2 The Balance SheetLearning ObjectivesAfter reading th.docx

2 The Balance Sheet
Learning Objectives
After reading this chapter, you should be able to:
1. Describe the elements of a balance sheet.
2. Describe the different types of accounts contained in the
balance sheet among assets, liabilities, and
shareholders’ equity.
3. Explore the different methods of accounting for inventory
(LIFO and FIFO) and the effects on the value
of the inventory.
4. Explain how to create a common-sized balance sheet.
© Yong Hian Lim/iStock/Thinkstock
eps81356_02_c02_045-096.indd 45 3/25/14 3:11 PM
Introduction
Pre-Test
1. What is the purpose of a balance sheet?
a. to show that the books are in balance
b. to give a snapshot of a company’s financial position on a
given date

c. to show what the company owns
d. to show what the company owes
2. Which is the basic formula for a balance sheet?
a. Assets minus Liabilities equal Equity
b. Assets equal Liabilities plus Equity
c. Net Assets equal Net Profit
d. none of the above
3. What is the bottom line of the balance sheet shown in account
format?
a. Total Assets
b. Total Liabilities and Equity
c. Total Liabilities
d. both A and B
4. What are inventory valuation methods?
a. LIFO and FIDO
b. LIFO and FIFO
c. Average Cost
d. both B and C
5. What is a tool used to compare balance sheets among various
companies, large
and small?
a. average balance sheets
b. common-sized balance sheets
c. industry balance sheets
d. no tool available
Answers can be found at the end of the chapter.
Introduction
In Chapter 1, we introduced the members of Best General
Company’s budget committee.

In this chapter, the budget committee begins its analysis of the
company’s results by tak-
ing a closer look at the balance sheet. To introduce the balance
sheet, we have created a
basic one for Best General Company (shown in Figure 2.1). It
uses numbers that are much
simpler than the ones that show up on the balance sheets of
major corporations. Later in
the chapter we will explore the complex balance sheets of two
real-world corporations:
IBM and 3M.
eps81356_02_c02_045-096.indd 46 3/25/14 3:11 PM
Introduction
Figure 2.1: Sample balance sheet for Best General Company
The balance sheet provides a quick snapshot into the overall
financial health of an organization as of a
particular date.
Best General Company
Balance Sheet
At December 31, 2013 and 2012
2013 2012
Current Assets:
Cash
Accounts Receivable

Inventories
Other Current Assets
Total Current Assets
Long-Term Assets:
Property, Plant, & Equipment
Less: Accumulated Depreciation
Other Non-Current Assets
Total Assets
Current Liabilities:
Accounts Payable
Short-Term Debt
Other Current Liabilities
Total Current Liabilities
Long-Term Liabilities:
Long-Term Debt
Other Non-Current Liabilities
Total Liabilities

Common Stock
Retained Earnings
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
Assets
Liabilities
Shareholders’ Equity
$ 8,400
7,800
40,000
6,000
62,200

99,600
(9,600)
45,000
$ 197,200
$ 8,900
26,000
20,400
55,300
62,450
52,000
$ 169,750
20,000
7,450
$ 27,450
$ 197,200

$ 9,500
7,200
38,000
6,000
60,700
99,600
(7,200)
45,000
$ 198,100
$ 9,400
26,000
19,800
55,200
65,000
54,000
$ 174,200

20,000
3,900
$ 23,900
$ 198,100
eps81356_02_c02_045-096.indd 47 3/25/14 3:11 PM
Section 2.1The Elements of a Balance Sheet
First, notice in Figure 2.1 that the Total Assets equal the Total
Liabilities and Equity. That
must always be true on a balance sheet. If that is not the case,
there is an error some-
where. We take a closer look at why this is so in this chapter.
Also in Figure 2.1 we see
that Accounts Receivable, which is where the accounts of
customers who owe money to
the company are tracked, is increasing in value. This could be a
sign of trouble or it could
mean that sales on credit increased from year to year. When
Juan and Susan see this num-
ber, they know they will need to research it further to find out
whether there is a problem
collecting from customers.
Another possible indicator of a problem is that Inventories are
increasing in value. This
could indicate that sales are slowing because inventory is sitting
on the shelf and not sell-
ing—or it could mean the company has added to the variety of

inventory carried.
As the Best General budget committee develops its budget
report, its members will want
to take a closer at these numbers and determine why the value
of inventory is increasing.
They may need to recommend that the company plan for lower
revenues or for new ways
to increase its sales if it wants to keep revenue expectations at
the same level or increase
projected revenues for the next budget year.
Let’s take a closer look at the elements of a balance sheet.
2.1 The Elements of a Balance Sheet
Consider a gymnast walking a balance beam: If she steps a bit
to the right or left, she will
fall off. She can only stay on the beam if she balances perfectly
in the center.
Just like that gymnast, a company’s balance sheet (also known
as the statement of finan-
cial position) must stay in balance on a very thin line. Any
deviation can throw a com-
pany’s books off balance. Balance is based on the key equation
for all accounting:
Assets 5 Liabilities 1 Equity
This balancing act works because funds borrowed from lenders
or cash raised from inves-
tors is used to fund the assets the company owns. The Liability
section shows the funds
borrowed from lenders and the Equity section shows money
invested in the company
by the investors (the owners of the company). The Equity

section also shows the profits
retained to reinvest in the company in an account called
Retained Earnings.
Every transaction entered into the accounting system must take
this key formula into
consideration. In Chapter 1, we introduced these three key
elements: assets, liabilities, and
equity. In this chapter, we’ll explore how the numbers are
developed for the balance sheet,
as well as the key rules companies follow when preparing this
statement.
eps81356_02_c02_045-096.indd 48 3/25/14 3:11 PM
Some Notes on Entering Numbers Into the Accounting System
Before exploring the balance sheet, let’s discuss how the
numbers are entered into the
accounting system to be sure the balance sheet will be in
balance.
For example, when a company makes a cash purchase, it trades
an asset, such as cash, for
another asset, such as furniture. The outlay of cash is
considered a credit and the intake
of furniture is called a debit. This cash transaction would be
entered in the accounts as
shown in Table 2.1:
Table 2.1: Accounting for cash transactions

Date Accounts Debit Credit
May 3 Furniture 1,000
Cash 1,000
In this entry, Assets are increased by $1,000 with the addition
of furniture and decreased
by $1,000 with the use of cash. So the balance sheet stays in
balance.
Suppose the company didn’t pay cash for the item but instead
used a credit card. This
credit transaction would be entered into the books as shown in
Table 2.2:
Table 2.2: Accounting for credit card transactions
Date Accounts Debit Credit
May 3 Furniture 1,000
Credit Card Payable 1,000
In this entry, Assets are increased by $1,000 with the
acquisition of furniture and Liabilities
are increased by $1,000 with credit card debt. Again, the
balance sheet stays in balance.
In this text, we will not discuss how debits and credits work in
detail; that is the subject of
a basic accounting text. Rather, we will briefly explore the
logistics that go into building
the numbers for a balance sheet and their relationship to the key
accounting formula:

Assets 5 Liabilities 1 Equity
If the transactions are not balanced when they enter the
accounting system, the balance
sheet will not be in balance.
Note that debits and credits in accounting mean very different
things than they do when
looking at bank accounts or credit cards. A debit in a bank
account always means that the
number will be subtracted from the bank balance. A credit
always means that the number
will be added to the bank balance.
eps81356_02_c02_045-096.indd 49 3/25/14 3:11 PM
In accounting it is not that simple. Debits and credits can add to
or subtract from the bal-
ance in an account depending on the type of account. For
accounts that track assets and
expenses, a debit will increase the value of that account and a
credit will decrease the
value. For accounts that track liabilities and income, a credit
will increase the value of the
account and a debit will decrease the value.
The key to entering data into an accounting system is to ensure
that the debits always
equal the credits in a transaction entry in order to keep the
books in balance. Table 2.3
summarizes how debits and credits impact a company’s
accounts:

Table 2.3: How debits and credits impact accounts
Account type Debit Credit
Assets Increase Decrease
Liabilities Decrease Increase
Equity Decrease Increase
Income Decrease Increase
Expenses Increase Decrease
Balance Sheet Presentation
When preparing a balance sheet, several basic rules guide the
dates for the statement, the
numbers used, and the presentation format. We take a brief look
at these key elements
next.
Task Box 2.1: Exploring Financial Statements: IBM and 3M
As we explore the balance sheet and other financial statements
in this and future chapters, we
will occasionally use the financial statements of two companies,
IBM and 3M, to find out how
the numbers play out in the real world.
We have chosen IBM because it is a service-based corporation
that both develops technology
solutions for its customers and sells the products for those
solutions. This will provide a good
overview of how both serviced-based and product-based

corporations present their financial
reports. IBM deemphasized manufacturing hardware beginning
in 1994, and in 2012 focused
its operations instead on services, software, and technology
solutions, yet it still does some
manufacturing.
3M also sells and manufactures its own products. It puts a
greater focus on manufacturing and
its financial statements reflect that difference.
As we explore these financial statements, we will note some key
differences presented in the
financial reports for service, product, and manufacturing
companies.
Download the PDFs for the 2012 annual reports of IBM and 3M.
Find the financial statements
and the Notes to the Financial Statements in each. Be prepared
to use them to complete
this chapter and throughout other chapters. Note that both
companies indicate they are
“Consolidated” statements, meaning that the results include all
subsidiaries.
eps81356_02_c02_045-096.indd 50 3/25/14 3:11 PM
http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_an
nual.pdf
http://media.corporate-
ir.net/media_files/irol/80/80574/Annual_Report_2012.pdf
Dates of the Statement

A balance sheet is like a snapshot of a company’s financial
position on a particular date.
That is why the top of the balance sheet always includes the
words “as of” or “at” and
then a month, day, and year.
A company’s financial position changes daily as sales are made,
inventory is bought or
manufactured, and other transactions take place to keep the
company operating. So when
reviewing a balance sheet, keep in mind that it provides the
company’s financial position
only for the date shown at the top.
The date on the balance sheet will be the last date of the period
being presented. This
can be the end of a year, end of a quarter, end of a month, or
end of another period, as
designated by the company. The date on the balance sheet will
be the same as the last
day of operations shown on the income statement. (We’ll
explore the income statement
in Chapter 3.) Note in the heading (top portion) of Best
General’s balance sheet shown in
Figure 2.2 that the date of the statement is “At December 31”
and the columns designate
the two years shown (2013 and 2012).
Figure 2.2: Top portion of the Best General Company balance
sheet
A great deal of information can be gleaned from the balance
sheet. For example, from this partial sheet
we can determine that Best General Company has less cash than
in the previous period and accounts
receivable and inventory amounts have increased.

Balance Sheet (Partial)
2013 2012
Current Assets:
Cash
Accounts Receivable
Inventories
Assets
$ 8,400
7,800
40,000
6,000
$ 62,200
$ 9,500
7,200

38,000
6,000
$ 60,700
Financial statements are not always presented on a calendar-
year basis. Some companies
report based on a different fiscal year. For example, many retail
companies present their
annual report starting on February 1 of any year until January
31 of the next year. They
choose this 12-month period for two reasons:
eps81356_02_c02_045-096.indd 51 3/25/14 3:11 PM
1. They do not want to be preparing financial statements during
their busiest time
of year, the Christmas holiday season. For example, Walmart
prepares its annual
reports at the end of January.
2. January sales often include December returns and new sales,
so the flow of their
finances is more accurately reflected with a year-end of January
rather than
December.
Another type of organization that does not usually report on a
calendar-year basis is aca-
demic institutions. Such institutions are more likely to prepare

statements based on their
academic year. For example, the Apollo Group, which operates
for-profit universities,
reports annually at the end of August. Many non-profit learning
institutions, which do
not need to report to the SEC, do provide annual reports to their
donors. These reports are
usually based on a year-end of August 31.
When comparing financial reports of various companies and
institutions, always be sure
to check the dates at the top of the reports. Be sure that the
companies report using the
same fiscal year in order to compare apples to apples. For
example, suppose a manager
wants to compare two retail companies. One company reports
based on the calendar year
ending December 31, 2012, and the second on a fiscal year
ending January 31, 2013. The
holiday season may affect these retailers very differently. If
January was a big month in
2013, but sales were not as good in 2012, the two reports will
not be easily compara-
ble. Before the manager can conduct a financial comparison, he
needs to find a quarterly
report that gives month-by-month details of both companies and
then adjust the financial
reports of one these companies so the results represent the same
time period.
Another way some companies prepare their financial statements
is to base the end of each
financial period on a particular day of the week. (We talk about
that scenario in “World of
Business.”)

