amortization table calculates the allocation of interest and principal for each payment and is used by accountants to make journal entries. The first step in preparing an amortization table is to determine the annual loan payment. The $10,000 loan amount is the value today and, in financial terms, is called the present value (PV). Since repayment will be in a series of five equal payments, it is an annuity. Look up the PV from an annuity table for five periods and 12% interest. The factor is 3.605. Dividing the principal, $10,000, by the factor 3.605 gives us $2,773.93, which is the amount of each yearly payment. For the rest of the chapter, we will provide the necessary data, such as bond prices and payment amounts; you will not need to use the present value tables.

When the first payment is made, part of it is interest and the other part is principal. To determine the amount of the payment that is interest, multiply the principal by the interest rate ($10,000 × 0.12), which gives us $1,200. This is the amount of interest charged that year. The payment itself ($2,773.93) is larger than the interest owed for that period of time, so the remainder of the payment is applied against the principal.

Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest. Assume that the final payment will be $2,774.99 in order to eliminate the potential rounding error of $1.06.

Financial Statement Analysis

Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities.

Three common analysis tools are used for decision-making: horizontal analysis, vertical analysis, and financial ratios.

For our discussion of financial statement analysis, we will use Banyan Goods. Banyan Goods is a merchandising company that sells a variety of products. The image below shows the comparative income statements and balance sheets for the past two years.

Keep in mind that the comparative income statements and balance sheets for Banyan Goods are simplified for our calculations and do not fully represent all the accounts a company could maintain. Let’s begin our analysis discussion by looking at horizontal analysis.

Horizontal Analysis

Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year.

The dollar change is found by taking the dollar amount in the base year and subtracting that from the year of analysis.

Dollar Change = Year of Analysis Amount - Base Year Amount

Using Banyan Goods as our example, if Banyan wanted to compare net sales in the current year (year of analysis) of $120,000 to the prior year (base year) of $100,000, the dollar change would be as follows:

Dollar Change = $120,000 - $100,000 = $20,000

The percentage change is found by taking the dollar change, dividing by the base year amount, and then multiplying by 100.

Let’s compute the percentage change for Banyan Goods’ net sales.

This means Banyan Goods saw an increase of $20,000 in net sales in the current year as compared to the prior year, which was a 20% increase. The same dollar change and percentage change calculations would be used for the income statement line items as well as the balance sheet line items. The image below shows the complete horizontal analysis of the income statement and balance sheet for Banyan Goods.

Depending on their expectations, Banyan Goods could make decisions to alter operations to produce expected outcomes. For example, Banyan saw a 50% accounts receivable increase from the prior year to the current year. If they were only expecting a 20% increase, they may need to explore this line item further to determine what caused this difference and how to correct it going forward. It could possibly be that they are extending credit more readily than anticipated or not collecting as rapidly on outstanding accounts receivable. The company will need to further examine this difference before deciding on a course of action.

Vertical Analysis

Another method of analysis Banyan might consider before making a decision is vertical analysis. Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.

On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities and stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of total assets. Total liabilities and stockholders’ equity will also be set at 100% and all line items within liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The line item set at 100% is considered the base amount and the comparison line item is considered the comparison amount. The formula to determine the common-size percentage is:

For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage of total assets were made up of cash in the current year, the following calculation would occur.

Cash in the current year is $110,000 and total assets equal $250,000, giving a percentage of 44%. If the company had an expected cash balance of 40% of total assets, they would be exceeding expectations. This may not be enough of a difference to make a change, but if they notice this deviates from industry standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in the business. The image below shows the calculations on the comparative income statements and comparative balance sheets for Banyan Goods.

Even though vertical analysis is a statement comparison within the same year, Banyan can use information from the prior year’s vertical analysis to make sure the business is operating as expected. For example, unearned revenues increased from the prior year to the current year and made up a larger portion of total liabilities and stockholders’ equity. This could be due to many factors, and Banyan Goods will need to examine this further to see why this change has occurred. Let’s turn to financial statement analysis using financial ratios.

Overview of Financial Ratios

Now that we have covered many of the basic types of transactions for companies and learned how to report them on the financial statements it is time to step back and analyze what the statements are telling us about the company. Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. 

Liquidity Ratios

Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash. This is done by comparing current assets to current liabilities. Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to extend a loan to a company. A company would like to be liquid enough to manage any currently due obligations but not too liquid where they may not be effectively investing in growth opportunities.

Working Capital

Working capital measures the financial health of an organization in the short-term by finding the difference between current assets and current liabilities. A company will need enough current assets to cover current liabilities; otherwise, they may not be able to continue operations in the future. Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. A larger difference signals that a company can cover their short-term debts and a lender may be more willing to extend the loan. On the other hand, too large of a difference may indicate that the company may not be correctly using their assets to grow the business. The formula for working capital is:

Working Capital = Current Assets - Current Liabilities

Using Banyan Goods, working capital is computed as follows for the current year:

Working Capital = $200,000 - $100,000 = $100,000

In this case, current assets were $200,000, and current liabilities were $100,000. Current assets were far greater than current liabilities for Banyan Goods and they would easily be able to cover short-term debt.

The dollar value of the difference for working capital is limited given company size and scope. It is most useful to convert this information to a ratio to determine the company’s current financial health. This ratio is the current ratio.

Current Ratio

Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current assets available to cover current liabilities. The higher the current ratio, the more likely the company can cover its short-term debt. The formula for current ratio is:

The current ratio in the current year for Banyan Goods is:

A 2:1 ratio means the company has twice as many current assets as current liabilities; typically, this would be plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may want to consider using those assets in a different way to grow the company.

