hi welcome back in this the third session in my series on accounting i want to look at balance sheets put simply when you think about what a balance sheet should capture there are dualing views even among accountants one view of a balance sheet it should be re it should record what you've actually invested in assets a record of capital invested in your land your building your current receivables whatever assets you show on your balance sheet the second is that is to record what the current value of those assets is earlier in one of the sessions i talked about fair value accounting the essence of fair value accounting is this push to make sure that assets that are shown on the balance sheet reflect the value that you'd get in the marketplace today the third is the balance sheet should reflect what you would get if you sold those houses in the marketplace so if you look at those during views get return capital invested current value or liquidation value you can already see why balance sheets can pull in different directions so let's break bread and sheets down look at fixed assets for the most part these tend to be physical assets and they tend to have long lives you've got current assets assets with lives less than a year you've got financial assets investments in securities or other companies and intangible assets we'll come back and talk about those current libraries tend to be things you owe in less than a year short-term obligations including short-term debt debt especially debt with an obligation longer than a year other liabilities things that you might owe that might not show up as part of that and equity reflecting what the accountants think the equity in this business is worth let's start with fixed and current assets the way i would start accounting and i'm old so this reflects the old way is record fixed assets and what you paid when you bought those assets net of what loss in value you think they've had since you bought them that loss in value of course is captured through depreciation that's the old way the new way of course with fair value accounting is that you should record these assets that what those assets are worth today i don't think as i said accountant should be valuing assets but with fair value accounting that's what they try to do and the effect on financial statements can be very different depending on how old you are as a company and what kind of assets you have here's what older assets will have a much bigger effect when you mark them up to current value and fixed assets will have a much bigger effect than current assets after all inventories not been sitting around for 15 or 20 years but land building and equipment might have so it's fixed in current assets always record what you paid for them net of depreciation new ways try to reflect what they're worth today with financial assets they could take the form of either holdings of securities in publicly traded companies or holdings in other companies you know three percent five percent ten percent of another company when you're holding publicly traded securities i think the movement is almost complete reflecting the value of those holdings at current market value because they're publicly traded that should be a market price now with holdings in other companies how it's accounted for will depend on whether the stake is a minority stake where you own three five seven ten percent of a company or a majority state if it's a minority stake you should show the portion of the income or loss you have in that company it's called the equity approach but you showed below the operating income line if it's a majority stake you have to do consolidation which means you've got to act like you own 100 and incorporate all of the revenues the operating income of that company as part of your revenues and your operating income you also depend if it's a minority stake the way it's accounted for will depend on why you're holding the that state you're saying what do you mean why you're holding the stick if you're holding it for trading you're required to mark it up to market in other words you have to make your best estimate then what that five percent of the other companies would given your estimate of the value of the company today that's if you hold it for trading if you hold it for business purposes you are holding is for the long term then you might be able to get away reflecting that holding in book value terms already you can see that when a company has financial assets you might have to dig a little deeper to get a sense of how those assets are being recorded in the balance sheet and then you have intangible assets now accountants have are taught the big game when it comes to intangible assets they talk about how much intangible assets account for as a portion of value and they're absolutely right and if you and i think about intangible assets we think about things like brand name and technological advantages and networking benefits but accountants when they record intangible assets and balance sheets reflect a very different reality i call it small bore accounting if you're looking for coca-cola's brand name value on its balance sheet stop looking because even if you find there'll be no reflection what it's true brand name value is in fact the most widely reported intangible asset is not an asset at all it's goodwill goodwill is fiction it is perhaps the most destructive and dangerous item to create in accounting because it reflects almost nothing and let me explain why for goodwill to manifest itself on your balance sheet you have to do an acquisition put simply if you're the greatest company in the face of the earth and you've grown entirely with internal investments there will be no goodwill the minute you do an acquisition goodwill shows up you say what does it measure it measures the difference between what you paid for a company and what the accounting book value for the company was with a little dressing up it's a reflection of a plug and the reason goodwill has to show up in the balance sheet is very simply to make balance sheets balance so for all of the items on a balance sheet the one that has the least behind it is goodwill but it is the biggest chunk of intangible assets in accounting we'll talk more about intangibles as we get into financial analysis but accounting when it talks about intensives often is talking about an item that really doesn't matter now one of the follow throughs on goodwill is remember i said you have to record it at the time of the acquisition is the difference between what you paid and the book value now the old way of taking goodwill off the books was to just write it off in equal annual installments over a long period 30 40 years as an autopilot those rules have changed since the late 90s both gaap and ifrs require accountants to impair goodwill what does that mean every year accountants have to come in and look at the company acquired and ask the question did you pay too much or didn't you if you paid too much the value what you acquired has dropped since the acquisition you have to impair goodwill if it's gone up you don't so it's kind of a one-sided process but that impairment of good will often mean that you can get big charges against goodwill in some years and nothing in other years now the reason accountants claimed that they wanted to move to this new approach they said we need to