World of Business
Another Twist to Financial
Report Dating
Most companies report on a calendar-year or
fiscal-year basis that ends at the end of a month,
but some companies prefer to report based on a
particular day of the week. One such company
is Darden, which operates popular restaurant
chains such as Red Lobster, Olive Garden, and
LongHorn Steakhouse. The company reports
on the last Sunday of the month during each
accounting period.
Darden has determined that the best way to
compare the results of its restaurants is to end
each reporting period on the same day of the
week because in the restaurant business, the
volume of business differs by day of the week.
Richard Levine/age fotostock/SuperStock
Darden, which operates the restaurant
chains Red Lobster and Olive Garden,
chooses to report its financials on the last
Sunday of each period because it helps
the company compare the results of its
various brands.
(continued)
eps81356_02_c02_045-096.indd 52 3/25/14 3:11 PM

For example, Friday and Saturday are the busiest nights for
many restaurants. Monday night
tends to be the quietest. Preparing reports that measure revenue
based on the same ending day of
the week provides more consistent reporting that is easier to
compare period to period. Managers
in businesses that are dependent on traffic flows based on the
day of the week can more easily
manage the finances of their business with numbers generated
based on that traffic flow.
However, reporting by the day of the week can add another
complication to analyzing results of
operations. This is because in some years, there will be 52
weeks, and in other years there will be
53 weeks. A company that uses this type of year-end reporting
will explain how it calculates its
results in the Notes to the Financial Statements. Darden
discusses its fiscal year on page 68 of its
2012 annual report. The three years 2012, 2011, and 2010 were
52-week years. The last 53-week
year was 2009. It is discussed on page 47 of the 2009 Darden
annual report.
When financial statements show an end date other than the 30th
or 31st of the month, look for
the discussion of the 52/53-week year in the Notes to the
Financial Statements. Also, when
comparing companies, be sure to either find another company
with a similar fiscal year or adjust
the results to compare performance during the same time period.
(Darden 2012)
Consider This:

1. You want to compare a restaurant chain that reports based on
weekly financial data
to one that reports on a calendar-year basis. What are the key
differences you must
consider in the way the figures are reported?
2. What benefits do you think companies gain by reporting on a
weekly schedule versus a
monthly schedule?
3. What types of businesses do you think might best be served
by weekly reporting?
World of Business (continued)
Numbers Used
In addition to knowing the date the report was generated, it is
important to pay atten-
tion to the way the numbers are shown. For example, IBM’s
Financial Position Statement
says “$ in millions except per share amounts.” This is a critical
piece of information and
is found at the top of all financial statements. Imagine how
difficult it would be to read all
the numbers IBM includes on its financial statements if the
numbers were shown without
rounding—a mathematical decision to use less exact,
abbreviated numbers. For example,
if sales were $12,275,645,320 and the company reported in the
millions, the number would
be shown as $12,276. In this case, the company rounded up
because the next number was
5 or more. If the next number had been 4 or less, the number
would be shown as $12,275.

Companies normally provide their numbers in the thousands or
millions, but either way,
it is important to note how a company is rounding its numbers.
This can be critical when
comparing the results of a large company, which may report its
numbers in the millions,
to that of a mid-sized or small company, which may report its
numbers in the thousands.
Presentation Format
Companies can use three different types of formats when
presenting their balance sheet:
report format, account format, or financial position format. We
present each format using
simple numbers and just a few line items to illustrate what to
expect for each.
eps81356_02_c02_045-096.indd 53 3/25/14 3:11 PM
For the Best General Company, we used the report format,
which is shown in Figure 2.3.
Figure 2.3: Report format balance sheet
In the report format, Assets are shown first, then Liabilities and
Equity. Note that Assets 5 Liabilities 1
Equity.
Current Assets
Long-Term Assets

Other Assets
Total Assets
Current Liabilities
Long-Term Liabilities
Total Liabilities
Total Liabilities and Equity
Assets
Liabilities and Equity
62,200
90,000
45,000
197,200
55,300
114,450
169,750
27,450

197,200
$
$
$
$
Balance Sheet (Report Format)
At December 31, 2013
Another commonly used format is the account format, shown in
Figure 2.4.
Figure 2.4: Account format balance sheet
In the account format, the Assets are in the left column and the
Liabilities and Equity are in the right
column. The two columns’ totals will always be shown in
balance.
Current Assets
Long-Term Assets
Other Assets
Total Assets
Assets

62,200
90,000
45,000
197,200
$
$
$
$
Current Liabilities
Long-Term Liabilities
Total Liabilities
55,300
114,450
169,750

27,450
197,200
Balance Sheet (Account Format)
eps81356_02_c02_045-096.indd 54 3/25/14 3:11 PM
The third format is the financial position format. This format is
used internationally but
is not commonly found in the United States, although it may be
used by foreign compa-
nies that do business in the United States. The key difference in
this format is the addition
of two lines that do not appear on the account or report formats:
• Working Capital: This line is the current assets the company
has available to pay
its bills. It is calculated by subtracting the current liabilities
from the current assets.
• Net Assets: This line shows what is left for the company’s
owners after all liabili-
ties have been subtracted from total assets.
Using the same numbers as are seen in the examples of the other
two formats, the financial
position format is shown in Figure 2.5.

Figure 2.5: Financial position format balance sheet
Net Assets is equal to Shareholders’ Equity. Companies using
this format also include a statement
detailing the equity section.
Current Assets
Less: Current Liabilities
Working Capital
Plus: Non-Current (Long-Term) Assets
Total Assets Less Current Liabilities
Less: Long-Term Liabilities
Net Assets
62,200
(55,300)
6,900
135,000
141,900
(114,450)
27,450
$
$

Balance Sheet (Financial Position Format)
Now that we have reviewed the items that appear on a balance
sheet or statement of
financial position, we will investigate the most common line
items and how these line
items are calculated. We also will explore the Notes to the
Financial Statements, which
provide the details behind these numbers.
eps81356_02_c02_045-096.indd 55 3/25/14 3:11 PM
Assets
As we discussed in Chapter 1, assets are divided into two
groups: current assets and long-
term assets. Current assets include those that will be used in the
next 12 months. All other
assets are considered long-term assets (also sometimes called
non current assets). The cur-
rent assets are shown first, followed by the long-term assets. As
a review, Figure 2.6 shows
the assets section of Best General Company’s balance sheet.
Figure 2.6: Assets section of Best General Company balance
sheet
Long-term, or non-current assets, are assets that will not be
used within the next 12 months. These assets

are listed after all current assets on the balance sheet.
2013 2012
( ) ( )
Current Assets:
Cash
Accounts Receivable
Inventories
Long-Term Assets:
Less: Accumulated Depreciation
Total Assets
Assets
$ 8,400

7,800
40,000
6,000
62,200
99,600
9,600
45,000
$ 197,200
$ 9,500
7,200
38,000
6,000
60,700
99,600
7,200
45,000

$ 198,100
Task Box 2.2: Exploring Notes on Financial Statements
Take a look at the 2012 financial statements you downloaded
for IBM and 3M. You will see that
IBM’s Statement of Financial Position makes it easy to find out
more details about its line items
because the appropriate note is indicated in a column called
Notes.
The first note you will see is Note D, on the line item
Marketable Securities. If you turn to the
Notes to the Financial Statements, you will find out more detail
about IBM’s marketable securities.
The balance sheet for 3M is not as helpful. There is only one
note mentioned on the statement
(Note 13, Commitments and contingencies), but 3M does
provide an index of its notes on page
43 of its 2012 annual report.
eps81356_02_c02_045-096.indd 56 3/25/14 3:11 PM
Cash and Cash Equivalents
The first line item on the balance sheet is always Cash or Cash
and Cash Equivalents. Cash
is just that: cash in bank accounts, savings accounts, cash
registers, and petty cash draw-
ers. For Best General Company, Cash and Cash Equivalents was
$8,400 in 2013.

On the balance sheets of more complicated companies, cash may
include many different
types of financial instruments. For example, IBM explains what
it considers Cash Equiva-
lents in Note A of its Notes to the Financial Statements: “All
highly liquid investments
with maturities of three months or less at the date of purchase
are considered to be cash
equivalents.” For example, a three-month Certificate of Deposit
(CD) would fit into this
category. In Note D, IBM details that Cash includes time
deposits, certificates of deposit,
commercial paper, money market funds, and other securities.
In Note 1, 3M explains this line item in a similar way: “Cash
and cash equivalents con-
sist of cash and temporary investments with maturities of three
months or less when
acquired.” (Maturity refers to the date the asset can be turned
into cash. For example, if
the asset is a CD, this will be the date the CD must be turned
into cash or reinvested in
another CD.)
When comparing how one company reports its cash to how other
companies do it, look at
the explanation to be sure both companies use the same
categorization of cash.
In Chapter 1 we discussed that the first note in the Notes to the
Financial Statements
reviews significant accounting policies. When searching for
details about how a number is
calculated (and the information is not presented in a separate
note), look for that informa-
tion in Note 1 or Note A, depending on how the company

numbers its notes.
Marketable Securities
Marketable securities can include stocks, bonds, and other
investments that can be turned
into cash within 12 months. The simple balance sheet for Best
General Company did not
show any marketable securities, but many major corporations
will include this line item.
Financial managers are likely to take a close look at this
information. For example, Bob,
a financial analyst at Best General Company, would likely
check competitors’ balance
sheets to find out if they hold marketable securities and which
types of securities they
hold. He could use this information to make recommendations
to his managers.
If Bob were looking at IBM and 3M, he would review the
relevant Notes to the Financial
Statements. He would see, for example, 3M’s balance sheet
includes two marketable secu-
rities line items: one is current and another is non-current. In
Note 8, 3M explains that
classification as current or non-current marketable securities is
determined by “manage-
ment’s intended holding period.” The note also indicates that
3M’s marketable securities
include U.S. and foreign government securities, commercial
paper, corporate debt, and
asset-back securities (such as automobile loans and credit card
securities). Also at the bot-
tom of Note 8, 3M details its unrealized gains and losses on
marketable securities and how
it derives the valuation for the balance sheet.

eps81356_02_c02_045-096.indd 57 3/25/14 3:11 PM
IBM explains in Note A that all securities on this line item can
be turned into cash in the
next 12 months. IBM also explains that realized gains and
losses on these securities are
included in Other Income or Other Expense on the income
statement (statement of earn-
ings). These gains or losses are calculated based on the specific
identification method,
which means they are based on the purchase and sold details of
each individual asset.
In addition, IBM says these assets are reported at “fair value
with unrealized gains and
losses, net of applicable taxes.” Note D includes a detailed
breakdown of the marketable
securities owned by IBM as well as explanations about fair
value calculations. IBM also
details the risks involved with its marketable securities.
With the details found in the notes, Bob can assess how well his
company is managing its
marketable securities compared to how the competition is
managing theirs.
Task Box 2.3: Comparing Marketable Securities
Review the details behind IBM’s and 3M’s marketable
securities in their 2012 financial
statements. How much does each show in unrealized gains and
unrealized losses for the two
years? Which company makes it easier for you to answer this

question? Explain why.
Accounts Receivable
Accounts Receivable is where the company tracks money due
from its customers. Note
that these are customers who bought on credit offered directly
by the company. Customers
who use credit cards are not included in this number because the
company will receive
immediate cash payment from the credit card company, which in
turn collects from the
customers.
As indicated above, the budget committee for Best General
Company would need to take
a close look at the details for this account since the value of this
asset went up from $7,200
in the prior year to $7,800 in the current year, even though
revenue went down. This likely
means more customers are not paying their bills, but the budget
committee cannot know
that for sure until it looks at the internal reports that detail what
is behind these numbers.
Internally, the budget committee can request an aging schedule,
which would be a con-
fidential report not found in the financial statements released to
the public. This report
might look something like the one shown for Best General
Company in Figure 2.7.
eps81356_02_c02_045-096.indd 58 3/25/14 3:11 PM

Figure 2.7: Best General Company accounts receivable aging
schedule
An aging schedule, like the one shown here, is an internal report
showing customer credit delinquencies
that are more than 30 days past due.
Accounts Receivable Aging Schedule
As of December 31, 2013
Customers 30–45 Days 46–60 Days 61–90 Days Over 90 Days
Total
Sally Adams
Jerry Jones
Andy King
Total
100
100
200
150
300
150
600

$
$
$
$
$
$
$
$
$
$
500
300
300
1,100
900
900
750
1,500

550
2,800
$
$
A complete aging schedule would list all the customers and
what they owe. The amount
owed is grouped by the “age” of the purchase, such as 30 to 45
days or 46 to 60 days. Since
Best General Company is experiencing an increase in its
Accounts Receivable line item, it
is likely that a greater number of its customers are paying their
bills late. The budget com-
mittee may need to recommend changes to Best General
Company’s credit policies. The
executive committee would then need to determine whether a
change is needed and how
that change should be implemented.
When looking at their competitors’ Accounts Receivable line
item, Best General’s budget
committee could not see this type of detail, but they can assess
whether their competitors
are experiencing similar problems. If so, it could be an
indication of an industry-wide
downturn or possibly even economic problems impacting a
larger portion of the nation’s
economy, such as the recession the United States experienced
between 2008 and 2012. If
economic conditions are impacting receivables, the budget
committee may need to lower
revenue expectations for the next year.