Quick Ratio

The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets. A company will want to know what they have on hand and can use it quickly if an immediate obligation is due. The formula for the quick ratio is:

The quick ratio for Banyan Goods in the current year is:

A 1.6:1 ratio means the company has enough quick assets to cover current liabilities.

Accounts Receivable Turnover

Accounts receivable turnover measures how many times in a period (usually a year) a company will collect cash from accounts receivable. A higher number of times could mean cash is collected more quickly and that credit customers are of high quality. A higher number is usually preferable because the cash collected can be reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on these accounts and customers may not be properly qualified to accept the debt. The formula for accounts receivable turnover is:

Many companies do not split credit and cash sales, in which case net sales would be used to compute accounts receivable turnover. Average accounts receivable is found by dividing the sum of beginning and ending accounts receivable balances found on the balance sheet. The beginning accounts receivable balance in the current year is taken from the ending accounts receivable balance in the prior year.

When computing the accounts receivable turnover for Banyan Goods, let’s assume net credit sales make up $100,000 of the $120,000 of the net sales found on the income statement in the current year.

An accounts receivable turnover of four times per year may be low for Banyan Goods. Given this outcome, they may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts.

Inventory Turnover

Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is:

Cost of goods sold for the current year is found on the income statement. Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year.

Banyan Goods’ inventory turnover is:

1.6 times is a very low turnover rate for Banyan Goods. This may mean the company is maintaining too high an inventory supply to meet a low demand from customers. They may want to decrease their on-hand inventory to free up more liquid assets to use in other ways.

Average days to sell inventory

Average days to sell inventory expresses the number of days it takes a company to turn inventory into sales. This assumes that no new purchase of inventory occurred within that time period. The fewer the number of days, the more quickly the company can sell its inventory. The higher the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is:

Banyan Goods’ days’ sales in inventory is:

243 days is a long time to sell inventory. While industry dictates what is an acceptable number of days to sell inventory, 243 days is unsustainable long-term. Banyan Goods will need to better manage their inventory and sales strategies to move inventory more quickly.

The last category of financial measurement examines profitability ratios.

Another category of financial measurement uses solvency ratios.

Solvency Ratios

Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future. To stay in business the company must generate more revenue than debt in the long-term. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt. 

Debt to Equity Ratio

The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. It is less risky and less costly to use equity sources for financing as compared to debt resources. This is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is:

The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be found on the balance sheet.

This means that for every $1 of equity contributed toward financing, $1.50 is contributed from lenders. This would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could be trending toward insolvency. Banyan Goods might want to get the ratio below 1:1 to improve their long-term business viability.

Times Interest Earned Ratio

Time interest earned measures the company’s ability to pay interest expense on long-term debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is:

The information needed to compute times interest earned for Banyan Goods in the current year can be found on the income statement.

The $43,000 is the operating income, representing earnings before interest and taxes. The 21.5 times outcome suggests that Banyan Goods can easily repay interest on an outstanding loan and creditors would have little risk that Banyan Goods would be unable to pay.

Another category of financial measurement uses efficiency ratios.

Efficiency Ratios

Efficiency shows how well a company uses and manages their assets. Areas of importance with efficiency are management of sales, accounts receivable, and inventory. A company that is efficient typically will be able to generate revenues quickly using the assets it acquires.

Profit Margin

Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is:

For Banyan Goods, the profit margin in the current year is:

This means that for every dollar of sales, $0.29 returns as profit. If Banyan Goods thinks this is too low, the company would try to find ways to reduce expenses and increase sales.

Asset Turnover

Total asset turnover measures the ability of a company to use their assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is:

Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year.

Banyan Goods’ total asset turnover is:

The outcome of 0.53 means that for every $1 of assets, $0.53 of net sales are generated. Over time, Banyan Goods would like to see this turnover ratio increase.

Return on Investment

The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is:

For Banyan Goods, the return on total assets for the current year is:

The higher the figure, the better the company is using its assets to create a profit. Industry standards can dictate what is an acceptable return.

Return on Equity

Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders’ investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is:

Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.

For Banyan Goods, we will use the net income figure and assume no preferred dividends have been paid. The return on equity for the current year is:

The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what is an acceptable return.

Stock Market Ratios

Investors rely on ratios to help make investment decisions. We will look at two main stock market ratios, Earnings per Share and Price-Earnings Ratio.

Earnings Per Share

Earnings per share (or EPS) measures the amount of earnings a company has made for each share of its stock. The formula for this is: 

Price-Earnings Ratio

The price-earnings (P/E) ratio compares the earnings per share of a company with the market price of the company’s stock. 

The market price of a company’s stock reflects the market’s judgment about the current and future performance of the company. Investors use ratios such as the P/E Ratio to make informed investment decisions. 

Advantages and Disadvantages of Financial Statement Analysis

There are several advantages and disadvantages to financial statement analysis. Financial statement analysis can show trends over time, which can be helpful in making future business decisions. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions. It can assist with understanding the makeup of current operations within the business, and which shifts need to occur internally to increase productivity.

A stakeholder needs to keep in mind that past performance does not always dictate future performance. Attention must be given to possible economic influences that could skew the numbers being analyzed, such as inflation or a recession. Additionally, the way a company reports information within accounts may change over time. For example, where and when certain transactions are recorded may shift, which may not be readily evident in the financial statements.

A company that wants to budget properly, control costs, increase revenues, and make long-term expenditure decisions may want to use financial statement analysis to guide future operations. As long as the company understands the limitations of the information provided, financial statement analysis is a good tool to predict growth and company financial strength.