give a investors more information that impairing goodwill is more informative than just writing off 140th every year is it when you look at goodwill impairments you look at the market reaction that you get to goodwill impairments even if they're multi-billion dollar impairments you know what the market reaction is nothing and you know why because by the time accountants get around impairing goodwill everybody knows that goodwill has already been impaired in other words if you bought a company for 10 billion four years ago and the value dropped to 2 billion it drawn 2 years ago by the time accountants wake up and say hey the value dropped everybody already knows so i think it's created more noise and this is just my cynical view than adding to information but it is what it is now when you look at current libraries broadly speaking current libraries can be broken into three groups one is non-interest bearing current libraries accounts payable supplier credit basically these are things you do in the process of business interest bearing short-term libraries including short-term borrowings and the short-term portion of long-term debt and deferred items deferred items can include things like deferred revenues remember early in the income statement discussion we talked about companies that sell items for multiple years but collect the revenues today when you do that the deferred revenues will show as part of the current libraries if you owe salaries or fees to other people show up here defer taxes deferred salaries deferred revenue they're all part of current libraries when computing non-cash working capital an item we'll talk about my suggestion is you remove the interest-bearing short-term debt from the rest of current libraries it's a very different creature but this is something we'll come back and talk more about in the context of computing cash flows but current liabilities should be there should be less debate about them because most of them have been on your books just a few months it comes to debt due debt you can take three forms the first is corporate bonds companies especially in the us often raise money by issuing debt to public markets you got bank loans short term as well as long term and then you've got least debt lease debt until 2019 did not for the most part show up on balance sheets unless it met some criteria that only a few companies met starting in 2019 all companies are required to report their least commitment system corporate bonds bank loans and lease debt now the move towards the mark to market the lease on the asset side is also creeping in to the balance sheet side and you're seeing attempts to mark that up to market as well or down to market but for the most part bank debt if you look at it or corporate bonds will reflect what you raised at the time of the issue not what it's worth today so when you look at the footnotes to the balance sheets the footnotes can sometimes provide you information about the debt that a company has and that information can be useful so let me highlight some of the things you might be able to find if you dig through the footnotes the first is you might get to see when debt comes to you something that's useful to know because you have to set aside cash to make the debt or issue new debt you might be able to get the features on the debt is it floating rate data fixed rate debt straight data convertible debt and usually most companies you'd also see a table telling you when debt payments come due by year something that can be useful again in the context of estimating cash flows which brings us to the final item on a balance sheet which is shareholders equity now the old way in which shareholders equity was was recorded was to reflect everything a company has done over its history it was the ultimate historical number the shareholders equity for coca-cola in 1990 would have reflected everything that coca-cola had done over their history starting with their ipo and every retained earnings sense because in a sense that's exactly what it was the new way though as you start marking items up to market will reflect not just your history but also the marking up or marking down of items which makes shareholders equity a little noisier a little more volatile in my cynical view you know i know accountants are trying to mark the market because they want to make shareholders equity a closer reflection of what the equity in the company is actually worth i think they have zero chance of accomplishing that no matter how hard they try but that's not going to stop them from trying because i think that their endgame is they want to make shareholders equity and balance sheets are competitive with the market cap as a measure of the equity in the firm and final points about shareholders equity before we leave balance sheets or put balance sheets rest the first is in many companies when you look at shareholders equity you see a breakdown which starts with par value you're saying what does that measure i have no idea i just ignore it it's a throwback in time there might have been a point in time shares were actually issued at par value to the market those days a long time i don't even know why companies bother reporting par value second one thing you will notice with shareholders equity is as companies age shareholders equity will start to get more substantial why because the history of the company will mean there's more retained earnings accumulating the third is because only capitalized items show up as part of accounting balance sheets when your accountants don't capitalize items that should be and i want to be mysterious remember in the income statement discussion we talked about how r d at a pharmaceutical company technology and content at netflix are really capital expenses but there are treatise operating expenses when you don't capitalize those expenses what you do is twofold one is you don't count those items assets and you also depress the value of your equity i think that what you see as shareholders equity and technology firms and pharmaceuticals doesn't reflect even from an accounting perspective what the equity in these companies is worth in the last two or three decades in the u.s companies have also increasingly turned to buying back stock you're saying so what when companies buy back stock it can massively affect your shareholders equity and here's why you have to reduce your shareholders equity by however much money you spend buying back shares and because the market value these companies is often four five ten times the book value a small buyback can deplete your shareholders equity in fact that depletion of shareholders equity can push the shareholders equity not just towards zero but beyond one in eight u.s companies as negative shareholders equity you're saying what does that mean don't read too much into it it's either a reflection that this company's been losing money for a long time a lot of young companies have negative shareholders equity or a reflection of the fact that the company's done a lot of buybacks so bottom line is accounting balance sheets in my view try to do too much if they're focused on reporting just what you invest in assets i think they'd be more useful but that's just my point of view i hope you found the session useful and i will try to apply these concepts on real companies in a follow-up session thank you very much