Every company reports some detail about its Accounts
Receivable in the Notes to the
Financial Statements. Note that IBM actually includes three
Accounts Receivable line
items: notes and accounts receivable, short-term financing
receivables, and other accounts
receivable. Also note that IBM shows these numbers “net of
allowances.” These allow-
ances are for bad debt, which means the amount of this debt that
IBM does not expect
to be able to collect from nonpaying customers. There are also
allowances for returns. In
Note A, IBM details how it calculates its allowance for credit
losses. In Note F, IBM details
its short-term financing receivables. IBM sells large computer
software systems and ser-
vices that are purchased using leases and long-term loans, so its
Accounts Receivable can
be very complex to sort out.
eps81356_02_c02_045-096.indd 59 3/25/14 3:11 PM
Accounts Receivable is only one line item on 3M’s balance
sheet. Its product offerings are
not as complex as IBM’s, and there aren’t many details about its
Accounts Receivable and
allowances. In Note 1, the company explains that the allowance
for doubtful accounts
(bad debt) is “based on historical write-off experience by
industry and economic data and
historical sales returns.” The company says it reviews this data

monthly.
Inventories
Inventories include the products the company has on hand to
sell to its customers. When
Best General’s budget committee looks at this number, it sees
that the value of inventories
is climbing from $38,000 in the prior year to $40,000 in the
current year. If more inventory
is on hand, this could indicate that business has slowed. Susan,
the marketing manager,
and Juan, the sales manager, would need to compare the sales
reports to find out what
products are selling and whether sales have dropped.
Mai and Frank would want to compare their inventory numbers
to those of their competi-
tors to see whether their competitors are also experiencing an
increase. If they are, it could
be a sign of an industry downturn. If the competitors do not
show the same problem, it
could be an indication of a company-specific issue. Either way,
the budget committee
would need to research why inventory is building up.
When looking at competitors, another factor could be of interest
to the budget committee:
whether their competitors manufacture the products they sell.
For example, IBM includes
only one line item for inventories, whereas 3M includes three
stages of inventory: finished
goods, work in process, and raw materials and supplies.
The primary reason for this difference is that 3M has a major
manufacturing component.
The only goods ready for sale are finished goods. The value of

goods in work in process
includes the value of goods currently in some stage of the
manufacturing process but not
yet ready for sale. Raw materials and supplies are goods on
hand that have not yet entered
the manufacturing process. In Note 1, 3M states it values its
inventory “at the lower of cost
or market, with cost generally determined on a first-in, first-out
basis.” We explore what
this means and how companies value inventory later in this
chapter.
IBM does manufacture some of its products, but it does not
show the detail on the bal-
ance sheet. Instead, the notes reveal information about its
inventories. IBM only provides
details for finished goods separately. Work in process and raw
materials are shown as one
line item in Note E. In Note A, IBM details its hardware and
software products, as well as
the services offered, but the focus in this note is on how the
company recognizes its rev-
enues. We’ll investigate those issues in Chapter 3.
Deferred Taxes
Some larger companies carry over tax deductions for another
year. IBM is one company
that carries assets on its balance sheet on a line item called
Deferred Taxes. The item
appears both as a current asset and as a long-term asset. The
details about this line item
can be found in Note N. IBM shows its income before taxes in
both U.S. and foreign opera-
tions, then goes on to detail its taxes by geographic operations
and taxing jurisdictions.

eps81356_02_c02_045-096.indd 60 3/25/14 3:11 PM
The key part of this note that affects deferred taxes can be
found in a chart called Deferred
Tax Assets (see Figure 2.8). Deferred taxes are an asset to a
company because they repre-
sent tax write-offs that may be used to reduce income taxes in
the future.
Figure 2.8: IBM’s deferred tax assets
Using deferred tax assets on future tax returns, companies can
reduce their tax obligations in the future.
Deferred Tax Assets
Retirement benefits
Share-based and other compensation
Deferred income
Domestic tax loss/credit carryforwards
Foreign tax loss/credit carryforwards
Bad debt, inventory and warranty reserves
Depreciation
Other

Gross deferred tax assets
Less: valuation allowance
Net deferred tax assets
($ in millions)
At December 31: 2012 2011 *
$ 5,870
1,666
1,018
954
681
586
456
1,384
12,615
1,187
$ 11,428
$ 5,169
1,598

834
914
752
608
474
1,479
11,828
912
$ 10,916
*Reclassed to conform with 2012 presentation.
Source: IBM. (2013). 2012 annual report. Retrieved from
nual.pdf
Prepaid Expenses
Prepaid expenses include expenses paid in advance and not yet
used. For example, a
company pays an insurance policy on the first of the year that
will cover the company for
12 months. The company must record the transaction when it
occurs, but it will record it
as an asset initially. Each month it will develop an adjusting
entry to the books to show the
amount of this asset used and offset it with an insurance
expense. This way, the expense
will be matched with the revenues generated that month. The

expense account will be
shown on the income statement.
This is a basic concept of accrual accounting, in which expenses
and revenues are shown
in the appropriate month. Revenues must be recognized in the
month they are earned
and expenses must be recognized in the month they are used,
which is not necessarily
the month that cash changed hands. Best General Company did
not show any prepaid
expenses. IBM lumps these with other assets, whereas 3M does
not show the item on its
balance sheet.
eps81356_02_c02_045-096.indd 61 3/25/14 3:11 PM
%20http://www.ibm.com/annualreport/2012/bin/assets/2012_ib
m_annual.pdf
Other Current Assets is a miscellaneous line item for anything
not detailed in the current
assets portion of the balance sheet. Usually this item reflects
the value of assets not used in
current operations (and possibly up for sale). Neither IBM nor
3M details what is included
in the Other Current Assets line item.
Property, Plant, and Equipment
Up until now we have discussed current assets on the balance
sheet. The rest of the assets
on the balance sheet are long-term assets. These assets will be

used for more than just a
12-month period.
The property, plant, and equipment line item is one such long-
term asset. It will sum-
marize the value of all the land, buildings, plants, laboratories,
and office equipment on
hand. It may include the value of rental equipment, as well, if
that equipment is likely to
become an asset at the end of the rental or lease period.
To keep things simple, Best General Company showed property,
plant, and equipment
net, which means after the reduction for depreciation. Note that
there are three Property,
Plant, and Equipment lines on both the IBM and 3M balance
sheets. The first line item
shows the gross value of property, plant, and equipment. The
second line item shows the
reduction in that value for depreciation.
Depreciation indicates how an asset is being expensed over its
lifespan. For example, a
vehicle that is expected to have a useful life of five years would
be depreciated over that
five-year period. That way its cost is spread over five years
rather than being subtracted
all in one year. The accumulation of depreciation over the five-
year period is shown on the
balance sheet as accumulated depreciation. The third line item
on IBM’s and 3M’s balance
sheets is the net value of property, plant, and equipment after
depreciation is subtracted.
Managers need to understand how depreciation reduces the net
income of a company,

but it is not actually a cash expense each year. The cash outlay
(or initiation of a long-term
debt, such as a car loan) for an asset happens in the year of
purchase. If a company were
to report that as an expense, the profits would be greatly
reduced. Depreciation expenses
spread out the cost of an asset over time, even though they do
not require the use of cash.
This enables a company to match its expenses with the time
over which the asset is used.
Task Box 2.4: Calculating Depreciation
Review the Notes to the Financial Statements and find out how
3M and IBM calculate
depreciation. (The method 3M uses to calculate depreciation is
shown in Note 1, page 53. IBM
details this on page 81 in Note A.) List the different classes of
depreciated assets and the number
of years of useful life each company gives for its various types
of assets. What depreciation
method does each company use?
eps81356_02_c02_045-096.indd 62 3/25/14 3:11 PM
Most companies use a straight-line depreciation method on their
balance sheet. This
means that the company determines an asset’s life span and then
divides the cost of that
asset by the number of years it will have a useful life to the
company. If there will be a
value after its useful life to the company, that is the salvage

value at which the item could
be sold to generate cash. If the company does not believe there
will be a salvage value, the
asset may be able to be sold for scrap.
Whether salvage or scrap, any value the company can get for the
item will be subtracted
from its cost prior to calculating the annual depreciation
amount. For tax purposes, the
company may use a depreciation method, called accelerated
depreciation, that speeds up the
deduction the company can take for the item. This will not be
shown on the balance sheet.
Occasionally, a company will detail a different method of
depreciation in its note called
“Significant Accounting Policies.”
In addition to detailing its depreciation calculation, IBM also
separates out its Property,
Plant, and Equipment in greater detail in Note G (see Figure
2.9).
Figure 2.9: IBM’s Note G (2012)
One can find details about IBM’s property, plant and equipment
by reviewing the notes to the financial
statements.
Note G.
Property, Plant and Equipment
Land and land improvements
Building and building improvement
Plant, laboratory and office equipment

Plant and other property—gross
Less: Accumulated depreciation
Plant and other property—net
Rental machines
Less: Accumulated depreciation
Rental machines—net
Total—net
($ in millions)
At December 31: 2012 2011
$ 747
9,610
27,731
38,088
25,234
12,854
2,414
1,271
1,142

$ 13,996
$ 786
9,531
26,843
37,160
24,703
12,457
2,964
1,538
1,426
$ 13,883
nual.pdf
Note that land and land improvements are not shown with net of
accumulated deprecia-
tion. This is because land does not age and become useless, as
other assets do. Buildings
and building improvements are shown separately from plant and
office equipment, but
they are shown as total plant and other property for depreciation
purposes.

eps81356_02_c02_045-096.indd 63 3/25/14 3:11 PM
nual.pdf
Depreciation of a building can be a complex calculation. Some
accountants use cost seg-
regation (dividing up a building’s structural components so
write-offs can be developed
based on the useful life of various key parts of a building; for
example, a roof may age
more slowly than the doors). We can’t determine by reading the
Notes to the Financial
Statements whether either IBM or 3M uses cost segregation, but
since they do separate
buildings from other property, that may explain the separation.
(Soled, 2004)
When looking at depreciation, note what percentage of the
assets has been depreciated.
As we can see in Figure 2.9, IBM shows a gross value of
$38,088 million for plant and other
property, but $25,234 million has already been depreciated with
only $12,854 million left
to depreciate. This indicates that 66% (25,234/38,088) of the
useful life of its assets has
been used up. This could mean IBM may need to spend a good
deal of money repairing
older facilities or building new facilities to maintain operations.
Prepaid Pension
The Prepaid Pension line item summarizes the assets on hand to
pay for the company’s

pension plans. We did not show a pension line item on the Best
General Company’s sim-
plified balance sheet, but managers will likely see them on
company balance sheets, so
let’s take a closer look at 3M’s and IBM’s information.
Both 3M and IBM have complex plans that differ based on the
date of hire and by the
country from which one works. 3M’s Note 10 indicates that the
company has over 70
plans in 25 countries. The assets are offset by the obligations
each company has to pay its
retirees from these assets. Note that for both companies, the
pension and post retirement
benefits on the liabilities side are much higher than the prepaid
pension assets shown on
the asset side.
The notes explain how each company structures its retirement
benefits and how well
funded each benefit may be. For many companies, pension
obligations are like a ticking
time bomb that may explode as the Baby Boomers retire in large
numbers. This future
obligation could be a drag on a company’s long-term earning
potential, draining a com-
pany’s cash that could instead be used for future growth.
Task Box 2.5: Comparing Age of Assets
As a manager, when comparing your company to a competitor,
you may want to consider the
age of your competitor’s property, plant, and equipment. A
company with newer equipment
will have higher depreciation costs but may have lower repair
expenses. So when comparing

these line items to analyze operating costs, you may need to
consider both depreciation
expenses and repair expenses. This calculation can also make a
big difference when preparing
budgets. If a company has mostly older assets, the budget
committee may need to plan for the
purchase of new assets or may need to plan for more repairs to
facilities and equipment.
Calculate the age of the assets of 3M using a similar calculation
to the one shown for IBM and
compare the age of assets for the two companies. When
evaluating the value of a company,
depreciation can give you a clue about the age of the company’s
assets.
eps81356_02_c02_045-096.indd 64 3/25/14 3:11 PM
IBM states in Note S that it ceased defined benefit accruals on
December 31, 2007. This
means that after that date, employees ceased to build defined
benefits—the type of ben-
efits in which an employee gets a set amount per year based on
a formula calculated by
the employee’s years of service and salary for the rest of his or
her life after retirement.
Today, all IBM employees participate in a defined-contribution
plan. In this type of plan,
employees, and possibly their employers, contribute to the plan.
Retirement benefits are
based on the cash saved in this retirement plan. The 401(K) is
an example of a defined

contribution plan.
In Note 10, 3M states that its defined-benefit plan in the United
States was closed to new
participants on January 1, 2009. The company currently offers
defined-contribution plans
to all its employees. Changes to pension plans for subsidiaries
outside the United States
are also detailed in this note.
Goodwill
Goodwill is an intangible asset (an asset that cannot be touched
or felt but that has value
for the company). This asset is built by acquiring companies
whose value is greater than
the physical or tangible assets the company holds. In other
words, when a company shows
goodwill on its balance sheet, it means it paid more for at least
one company than its tan-
gible assets were worth. Often these intangible assets include
things like customer base,
desirable locations, or popular technology, products, or
services.
We do not show goodwill on Best General Company’s balance
sheet, but both IBM and
3M show goodwill on their books, and both companies have
bought many smaller com-
panies over the years. Details about IBM’s goodwill are located
in Note I, whereas 3M’s
are located in Note 3. Both companies show goodwill broken
down by industry segments,
but they do not provide much more detail.
More information about recent acquisitions is located in Note 2
for 3M and Note C for

IBM. The acquisition note contains specific financial details
about the company’s recent
acquisitions. For example, if the company has sold any
divisions, that information is usu-
ally found in the acquisitions note, which is then called
Acquisitions/Divestitures. Only
IBM details divestitures.
Intangible Assets—Net
Goodwill is not the only intangible asset on a balance sheet.
Intangible assets also include
things such as:
• Copyrights: Original works such as books, film, audio,
software, and drawings
can be protected for between 50 and 100 years after the
creator’s death, assuming
the creator is an individual. The time is shorter for a
corporation.
• Trademarks: These include symbols, logos, phrases, or
combinations of these that
legally distinguish the company.
• Patents: The exclusive right to an invention, design, or process
for a designated
period of time.
eps81356_02_c02_045-096.indd 65 3/25/14 3:11 PM
All non-goodwill intangible assets are usually lumped in one
line and shown as “net.”

This means that the asset’s value is shown minus any reduction
for amortization. Amor-
tization is similar to depreciation. Many intangible assets have a
limited life span. Amor-
tization is used to track the aging of these assets and to show
what portion of these assets
has been used up.
Neither IBM nor 3M shows much detail in its Intangible Assets
note. IBM shows some
information in Note I, and 3M includes information in Note 3.
IBM has two line items on its balance sheet that we will not
explore in detail: Long-Term
Financing Receivables and Deferred Taxes. The Long-Term
Financing Receivables is a
long-term account similar to the Current Assets account
discussed above. Deferred taxes
also was discussed above as a current asset. The only difference
between these items and
the respective Current Asset line items above is that these items
will be useful for more
than 12 months. The details for the line items can be found in
the notes cited above.
Other Assets
Other Assets is a catchall category for assets not shown
individually on the balance sheet.
IBM calls this line item “Investments and sundry assets.” Some
detail can be found in Note
H, but not much. There is no note specifically for other assets in
3M’s financial reports.
Let’s now examine the Liabilities section of the balance sheet
more thoroughly.

Liabilities
Liabilities include things the company owes. Just as we saw
with assets, there are two
groupings: current liabilities (money due within the next 12
months) and long-term liabil-
ities (money due in more than 12 months).
Financial analysts for Best General Company would be most
interested in the liabilities
side of the balance sheet. They would want to test the
company’s ability to pay its debts,
both in the short term and long term. (We will discuss how to
test that in Chapter 6.) In
this chapter, we explain the various types of liabilities that a
company might incur.
In the beginning of this chapter we saw the balance sheet of the
Best General Company.
Let’s take a closer look at its liability section and compare it to
those sections from IBM
and 3M. Figure 2.10 is the liability section of Best General
Company balance sheet.
eps81356_02_c02_045-096.indd 66 3/25/14 3:11 PM
Figure 2.10: Liabilities section of Best General Company
balance sheet
The liabilities section of the balance sheet is set up just like the
assets section, listing both current and
long-term liabilities.

2013 2012
Accounts Payable
Short-Term Debt
Long-Term Debt
Total Liabilities
Liabilities
$ 8,900
26,000
20,400
55,300

62,450
52,000
$ 169,750
$ 9,400
26,000
19,800
55,200
65,000
54,000
$ 174,200
Taxes
Best General Company shows no tax liabilities, nor does 3M,
but IBM starts its 2012 Cur-
rent Liabilities section of the balance sheet with a line item
called Taxes. These are deferred
tax liabilities that IBM must pay during 2013. They are
explained in Note N along with
Deferred Tax Assets.
Corporate taxation can be a course in itself, and its discussion
goes beyond the scope
of this course. IBM states that its tax deferrals are related to
foreign and domestic loss
carryforwards (deductions for losses that could not all be taken
in the current year but

can be taken in future years). When comparing companies, this
can be a critical issue if the
taxes represent a significant portion of liabilities due. For IBM,
the deferred tax liabilities
of $6,508 million are offset by $11,428 million in deferred tax
assets.
Look in the notes to find out why the company is deferring such
a large portion of its
taxes due. It is possible the company is in negotiations with the
IRS regarding tax obliga-
tions. If so, the company will detail the information in the
notes. For example, IBM states
that in the fourth quarter of 2011, the IRS started an audit of its
U.S. tax returns for the
years 2008 through 2010, and IBM expects the audit to be
complete in 2013. When that
audit is complete, any changes to IBM’s tax bill will be
reported in a future report to
shareholders.
eps81356_02_c02_045-096.indd 67 3/25/14 3:11 PM
Short-Term Debt
Short-term debt includes all debt payments that must be made in
the next 12 months. This
is the second line item of Best General Company’s current
liability section of the balance
sheet as shown in Figure 2.10. IBM details this further for its
balance sheet in the notes to
the financial statements. In the notes it breaks down short-term
debt into three line items,

as shown in Figure 2.11:
• Commercial paper is often used to finance accounts
receivable, inventories, and
other cash needed to meet short-term needs.
• Short-term loans are loans due in full during the next 12
months.
• Long-term debt—current maturities shows the amount the
company will have
to pay on the interest and principal due in the next 12 months
for long-term debt
borrowings.
IBM includes the current portion of its long-term debt as part of
its short-term debt detail
in Note J (shown in Figure 2.11). IBM also indicates that the
weighted-average interest rate
was 1.8% in 2012 and 1.2% in 2011 for short-term debt.
Figure 2.11: IBM’s Note J
In the notes to the financial statements, a chart shows a detailed
breakdown of IBM’s debt obligations.
Note J.
Borrowings
Short-Term Debt
Commercial paper
Short-term loans
Long-term debt—current maturities

Total
($ in millions)
At December 31: 2012 2011
$ 1,800
1,789
5,593
$ 9,181
$ 2,300
1,859
4,306
$ 8,463
nual.pdf
3M gives this line item a longer name: Short-term borrowings
and current portion of long-
term debt (see Figure 2.12). The detail for this line item is in
Note 9. Note that 3M does not
use commercial paper as part of its short-term borrowings, but it
does have a line item for
other borrowings, with an effective interest rate of 4.7%.
eps81356_02_c02_045-096.indd 68 3/25/14 3:11 PM

nual.pdf
Figure 2.12: 3M’s short-term borrowings and current portion of
long-term debt
This chart from the notes to the financial statement shows the
details about IBM’s short-term debts.
Effective
Interest Rate
$ 986
—
99
$ 1,085
3.85%
—%
4.70%
$ 563
—
119
$ 682

Short-Term Borrowings and Current Portion of Long-Term Debt
Current portion of long-term debt
U.S. dollar commercial paper
Other borrowings
Total short-term borrowings and
current portion of long-term debt
(Millions) 2012 2011
nual.pdf
Note that 3M also details the current portion of its long-term
debt (the interest and princi-
pal of the loan that is due during the next 12-month period).
This is separated out because
this part of long-term debt is a current debt, whereas the rest of
the money owed on long-
term debt will be paid after the next 12-month period.
Both IBM and 3M detail their types of borrowing in their
respective notes. This infor-
mation is critical to a company’s financial managers. They need
to be fully aware of the
amount of borrowing, type of borrowing, and the interest rates
the company pays on its
borrowings. Interest can be a drag on earnings, so it is
important to pay close attention to
how the company is managing its debt.
For example, Bob, as the financial analyst for Best General

Company’s budget committee,
would need to look closely not only at how his company
structures its debt, but he may
want to review the debt structure of his company’s competitors.
He may discover ideas
for how to better structure his own company’s debt by
reviewing his competitors’ finan-
cial obligations. If Bob can develop a plan to lower his
company’s interest payments, he
could improve his company’s net income and impress his
managers.
Accounts Payable
The Accounts Payable line item represents bills that were
received in the previous
year but have not yet been paid. Companies must record
expenses at the time they are
incurred (when bills were received) even if they have not yet
paid cash to cover those
expenses. For example, suppose a company gets a bill at the end
of December 2012 for
inventories sold in 2012, but the payment is not due until
January 2013. The company
must report the receipt of the bill in 2012. These bills are
tracked in an account called
Accounts Payable.
Companies do not usually discuss this number in detail in the
Notes to the Financial State-
ments. This is a basic rule of accrual accounting and there
usually is no need to detail the
number.
eps81356_02_c02_045-096.indd 69 3/25/14 3:11 PM

nual.pdf
Accrued Payroll
The Accrued Payroll account tracks payroll expenses that have
not yet been paid. At the
end of the year, it is not uncommon for companies to owe
money to employees that will
be paid at the beginning of the next year. For example, suppose
employees are paid every
two weeks, and one week falls in the last week of December
2012 and the second week
falls in the first week of January 2013. The money due
employees for that last week in
December will be paid in the first week of January 2013. The
company needs to include
the December 2012 expense in the 2012 reports, so it accrues
the one week at the end of
December in an account called Accrued Payroll. When the
employees are paid in January
2013, that accrual will be reversed to zero.
Deferred Income
Deferred income is a line item found on the balance sheets of
service businesses that get
paid up front for services, training, installation, construction, or
other items before they
have completed the work. The Deferred Income account is
therefore a liability account
because the company has not yet earned the money. Some
companies call this Unearned
Revenue.
Only IBM shows a line item for deferred income. It does not

include a specific note for this
line item, but this liability represents income that has been
received but not yet earned.
Note that in the next chapter, we will examine revenue
recognition in more detail when
we discuss the income statement. IBM indicates how it
recognizes income in Note A.
Other Liabilities
Other Liabilities is a catchall account for any current liabilities
not shown as an individual
line item. Companies rarely detail their Other Liabilities line
item, and neither 3M nor
IBM includes a note to explain what these liabilities include.
Long-Term Debt
Up until this point, we have examined short-term liabilities. We
will now turn our atten-
tion to long-term liabilities. Recall that these are liabilities that
will be paid over a period
longer than 12 months. The amount of interest or principal due
on these long-term liabili-
ties was shown in a current liability called Current Portion of
Long-Term Liabilities.
Best General Company includes just one line item called Long-
Term Debt, but more details
can be seen when looking at the long-term debt explanations of
IBM and 3M. IBM details
its long-term debt in Note J, whereas 3M details it in Note 9.
The details show the bonds
or notes outstanding with information about the interest rates on
each debt security and
the date of maturity. IBM’s Note J shows that IBM’s long-term
debt ranges from 2.7% to
7.125%. IBM also holds debt in foreign currencies, including

the Euro, Japanese Yen, Swiss
Franc, and Canadian dollar. IBM separates its U.S. debt and
details each debt type, but it
does not show individual details for each debt held in a foreign
currency.
eps81356_02_c02_045-096.indd 70 3/25/14 3:11 PM
3M’s Note 9 explains that the company combines U.S. and
foreign debt instruments and
details each holding. Its interest rates range from 0.0% to
6.01%. The dates of maturity for
this debt range from 2013 to 2044.
Why do these numbers matter? The interest rates show that 3M
was able to negotiate
better terms on its debt. When reviewing the long-term debt of
his competitors, Bob, Best
General Company’s financial analyst, will assess whether the
interest rates his company
is paying on long-term debt are reasonable compared to those of
the competitors—just as
he did with short-term debt, and for the same reason. Any
opportunity to reduce interest
payments has a positive impact on a company’s net income.
Both IBM and 3M show a weighted average for interest rates on
their debt. (To calculate
weighted average, the interest rate for each debt instrument is
given a weight to deter-
mine the relative importance of each quantity on the average. A
$50,000 debt at 4% would

have a larger weight than a $10,000 debt at 5% because more of
the interest is generated by
the larger debt. IBM’s weighted average interest rate is 3.43%
and 3M’s is 3.16% on long-
term debt. The difference is just 0.27%, which may not seem
like much, but for IBM, that
extra 0.27% translates into about $65 million ($24,049 million 3
0.27 percent) in interest
expenses on its fixed-rate debt.
Another key factor to look at when reviewing a company’s long-
term debt is to determine
whether a company is paying down debt or adding to that debt.
IBM’s fixed-rate debt
increased from $18,547 million in 2011 to $24,049 million in
2012. The story is somewhat
similar for 3M, which also increased its long-term debt in 2012.
Long-term debt for 3M
was $5,047 million in 2011 and $5,902 million in 2012. For
IBM, long-term debt is 12.1%
(24,088 million/199,213 million) of its total assets. For 3M,
long-term debt is 14.5% (4,916
million/33,876 million) of its total assets.
Companies with lower debt, like IBM and 3M, can negotiate
better interest rates. If the two
companies were competing in the same industry, the company
with the lower weighted
average and the same level of debt would likely have lower
interest rate expenses and
higher net income. A financial analyst, like Bob at Best General
Company, might see an
opportunity to refinance some of his company’s debt and lower
interest payments, which
would have a positive impact on the projected budget for the
next year.

Retirement and Post-Retirement Benefits
For many large corporations, Retirement and Post-Retirement
Benefits is an obligation
that is already big—and getting bigger as Baby Boomers retire.
Many corporations also
have not fully funded the obligation. In the future, when
employees retire, these obliga-
tions will become liabilities if the company does not fully fund
their pension benefits.
When reading the notes behind this line item, be sure to look for
a statement that indicates
how well funded these benefits are.
For IBM, the detail can be found in Note S. IBM states that as
of December 31, 2012, the
“qualified defined-benefit plans worldwide were 94 percent
funded compared to the ben-
efit obligations . . . . Overall, including nonqualified plans, the
company’s defined benefit
pension plans were 86 percent funded.” That is still above the
average funding level for
major corporations, which is 80.6%, according to the annual
analysis of corporate SEC fil-
ings done by Pensions and Investments.
eps81356_02_c02_045-096.indd 71 3/25/14 3:11 PM
For 3M, the detail can be found in Note 10. The company states
its “qualified benefit
plan does not have a mandatory cash contribution because the
Company has a significant

credit balance from previous discretionary contributions.” So
3M has met the 100% fund-
ing criteria. It can be important for all managers and employees
of a company to know
whether their company is fully funding their retirement benefits.
Not only is this impor-
tant for the individuals’ futures, it can also be significant for
the future of the company
itself. If the company must catch up on funding its retirement
system at some point in the
future, fewer resources may be available for the growth of the
company. (We talk more
about funding pensions in “World of Business.”)
IBM includes another line item called Deferred Income in the
long-term liability section.
It essentially includes the same type of unearned obligations as
the Current Liabilities line
item mentioned earlier. The only difference is that this line item
shows income that will
not be earned for more than 12 months.
Both IBM and 3M include an Other Liabilities line item in long-
term debt. Again, this is a
catchall line item with little detail about what is included.
World of Business
Is Your Company Funding Your Pension?
As employees near retirement, they become more concerned
about whether there will be enough
money for them to retire. This can include what has been saved
using the company’s retirement
savings programs, as well as what the employee has saved
outside that system.

Companies in recent years have been changing
the rules for retirees by shifting their retirement
benefits from defined-benefit plans to cash-
balance plans or 401(k)s, which are defined-
contribution plans. In most cases, this shift will
result in lower monthly retirement income.
(Zanona 2013)
Employees can review the details about the
state of their company’s retirement plans and
determine where they stand by reading the
Notes to the Financial Statements. An excellent
article by the U.S. Department of Labor, “What
You Should Know about Your Pension Plan,”
helps employees sort out this very complex
issue.
Consider This:
1. Do you know how your retirement account is funded? Where
could you go to learn
more about this?
2. What type of retirement plan or plans does your company
offer? Is the one that you
have chosen the most secure? Why or why not?
.Jon Patton/iStock/Thinkstock
All employees should be encouraged to
look into the details of their company’s
retirement plans.
eps81356_02_c02_045-096.indd 72 3/25/14 3:11 PM

Commitments and Contingencies
Under Total Liabilities, both 3M and IBM indicate there is a
note called Commitments
and Contingencies without any numbers included on the line
item. (For IBM, this is Note
M; for 3M, it is Note 13.) This is to alert readers to the fact that
there are other potential
commitments (contractual arrangements) or contingencies (legal
matters) that do not cur-
rently appear on the balance sheet but that may have a financial
impact on the company at
some point in the future. The commitments and contingencies
include information about
legal matters that could end up costing the company money in
the future, but at the time
the annual report was issued, no dollar amount could be
estimated for the future cost.
The most common type of commitment detailed is operating
leases that do not appear on
the balance sheet. These types of leases appear as a rent
expense, but since they are not
owned, they do not appear as an asset. Yet the company could
have thousands if not mil-
lions due in future payments on operating leases, so the
obligation should be taken into
consideration when considering liabilities. This is a form of off-
balance sheet financing.
3M’s long-term operating lease obligations—leases for
equipment, such as copiers, con-
sidered an asset to the company—total $71 million. Also, 3M
indicates it has accrued

product warranty liabilities of $28 million.
Another type of commitment can be a hybrid security, which is
a financial instrument that
can be both a bond and an equity holding. The bond portion of
the money paid in by the
investor must be paid back, just like any other bond. The
investor holding this type of
security also has equity rights and may be able to convert some
portion of this security
into stock.
IBM discusses three types of commitments in which it has
unused extended lines of credit
to third-party entities of $4,717 million as of December 31,
2012. These are like credit lines
that IBM may use later. IBM may loan this money in the future
to its business partners to
support working capital needs. The company also discusses
guarantees that it does not
expect will result in expenses to the company related to contract
promises. In addition,
the company states it guarantees certain financial agreements,
which totaled $65 million
as of December 31, 2012.
Contingencies involve legal matters that have yet to be
resolved. Both IBM’s and 3M’s
notes include details of ongoing lawsuits. In many cases, legal
matters could take years to
settle with no idea of the outcome until settlement. As soon as a
company can determine
the approximate cost of a legal matter, it must report that cost
to shareholders.
Equity

The Equity section of the balance sheet shows the claims that
owners have against the
assets of the company. For a major corporation, those owners
are shareholders. In smaller
companies, an owner’s claim would be shown as Owners’
Equity. Figure 2.13 is the equity
section of Best General Company’s balance sheet.
eps81356_02_c02_045-096.indd 73 3/25/14 3:11 PM
Figure 2.13: Equity section of Best General Company’s balance
sheet
The equity section of a balance sheet details the amount the
owners of the company have invested in the
company. For a public company, the owners would be
shareholders of the company’s stock.
2013 2012
Common Stock
Retained Earnings
20,000
3,900

23,900
20,000
7,450
27,450
$
$
$
$
The owners’ equity portion of the balance sheet for a
partnership may show several differ-
ent owner line items, which detail the portion of ownership each
owner has. For example,
suppose Raul and Catherine own the Best General Company.
There would be an Owners’
Equity line item showing Raul’s portion of the ownership and
there would be an Owners’
Equity line item showing Catherine’s ownership. In public
documents, this detail likely
would not be shown; instead, a summary of all owners’ equity
would be shown on one

line item.
Now let’s look at the more complicated presentation of the
equity section of the balance
sheet for a major corporation. We review both IBM and 3M’s
equity sections.
Stockholders’ Equity
As noted, equity represents the claims company owners have
against the company’s
assets. Most of these holdings are in different types of stock.
IBM details its Stockholders’
Equity in Note L, and 3M includes additional details in Note 5.
We will examine the com-
mon line items found in the Stockholders’ Equity section of the
balance sheet.
Common Stock
Common Stock details the number of shares authorized to be
sold on the public stock
market and the number of shares issued. In Note L, IBM
indicates that 4,687 million shares
have been authorized, but as of December 2012, only 2,197
million shares are outstanding.
In Note 9, 3M indicates that 3 million shares have been
authorized but less than 1 million
are in the market. IBM also details in Note L the number of
shares issued for stock-based
compensation plans and for employee stock purchase plans.
eps81356_02_c02_045-096.indd 74 3/25/14 3:11 PM

Common shareholders have the right to vote on corporate policy
and elect members of the
board of directors, but they are on the bottom of the totem pole
when it comes to owner-
ship priority. If the company were to go bankrupt, common
shareholders would have to
wait until bondholders, preferred shareholders, and other debt
holders are paid before
they get any money.
Preferred Stock
Preferred Stock is another line item in the Stockholders’ Equity
section of the balance
sheet. Preferred stock differs from common stock in three ways:
1. If a company is not able to pay dividends in a particular year,
those dividends
accumulate. When the company is again in a position to pay
dividends, all past
due dividends (which can also be shown as dividends in arrears)
must be paid to
preferred shareholders before common stock holders get any
money.
2. Preferred shareholders usually do not have voting rights.
3. If a company goes bankrupt, preferred shareholders get paid
before common
shareholders. Each company can structure its preferred stock
differently, but all
preferred stock usually can be thought of in two ways: it is a
type of debt (fixed
dividends) and a type of equity (it has the potential to go up in
value).
Neither IBM nor 3M show a Preferred Stock line item. IBM

does indicate in Note L that
there is authorization for 150 million shares of preferred stock,
but none of this type of
stock is currently in the market. In Note 5, 3M indicates that 10
million shares of preferred
stock are authorized, but none have been issued.
Additional Paid-In Capital
Companies set a price for their stock when it is first issued. Any
money paid in above
the issue price is additional paid-in capital. For example, IBM
sets a “par value” for its
stock of $20 per share. If people bought the stock for $50 per
share from IBM, then $30
per share would be shown as additional paid-in capital. Once a
stock is in the market,
its price does not change the equity portion of the balance sheet.
The balance sheet will
always show the value initially paid for the stock when the
investor bought the stock
directly from the company.
Some companies will include a line item at par value plus an
additional paid-in capital
line item. Others will only show the value of common stock
based on the amount paid
when the stock was bought. For example, in Figure 2.14, IBM
shows common stock at a
par value of $20 plus additional paid-in capital. Below that are
details about the number
of shares authorized and the number of shares already issued.
eps81356_02_c02_045-096.indd 75 3/25/14 3:11 PM

Figure 2.14: IBM’s equity section
The equity section of IBM shows the detail about the claims
owners of the company have against the
company’s assets.
Equity
IBM stockholders’ equity
Common stock par value $20 per share, and additional paid-
in capital
Shares authorized: 4,687,500,000
Shares issued (2012–2,197,561,159; 2011–2,182,469,838)
50,110 48,129
nual.pdf
Retained Earnings
Retained earnings represent an accumulation of earnings by the
company since its incep-
tion and reinvested in the company each year. The balance in
retained earnings is adjusted
each year by adding any net income or subtracting any net loss.
Any dividends paid
are subtracted from net income before any adjustment is made
to the retained earnings
account. This does not reflect cash held by the company. These
earnings are used to grow

the company or pay down debt. The line item tracks the
historical value of undistributed
earnings. Here is the formula for calculating retained earnings:
Prior Year’s Retained Earnings
6 Net Income (Loss)
2 Dividends
Current Year’s Retained Earnings
Treasury Stock
The treasury stock line item refers to stock that has been bought
back by the company
from shareholders. In some companies, it may represent stock
that has never been sold.
IBM indicates in Note L that the Board of Directors has
authorized the repurchase of stock,
and up to $8,652 million was still available for repurchase. In
2012, IBM bought back over
267 million shares. Currently, 3M does not detail any plans to
buy back stock in Note 5.
When a company buys back stock, it means fewer shares are in
the market, and the market
value per share will likely go up. There is never a guarantee of
what the market will do
when it comes to share price—after all, companies do not
control the share price on the
open market. It is controlled by the basic rules of supply and
demand. For a share price
to go up, there must be more people who want to buy the share
than who want to sell it.
With greater demand, the share price rises. Of course, the
opposite is true as well. If there
aren’t any buyers, those who want to sell the share would need

to drop their price to find
a willing buyer.
eps81356_02_c02_045-096.indd 76 3/25/14 3:11 PM
nual.pdf
Section 2.2Inventory Value
Accumulated Other Comprehensive Income (Loss)
The Accumulated Other Comprehensive Income (Loss) line item
shows income or losses
that have not yet been realized. These unrealized gains or losses
can be from things such
as unrealized pension costs, unrealized gains or losses on
securities, and unrealized gains
or loss on foreign currency exchanges or other foreign
investments. IBM includes these
details in Note L, and 3M includes them in Note 5.
This completes our survey of the key line items found on a
balance sheet, as well as the
types of detailed information located in the Notes to the
Financial Statements. This is by
no means a complete list of all possible line items. Financial
statements from companies
in different industries will list other items not detailed here.
Whenever a line item seems
unclear on financial statements, first look for more information
in the Notes to the Finan-
cial Statements for an explanation about how that line item was
calculated. To investigate
further, research the information online.

2.2 Inventory Value
Companies value their inventory using five different methods:
• LIFO (Last In, First Out)
• FIFO (First in, First Out)
• Average Cost
• Specific Identification
• Lower of Cost or Market
We will discuss each in detail below. A company explains how
it values its inventory in
the Notes to the Financial Statements. To compare one
company’s assets to those of its
competitors, it is important to know whether both companies
value their inventory in the
same way. Different inventory valuation methods can impact
formulas for determining a
company’s ability to pay its bills. It can also impact formulas
for measuring a company’s
profitability. (How inventory factors into credit worthiness and
profitability will be dis-
cussed in Chapter 6, where we analyze financial reports.)
Before discussing inventory val-
uation methods, let’s discuss two methods of counting
inventory: perpetual and periodic.
Counting Inventory: Perpetual and Periodic
Perpetual inventory method means that inventory is counted as
it is sold. Companies
that use this method usually make changes to the inventory in
stock at the cash register.
When an item is sold, a computer software program decreases
the inventory in stock.
When inventory is purchased, the additional inventory is added
to the totals of inventory

in stock in the computer software.
In order to use this method of inventory counting, a company
must have a computerized
inventory system that is attached in some way to the actual sale
of goods or services. One
big disadvantage of this type of inventory method is that if the
system goes down, a
eps81356_02_c02_045-096.indd 77 3/25/14 3:11 PM
business may not be able to sell goods to its customers until the
computer system goes
back up.
Periodic inventory method means
that the company periodically does
a physical count of the inventory
on hand. Depending on the type of
business, this could be done daily,
weekly, monthly, or yearly. Some-
times customers will go to a store and
find out it is closed for a few hours
or even a day because the employees
are counting inventory.
Even if a company chooses to use
the perpetual inventory method, it
will do periodic physical counts to
be sure the numbers in the computer
match what is actually on the shelves
and in the warehouses. Not all items

leave the store as a sale. Some may
be broken or stolen instead. Both of
these fall into the category of inventory shrinkage. Companies
adjust their books by pre-
paring an adjusting entry for their accounting system to record
inventory shrinkage. The
number on the financial statements will be net of that inventory
shrinkage.
Most major corporations use the perpetual inventory method, as
more and more compa-
nies link their sales operations to their inventory systems. This
makes it much easier to
know when more inventories are needed. Smaller companies
without the required com-
puter systems use the periodic inventory method.
Managers of companies still using the periodic method may
want to investigate whether
it is logistically feasible to switch to the perpetual inventory
method. This does require a
new investment in computer hardware and software, so this can
be a major capital expen-
diture for a company.
Now let’s take a closer look at the five different methods for
valuing inventory.
LIFO
The LIFO (Last In, First Out) method assumes that the last
piece of inventory purchased
is the first piece of inventory sold. This method works for
companies selling inventory
that does not spoil or become obsolete. For example, a hardware
store would likely use

this method since the tools it sells—hammers, saws, and
shovels—do not spoil or become
obsolete. Also, when the store gets new hammers, for example,
employees are unlikely to
take everything off a shelf to put the newest items in the back
so that the older items are
sold first. In this case, the item most recently put on the shelf
would be the one most likely
picked up and bought by the customer.
Blend Images/SuperStock
Companies can choose how to valuate their invento-
ries, as long as the chosen method is consistent and
accurate.
eps81356_02_c02_045-096.indd 78 3/25/14 3:11 PM
In calculating the value of inventory using the LIFO method, we
will practice calculat-
ing the value of inventory at the end of the month. Most
companies value inventory on a
monthly basis as they prepare their month-end financial
statements. Suppose a company
sells hammers. At the beginning of the month, the company has
50 hammers in inventory
worth $400 (at $8 per hammer). During the month, the company
purchases 300 more ham-
mers. At the end of the month, the company has 75 hammers left
on the shelf. What is the
value of the hammers left on the shelf at the end of the month
using the LIFO method?

We will assume the following schedule of purchases (note that
prices are rising, so the unit
price goes up from $8 to $10 before the first of the month, and
again from $10 to $12.50
near the middle of the month):
Date Quantity Unit price
April 3 100 ,$10.00
April 15 100 ,$12.50
April 28 100 ,$12.50
First, we calculate the number of units sold:
Units
Beginning Inventory 50
1 Purchases 300
5 Goods Available for Sale 350
2 Ending Inventory (75)
5 Items Sold 275
From this calculation, we know that 275 hammers were sold.
Using the LIFO method
of valuation, we assume the hammers purchased on April 28 and
on April 15 were sold
first, for a total of 200 hammers. The remaining 75 hammers
were bought on April 3. So
we know that we still have 25 hammers bought on April 3 and

the 50 hammers we had in
inventory when the month started. So our Ending Inventory
would be worth:
50 hammers at $8.00 (Beginning Inventory) $400
1 25 hammers at $10.00 (April 3 Purchase) 250
5 Total Ending Inventory $650
We also know that 200 of the hammers that were sold were
bought for $12.50 and 75 were
bought for $10, so the Cost of Goods Sold would be:
200 hammers at $12.50 (April 15 & 28 Purchases) $2,500
1 75 hammers at $10.00 (April 3 Purchase) 750
5 Total Cost of Goods Sold $3,250
eps81356_02_c02_045-096.indd 79 3/25/14 3:11 PM
The balance sheet will show the amount $650 for Inventory if
this is the only item being
sold. Of course, it’s unlikely that a company would have only
one type of inventory, but
we are using this simple calculation to explain the LIFO
method.
In this example, we saw that prices were rising. When that
happens, the inventory amount
shown on the balance sheet tends to understate the true value of

inventory. To replace that
inventory at current prices in this example, the store would have
to purchase 75 hammers
at $12.50 for a total of $937.50.
If the market situation were reversed and prices were dropping,
then the inventory
amount shown on the balance sheet would overstate its value
when the LIFO method is
used. (Rules may soon change for companies using LIFO. See
“New World of Financial
Report Oversight.”)
FIFO
The FIFO (First In, First Out) method assumes that the first
item put on the shelves will
be the first item sold. Companies whose products spoil quickly
or become obsolete use
this method of inventory valuation. For example, suppose a
grocery store gets a new ship-
ment of milk. When stocking the shelves, employees put the
newest milk at the back of
the shelves and the oldest milk up front, hoping that customers
will buy the oldest milk
first. Many of us know this and look for milk at the back of the
shelf anyway. But the store
wants the products put on the shelves first to sell first.
In calculating the value of inventory using FIFO, we will
practice calculating the value of
inventory at the end of the month. Just for the sake of
comparison, we will use the same
product discussed with LIFO—hammers. At the beginning of the
month, the company
has 50 hammers in inventory worth $400, or $8 per hammer.

During the month, the com-
pany purchases 300 more hammers. At the end of the month, the
company has 75 ham-
mers left on the shelf. What is the value of the hammers left on
the shelf at the end of the
month using the FIFO method?
New World of Financial Report Oversight
The use of LIFO is unique to the United States. Most other
countries have banned its use and
it does not meet International Financial Reporting Standards
(IFRS) set by the International
Accounting Standards Board (IASB).
At some point in the future, LIFO could be banned in the United
States as well, if the United
States decides to accept IFRS. While there have been
discussions about adopting IFRS or
adapting GAAP to incorporate IFRS rules, there is no date set
for this to happen, and some
question if it ever will. (Fazal 2011) (Rosivach 2012)
eps81356_02_c02_045-096.indd 80 3/25/14 3:11 PM
Again, we will assume the following schedule of purchases:
April 3 100 ,$10.00
April 15 100 ,$12.50

April 28 100 ,$12.50
Units
1 Purchases 300
5 Items Sold 275
Using the assumption of the
FIFO method of valuation, we assume the hammers in inventory
were sold first. Then the
hammers bought on April 3 and 15 were sold next. The last 25
sold were bought on April
28. So our Ending Inventory would be worth:
75 hammers at $12.50 (April 28 Purchase) $937.50
5 Total Ending Inventory $937.50
We also know that 50 of the hammers sold were bought for $8,
100 of the hammers sold
were bought for $10, and 125 of the hammers sold were bought
for $12.50, so the Cost of
Goods Sold would be:
50 hammers at $8.00 (Beginning Inventory) $400.00

1 100 hammers at $10.00 (April 3 Purchase) 1,000.00
1 125 hammers at $12.50 (April 15 & 28 Purchases) 1,562.50
5 Total Cost of Goods Sold $2,962.50
The balance sheet will show the amount $937.50 for Inventory
if this is the only item being
sold. This number more accurately reflects the current cost of
replacing that inventory.
Note that both methods result in a total cost of goods available
for sale of $3,900 after add-
ing the Cost of Goods sold to Ending Inventory.
Average Costing
The inventory valuation method that is the easiest to calculate
and that gives companies
the best picture of inventory trends is average costing. This
method can level out the
ups and downs of inventory pricing and give the company an
average through the year
eps81356_02_c02_045-096.indd 81 3/25/14 3:11 PM
because the average cost is adjusted using a weighted average
method as inventory is
purchased.
When using this method, companies do not need to worry about
what gets sold first.

Companies that sell liquid or other products, such as oil, that
gets mixed on the shelf (or
in tanks buried underground, such as at a gas station) find this
method the most logical
to use. However, others use it as well because, as noted, it is
simple to calculate and evens
out the ups and downs of inventory pricing.
We will use the same scenario as above to practice calculating
this method so that the
inventory methods are easily compared.
In calculating the value of inventory using average costing, we
will again calculate the
value of inventory at the end of the month for a company that
sells hammers. At the
beginning of the month, the company has 50 hammers in
inventory worth $400, or $8 per
hammer. During the month, the company purchases 300 more
hammers. At the end of the
month, the company has 75 hammers left on the shelf. What is
the value of the hammers
left on the shelf at the end of the month using the average cost
method?
Again, we will assume the following schedule of purchases:
April 3 100 ,$10.00
April 15 100 ,$12.50
April 28 100 ,$12.50

Units
1 Purchases 300
5 Items Sold 275
Using the average cost
method, we first need to figure out the average cost of a
hammer. Here is how to calculate
the average cost:
50 hammers at $8.00 (Beginning Inventory) $400
1 100 hammers at $10.00 (April 3 Purchase) 1,000
1 200 hammers at $12.50 (April 15 & 28 Purchases) 2,500
5 Total Cost of Goods Available for 350 Hammers $3,900
** Average Cost Per Hammer ($3,900/350 units) $11.14
eps81356_02_c02_045-096.indd 82 3/25/14 3:11 PM
We then calculate the Cost of Goods Sold and value of Ending

Inventory using the aver-
age cost of $11.14:
Total Cost of Goods Sold (275 hammers at $11.14/unit)
$3,063.50
Total Ending Inventory (75 hammers at $11.14/unit) $ 835.50
The balance sheet will show the amount $835.50 for Inventory
if this is the only item being
sold. Note that the Inventory amount shown on the balance
sheet falls between LIFO and
FIFO. Note that the total of Cost of Goods Sold and Ending
Inventory is $3,899, which is
just slightly different from the $3,900 found with FIFO and
LIFO. When averaging costs,
rounding can result in a slight difference in the totals. If
averaging is calculated without
using rounding, the total will be the same.
Specific Identification
Companies that sell products that each have a different value
use the
specific identification method. For example, a company that
sells cars would likely use
this method. Each car comes with a different set of features, and
so the price for each car
is unique. These companies would calculate their Inventory
value by adding up the value
of each product in inventory.
Lower of Cost or Market
Companies that sell products whose value is constantly
fluctuating use the lower of cost

or market method. With this method of inventory costing, the
company calculates both
the cost of the product when purchased and the current market
value of the product. The
value shown on the balance sheet should be whichever one is
lower.
Comparing the Effects of Valuation Methods
Now that we have considered the various types of inventory
valuation methods, we will
compare how these methods affect the balance sheet and income
statement. Here is a
summary of the numbers we calculated above for the three most
common methods:
LIFO FIFO
Average
costing
Beginning Inventory $400.00 $400.00 $400.00
Cost of Goods Sold $3,250.00 $2,962.50 $3,063.50
Ending Inventory $ 650.00 $937.50 $835.50
The highest Ending Inventory value is generated using the FIFO
method of inventory
valuation, and the highest Cost of Goods Sold value is
generated using the LIFO method
of inventory valuation. In this example, the cost of purchasing
inventory was going up.
The results would be opposite if the costs of purchasing
inventory were going down. The
average costing method will always be between these two
methods.

eps81356_02_c02_045-096.indd 83 3/25/14 3:11 PM
Section 2.3Common-Sized Balance Sheets
The biggest impact is the amount shown for Cost of Goods Sold
because that directly
affects the profits of a company as well as the taxes to be paid.
When Cost of Goods Sold
is higher, profits will be lower. Lower profits also mean a lower
tax bill. So in the scenario
shown above, using LIFO would result in the lowest inventory
valuation, as well as the
lowest profit.
While the numbers used here are small, for a major corporation,
the choice of inventory
method can have a big impact on the assets shown on the
balance sheet and the profits
shown on the income statement. We will take a closer look at
Cost of Goods Sold and its
impact on the income statement in Chapter 3.
Companies cannot switch inventory valuation methods as the
prices change, according
to IRS rules. The GAAP rules require companies to consistently
use the same method of
inventory valuation. If a company determines with its
accountants that a different inven-
tory valuation method would better show the way inventory is
sold, then a long expla-
nation of this decision will be included in the Notes to the
Financial Statements under
Accounting Changes. The company would need to show the

financial impact of this
change for prior years as well as on the current financial
statements to enable financial
report readers to see the impact of the change.
Task Box 2.6: Selecting Inventory Valuation Methods
Think about the types of businesses that would likely use each
of the five inventory valuation
methods. Name one type of business that best matches each of
the methods discussed.
Do you know what type of inventory valuation method your
company uses? Why do you think
it chose to use that method?
2.3 Common-Sized Balance Sheets
When comparing a large company to a small company, it can be
difficult to compare apples
to apples. For example, the Best General Company budget
committee may want to look
at larger companies with similar business models to see how
their sales and other bench-
marks compare, but this would be hard to do by just looking at
the dollar values. While
the common-sized balance sheet is not a required format of the
SEC, it can be a helpful
tool. Few companies provide this information, but anyone can
generate this statement.
Creating a common-sized balance sheet makes comparison
easier no matter what size the
company, because it is based on percentages rather than dollars.
A common-sized balance
sheet enables users to analyze the balance sheet from a different
perspective by calculating

each number as a percentage. A common-sized balance sheet
therefore presents the infor-
mation in two ways: both as dollar figures and as percentages.
The Asset section of the col-
umn shows all assets as a percentage of Total Assets. The
Liabilities and Equity section of
the column shows all Liabilities and Equity as a percentage of
Total Liabilities and Equity.
eps81356_02_c02_045-096.indd 84 3/25/14 3:11 PM
Figure 2.15 is a sample common-sized balance sheet for Best
General Company.
Figure 2.15: Common-sized balance sheet for Best General
Company
A common-sized balance sheet enables easier comparisons of
smaller to larger companies. It also gives
users a different perspective for comparing financial results
from period to period.
Common-Sized Balance Sheet
2013 2012 2013 2012
Current Assets:
Cash

Accounts Receivable
Inventories
Long-Term Assets:
Total Assets
Accounts Payable
Short-Term Debt
Long-Term Debt
Total Liabilities

Common Stock
Retained Earnings
Total Liabilities and Shareholders’ Equity
Assets
Liabilities
4.80%
3.63%
19.18%
3.03%
30.64%
46.64%

22.72%
100.00%
4.75%
13.12%
9.99%
27.86%
32.81%
27.26%
87.94%
10.10%
1.97%
12.06%
100.00%
4.26%
3.96%
20.28%
3.04%
31.54%

45.64%
22.82%
100.00%
4.51%
13.18%
10.34%
28.04%
31.67%
26.37%
86.08%
10.14%
3.78%
13.92%
100.00%
$ 8,400
7,800
40,000

6,000
62,200
90,000
45,000
$197,200
$ 8,900
26,000
20,400
55,300
62,450
52,000
$169,750
20,000
7,450
$ 27,450
$197,200
$ 9,500
7,200

38,000
6,000
60,700
92,400
45,000
$198,100
$ 9,400
26,000
19,800
55,200
65,000
54,000
$174,200
20,000
3,900
$ 23,900
$198,100
eps81356_02_c02_045-096.indd 85 3/25/14 3:11 PM

Taking a quick look at Best General Company’s common-sized
balance sheet in Figure
2.15, the budget committee can see what proportion of the
company’s funds is allocated
to what line items. For example, the largest portion of current
assets is held in inventories:
20.28%. Property, plant and equipment claim 45.64% of assets.
Are these percentages com-
mon in the industry in which Best General Company operates?
The budget committee could answer this question by looking at
industry averages and
comparing its common-sized balance sheet to competitors. No
matter how large a com-
pany is, the percentage allocations for each type of asset should
be similar. Looking at only
the dollar figures, one cannot do the same comparison for
different-sized companies.
Therefore, common-sized balance sheets can help managers and
executives analyze the
numbers for three different and critical purposes:
1. To benchmark a company’s financial position to that of other
similar compa-
nies and industry norms. For example, suppose one company
holds 20% of its
total assets in inventory, but other companies in the same
industry normally hold
15%. Managers may then have questions about how well the
company holding a

higher percentage of inventory is managing its inventory.
2. To compare two companies in the same industry, regardless
of size. By using a
common-sized balance sheet, managers can compare the
percentage each com-
pany has for each line item. Size of the company won’t matter.
3. To find trends in the line items of a balance sheet. If
managers prepare a common-
sized balance sheet with five years’ worth of data, they can
more easily spot a trend
for the various line items on the balance sheet. For example, if
Accounts Receivable
is gradually going up as a percentage of Total Assets, managers
can quickly recog-
nize that with a common-sized balance sheet.
The SEC rules do not require companies to prepare a common-
sized balance sheet. These
are reports generated by companies to spot trends, so there are
no SEC rules about how
these reports need to be prepared.
Common-sized balance sheets are most often prepared by
showing the current year and
then the last fiscal year as dollar amounts in the first two
columns. Then the same infor-
mation for the two years of data is shown as percentages. Some
analysts prefer to show
only the percentages and not the dollar amounts. Both ways are
acceptable.
eps81356_02_c02_045-096.indd 86 3/25/14 3:11 PM

Figure 2.16 shows a common-sized balance sheet for IBM. To
make it easier to compare
IBM with other companies, this balance sheet totals all three
types of Accounts Receivable
into one line item. Also to keep things easy for comparison, it
uses only the net numbers
for Property, Plant, and Equipment and Intangible Assets.
Task Box 2.7: Creating a Common-Sized Balance Sheet
for IBM
To prepare a common-sized balance sheet, start an Excel
worksheet. Copy the information from
the IBM balance sheet into the Excel worksheet.
Develop a formula to divide each line item in the Assets section
by Total Assets. Next, develop a
formula to divide each line item in the Liabilities and Equity
section by Total Liabilities and Equity.
To make things easier for you, we have developed a template
that includes the most common
line items on a balance sheet and the formulas already
developed for the percentage columns.
You can download that template here.
eps81356_02_c02_045-096.indd 87 3/25/14 3:11 PM
Figure 2.16: Common-sized balance sheet for IBM

This common-sized balance sheet was created using IBM’s 2012
Balance Sheet.
IBM
Common-Sized Balance Sheet
At December 31, 2012 and 2011 (in millions)
2012 2011 2012 2011
Current Assets:
Cash and Cash Equivalents
Marketable Securities
Accounts Receivable
Inventories
Deferred Taxes
Prepaid Expenses and Other Assets
Long-Term Assets:
Property, Plant, & Equipment – Net
Long-Term Financing Receivables
Prepaid Pension Assets
Deferred Taxes
Goodwill
Intangible Assets – Net
Investments and Sundry Assets
Total Assets
Taxes
Short-Term Debt
Accounts Payable
Compensation and Benefits
Deferred Income

Other Liabilities
Long-Term Debt
Retirement Benefit Obligations
Deferred Income
Other Liabilities
Total Liabilities
IBM Stockholders’ Equity
Retained Earnings
Treasury Stock
Accumulated Other Income (Loss)
Total IBM Shareholder Equity
Noncontrolling interests
Total Equity
$ 10,412
717
30,578
2,287
1,415
4,024
$ 49,433
$ 13,996
12,812
945
3,973
29,247
3,787
5,021

$ 119,213
$ 4,948
9,181
7,952
4,745
11,952
4,847
$ 43,625
24,088
20,418
4,491
7,607
$100,229
$ 50,110
117,641
(123,131)
(25,759)
$ 18,860
124
$ 18,984
$ 119,213
$ 11,922
0
29,561

2,595
1,601
5,249
$ 50,928
$ 13,883
10,776
2,843
3,503
26,213
3,392
4,895
$ 116,433
$ 3,313
8,463
8,517
5,099
12,197
4,535
$ 42,123
22,857
18,374
3,847
8,996
$ 96,197
$ 48,129
104,857

(110,963)
(21,885)
$ 20,138
97
$ 20,236
$ 116,433
8.73%
0.60%
25.65%
1.92%
1.19%
3.38%
41.47%
11.74%
10.75%
0.79%
3.33%
24.53%
3.18%
4.21%
100.00%
4.15%
7.70%
6.67%
3.98%
10.03%

4.07%
36.59%
20.21%
17.13%
3.77%
6.38%
84.08%
42.03%
98.68%
-103.29%
-21.61%
15.82%
0.10%
15.92%
100.00%
10.24%
0.00%
25.39%
2.23%
1.38%
4.51%
43.74%
11.92%
9.26%
2.44%
3.01%

22.51%
2.91%
4.20%
100.00%
2.85%
7.27%
7.31%
4.38%
10.48%
3.89%
36.18%
19.63%
15.78%
3.30%
7.73%
82.62%
41.34%
90.06%
-95.30%
-18.80%
17.30%
0.08%
17.38%
100.00%
Assets

Equity
nual.pdf
eps81356_02_c02_045-096.indd 88 3/25/14 3:11 PM
nual.pdf
Viewing this information as percentages makes it easier to
analyze the trends. Note that
IBM is holding a lower percentage of Cash in 2012 (8.73%)
versus 2011 (10.24%). Accounts
Receivable is just a slightly higher percentage, 25.65% versus
25.39%. Total Current Assets
is lower at 41.47% in 2012 versus 43.74% in 2011.
Not much can be gleaned from these trends because not a lot of
data is presented. To truly
determine whether any of this represents a true trend for the
company, managers and
executives would need to add the numbers for 2010, 2009, and
2008. Those numbers could
be found by downloading IBM’s 2010 annual report, which

includes the 2010, 2009, and
2008 annual reports.
Task Box 2.8: Creating a Common-Sized Balance Sheet for 3M
Use the template provided for a common-sized balance sheet
(available here). Prepare a
common-sized balance sheet for 3M. Comment on key
differences between IBM and 3M for five
line items you think are relevant.
Which company is doing a better job of managing these five
line items: IBM or 3M? Why do you
think that is the case? Use information from the Notes to the
Financial Statements to support
your argument.
Task Box 2.9: Analyzing Industry Competitors, Part A
Pick an industry that interests you. This could be the industry in
which you currently work or
an industry in which you would like to work. It could be an
industry in which you would like to
invest. You may even want to compare the company you are
currently working for with another
in the same industry.
Select two public companies to compare in the selected
industry. You can use the Yahoo Finance
Industry List to help identify possible candidates: Just click on
the industry that interests you to
get a list of public companies in that industry.
Prepare a common-sized balance sheet for each company you
are comparing. Then discuss how
the two companies compare in the five critical areas below. You

may want to use the Notes to
the Financial Statements to help make your points.
1. Which company does a better job of managing its Inventory
and why?
2. Which company does a better job of managing its Accounts
Payable and why?
3. Which company does a better job of managing its Long-Term
Debt and why?
4. Which company does a better job of managing its Retirement
Benefits and why?
5. Is either company buying back stock or have they bought
back stock in the past? If so,
discuss their buy-back plans.
Throughout the following chapters, you will have the
opportunity to fully analyze the financial
reports of these two companies. Each chapter will guide you
through the process, step by step,
as you learn about the key financial statements. Lastly, we will
show you how to use basic
financial analysis calculations to complete your analysis.
eps81356_02_c02_045-096.indd 89 3/25/14 3:11 PM
Summary and Resources
Chapter Summary
• In this chapter, we examined the balance sheet, or statement of
financial position.

This critical statement provides a snapshot of a company’s
financial position at
one point in time. It reveals what the company owns and owes
as well as details
regarding the claims shareholders have on the company’s assets.
• The valuation of inventory can be very different within each
company. There are
five common valuation methods: LIFO (last item received is
first item sold), FIFO
(first item received is first item sold), average cost (averages
costs of inventory
no matter when the inventory is received), specific
identification (tracks the cost
of each unique piece of inventory), and lower of cost or market
(used for assets
whose value can change dramatically depending on market
conditions).
• A common-sized balance sheet is a tool used to help managers
and executives
compare competing companies of varying size. Managers can
use this tool for
benchmarking, spotting trends, and comparing the key line
items of the balance
sheet. A manager can make this comparison by looking at the
results of various
years of their own company’s activities along with the results of
their competitors.
Takeaways for Chapter 2
• Managers need to watch the trends in the value of their assets,
whether they are
going down or up. Each asset line item can tell a story about the
direction of the

company’s financial position.
• Managers need to analyze each asset’s proportion of the total
assets. Managers
should ask whether the proportions make sense for the industry
or whether one
asset has more value than is common in the industry. If so, what
adjustments
should be made to be more competitive within the industry?
• Managers must watch the expense of their liabilities and
whether the company
is generating enough cash to pay its bills, meet interest
obligations, and pay the
principal due on each of its liabilities. They should also watch
closely the inter-
est rates paid and whether those rates compare favorably to the
current market
interest rates. If not, refinancing may be needed.
Post-Test
1. Why do some companies choose not to report as of December
31 each year?
a. The company is a retail store and prefers to close its books
at the end of January.
b. The company is an educational institution and it prefers to
close its books at
the end of an academic year.
c. The company prefers to close its books based on a particular
day of the week.
d. all of the above
2. Which of the following is not a common format for the
balance sheet?
a. account format

b. report format
c. bookkeeping format
d. financial position format
eps81356_02_c02_045-096.indd 90 3/25/14 3:11 PM
3. Which of the following are types of marketable securities?
a. government securities
b. corporate debt
c. asset-backed securities
d. all of the above
4. Which of the following is not a type of cash equivalent?
a. certificates of deposit
b. bonds
c. money market funds
d. commercial paper
5. Which of these items in Property, Plant, and Equipment is not
depreciated?
a. buildings
b. land
c. plants
d. equipment
6. What are examples of current liabilities?
a. Accounts Payable
b. Short-Term Debt
c. Long-Term Debt
d. both (a) and (b)
7. Which is method for counting inventory?

a. periodic
b. perpetual
c. annual
d. both (a) and (b)
8. Which are methods used to value inventory?
a. FIFO
b. LIFO
c. average cost
d. all of the above
9. Which inventory valuation method is likely to give you the
lowest net profit
when prices are going up?
a. FIFO
b. LIFO
c. average cost
d. specific identification
10. How can a common-sized balance sheet assist you with
financial statement
analysis?
a. It helps you to spot trends.
b. It helps you to compare companies of different sizes.
c. It helps you to benchmark the company’s financials.
d. all of the above
Answers: 1 (d), 2 (c), 3 (d), 4 (b), 5 (b), 6 (d), 7 (d), 8 (d), 9
(b), 10 (d)
eps81356_02_c02_045-096.indd 91 3/25/14 3:11 PM

Answers and Rejoinders to Chapter Pre-Test
1. b. All other options are shown, but the purpose of the
balance sheet is to give a
snapshot in time of the financial position.
2. b. Assets include everything the company owns. Liabilities
include the claims
lenders have on the company’s assets. Equity includes claims
the company’s
owners have on the assets.
3. d. The account format of the balance sheet has a bottom line
for the assets sec-
tion, which shows total assets and a bottom line for the
liabilities and equity
sections, which shows total liabilities and equity.
4. d. LIFO, FIFO, and average cost are three types of inventory
valuation methods.
5. b. One tool used to compare companies period to period or to
other companies
is the common-sized balance sheet, which gives another
perspective of the
companies’ financial results.
Rejoinders to Chapter Post-Test
1. Not all companies must prepare their reports based on a
calendar year. Some com-
panies choose a fiscal year that better matches the actual
operations of the com-
pany. When comparing financial reports of more than one

company, it’s critical to
make sure they have the same fiscal year or make adjustments
for different ones.
2. The account and report formats are the two most common
formats. The financial
position format is most commonly used when comparing non-
U.S. companies.
Foreign companies can file their statements based on
international financial
reporting standards. There is no such thing as a bookkeeping
format for the bal-
ance sheet.
3. Marketable securities can be stocks, bonds, and other
investments that can be
turned into cash in 12 months.
4. Cash equivalents are temporary investments that can be
turned into cash within
three months. Bonds are longer-term investments.
5. Land does not depreciate in value. Depreciation shows the
“using up” of an asset
because of age.
6. Both (a) and (b) are types of current liabilities. Long-term
debt is a long-term
liability.
7. Both (a) and (b) are types of methods for counting inventory.
Periodic means the
inventory is physically counted on a regular basis, whether
weekly, monthly, or
annually. Perpetual means inventory is counted using a software
program that

adjusts inventory levels at the time of sale. While some
companies may only count
inventory on an annual basis, it is not a method for counting
inventory. Even if it
were done once per year, the count would be considered a
periodic count.
8. FIFO, LIFO, and average cost are methods for valuing
inventory.
9. LIFO means that the last in is the first out. So if prices are
going up, the most
expensive inventory will be sold first and the lower-priced
inventory will be left
on the shelves. That means the Cost of Goods Sold will be
higher and the profits
will be lower.
10. Common-sized balance sheets are a useful tool to help
managers spot trends,
compare companies of different sizes, and benchmark a
company’s financials
based on industry norms.
eps81356_02_c02_045-096.indd 92 3/25/14 3:11 PM
Discussion Questions
1. Why should managers compare the level of inventory from
one year to the next?
Why should managers compare inventory levels with their
competitors?

2. What should managers review if they see that Accounts
Receivable is increasing
in value? What changes may be needed?
3. A manager works for a pharmacy and sees that inventory is
valued using LIFO.
Considering that pharmaceuticals can become outdated quickly,
should he ques-
tion the use of LIFO rather than FIFO? Why or why not?
4. A finance manager reviews the short- and long-term
liabilities detailed in the
Notes to the Financial Statements and sees that the interest rates
being paid are
higher than current market rates. What should she do?
5. What line items on a common-sized balance sheet might be
the most useful to
compare over a number of years of data? Why?
Further Reading/Resources
Janssen, C. (2012, March 3). A Breakdown of Stock Buybacks.
Investopedia. Retrieved from
http://www.investopedia.com/articles/02/041702.asp
U.S. Department of Labor. (n.d.). What You Should Know
About Your Retirement Plan.
Retrieved from
http://www.dol.gov/ebsa/publications/wyskapr.html
White, R. (2012, June 26). Is your defined-benefit pension plan
safe? Investopedia. Retrieved
from http://www.investopedia.com/articles/retirement/08/safe-
db-plan.asp

Yahoo Finance Industry List
Key Terms
account format One type of format for a
balance sheet. Assets are shown on the left
and Liabilities and Equity are shown on
the right.
accrual accounting A method of account-
ing in which expenses and revenues are
shown in the appropriate month. Rev-
enues must be recognized in the period
they are earned and expenses must be
recognized in the period they are used,
which is not necessarily the period that
cash changed hands.
accrued payroll Account that tracks pay-
roll due to employees not yet paid.
accumulated depreciation An account
that tracks the depreciation of an asset
over the years the asset is owned.
Accumulated Other Comprehensive
Income (Loss) A line item that shows
income or losses that have not yet been
realized. These unrealized gains or losses
can be from things such as unrealized
pension costs, unrealized gains or losses
on securities, and unrealized gains or loss
on foreign currency exchanges or other
foreign investments.
aging schedule A report generated that
lists the customers who purchased items

on company credit and the amounts
owed. The amounts owed are grouped by
the age of the debt.
eps81356_02_c02_045-096.indd 93 3/25/14 3:11 PM
http://www.investopedia.com/articles/02/041702.asp
http://www.dol.gov/ebsa/publications/wyskapr.html
http://www.investopedia.com/articles/retirement/08/safe-db-
plan.asp
http://biz.yahoo.com/p/sum_conameu.html
average costing One method for valuing
inventory. As inventory is purchased, the
cost of the new inventory is averaged with
the cost of the other inventory on hand.
bad debt Debt the company is owed by
its customers that it does not expect to col-
lect from them.
carryforwards A deduction for losses that
could not all be taken in the current year
but can be taken in future years.
commitments Contractual agreements.
common-sized balance sheet Document
that converts the financial results into
percentages to make it easier to compare
companies, no matter what their sizes.
contingencies Pending legal matters.

credit A type of entry in an accounting
system. For some types of accounts it
will increase its balance; for other types of
accounts it will decrease its balance.
debit A type of entry in an accounting
system. For some types of accounts it
will increase its balance; for other types of
accounts it will decrease its balance.
deferred income An account that tracks
income received by the company, but not
yet earned.
deferred taxes Taxes that are not paid
immediately, but instead are paid at some
point in the future. These can represent
tax deductions that could not be taken in
the current tax year, but could be taken in
the future.
FIFO (First In, First Out) An inventory
valuation method that assumes the first
item put on the shelves will be the first
item sold. Companies whose products
spoil quickly or become obsolete use this
method of inventory valuation.
financial position format A balance
sheet format that is used internationally
but is not commonly found in the United
States, although it may be used by foreign
companies that do business in the United
States. The key difference with this format
is the addition of two lines that do not

appear on the account or report formats:
working capital and net assets.
goodwill An intangible asset (an asset
that cannot be touched but that has value
for the company). When a company
shows goodwill on its balance sheet, it
means it paid more for at least one com-
pany than its tangible assets were worth.
Often these intangible assets include
things like customer base, desirable loca-
tions, or popular technology, products, or
services.
inventories Products or merchandise
the company has on hand to sell to its
customers.
LIFO (Last In, First Out) An inventory
valuation method that assumes the last
piece of inventory purchased is the first
piece of inventory sold. This method
works for companies selling inventory
that does not spoil or become obsolete.
lower of cost or market method A
method of inventory costing in which the
company calculates both the cost of the
product when purchased and the current
value of the product. The value shown on
the balance sheet would be whichever one
is lower.
maturity The date at which time a finan-
cial instrument, such as a bond or certifi-
cate of deposit, will cease to exist. The

principal is repaid with interest on the
maturity date.
operating lease obligations A type of
lease for equipment, such as copiers, con-
sidered an asset to the company.
eps81356_02_c02_045-096.indd 94 3/25/14 3:11 PM
periodic inventory method A physical
count of the inventory on hand. Depend-
ing on the type of business, this could be
done daily, weekly, monthly, or yearly.
perpetual inventory method A method
for counting inventory as it is sold. Com-
panies that use this method usually make
changes to the inventory in stock at the
cash register.
prepaid expenses Expenses that are paid
in advance. For example, a 12-month
insurance policy paid at the beginning
of the year. This is held as an asset and
reduced monthly as the expense for each
month is recorded.
property, plant, and equipment A line
item on the balance sheet that shows the
net value of all the property, plants, and
equipment a company owns.

report format One type of balance sheet
format. Assets are shown first, Liabilities
and Equity are shown below.
rounding A mathematical decision
made to use less-exact (but easier-to-use)
numbers.
short-term debt All debt payments that
must be made in the next 12 months.
specific identification method A way of
calculating inventory values by adding
up the value of each product in inventory
(based on the purchase and sold details of
each).
straight-line depreciation method A way
to value inventory. The company deter-
mines an asset’s life span and then divides
the cost of that asset by the number of years
it will have a useful life to the company.
treasury stock Stock that has been bought
back by the company from stockholders.
eps81356_02_c02_045-096.indd 95 3/25/14 3:11 PM
Instructions
Instructions
To complete this workbook, answer the questions on each
worksheet in the space provided.
Financing and Investing

Questions
1. McCormick & Company is considering purchasing a new
factory in Largo, Maryland. The purchase price of the factory is
$4,000,000. McCormick & Company believes they can produce
a net cash inflow of $780,000 a year for 10 years. If the
discount rate is 14 percent, should McCormick & Company
purchase the factory at the $4,000,000 asking price?
2. If McCormick & Company decides to purchase the new
factory in Largo, they need to consider relevent after-tax cash
flow. McCormick & Company estimated their potential first-
year sales revenue at $780,000, expenses at $225,000, and
depreciation expense at $150,000. McCormick's marginal tax
rate is 40 percent (21 percent federal and 19 percent state
combined). What is first-year relative cash flow?
3. The estimated relevent annual expected cash flows (C1)
associated with the puchase of the new factory in Largo are as
follows:
Year C1 PV(C1)
1 ? ?
2 $291,000 $202,083
3 $191,000 $110,532
4 $306,000 $147,569
5 $424,000 $170,396
In Year 3, the estimated relevent annual expected cash flows
represents funds used to pay operating expenses for subsequent
years. All estimated relevent annual expected cash flows
include a risk premium of 13 percent, which has already been
applied to the cash flows above. Solve for cash flow for Year 1
based on your answer in Question 2. Then, solve for present
value (PV) for Year 1. What is the total of present value for all
five years? Should the factory be purchased? Why or why not?

4. McCormick & Company is also considering introducing two
new product lines to be made at the new factory (if it is
purchased). As a new member of MCS's finance team, you are
asked to determine whether McCormick & Company should
invest in the two product line expansions. Project A has lower
future cash flows than Project B, but because Project A is more
closely related to McCormick's existing product line, the
company feels it is less risky than Project B. You’ve done some
more analysis and have formulated the following future profits
for each project (with the first cash flow occurring one year
from now). Each project is expected to have a life of 5 years.
Year 1 Year 2 Year 3 Year 4 Year 5
Project A $5M $10M $10M $15M $15M
Project B $5M $10M $15M $20M $20M
You also believe that each project will require about $40
million in upfront investment. Finally, based on the different
risk assumptions, you believe that Project A should use a
discount rate of 7 percent, while Project B will have a discount
rate of 20 percent. Which project or projects should the
company undertake?
Answer Questions 1 to 4 here. Show your calculations.
Valuation of PerformanceShow your answers below:
Questions
1. McCormick & Company is considering buying a new factory
in Largo, Maryland. The company is considering issuing
additional common stock to finance the purchase of the factory.
McCormick & Company stock has recently paid a dividend
payment of $0.52 per share. Dividends are expected to grow by
8.5 percent per year for the next five years. The required return
on the stock is 12 percent. Determine the intrinsic value of the
stock, also known as today's stock price.

2. The current price of an American call option with exercise
price $80, written on McCormick & Company stock is $41.40.
The current price of one McCormick & Company stock is
$123.13. If you were to sell the stock, how much money would
you expect to make?
3. McCormick & Company is considering establishing new
products in a new factory in Largo, Maryland. The project is
expected to last for eight years. To determine the right
financing option, you need to determine the appropriate
discount based on the weighted average cost of capital. The cost
of equity is estimated using the capital asset pricing model.
Cash flows are assumed to be steady, the nominal risk-free rate
for the short-term US government treasury bills is 1.5 percent,
the 10-year government bonds rate is 2.5 percent, and the
inflation rate is 2.54 percent. What is the real risk-free rate?
Then, assume a beta of 1.2 and a market return of 5 percent.
What is the cost of equity?
4. McCormick & Company is considering purchasing a new
factory in Largo, Maryland. After you and your team have
conducted an analysis of alternative investments and cost of
capital, McCormick has decided that a risk premium of 13
percent is appropriate for the investment into a new factory.
Adding the risk premium to the current risk-free rate of 7
percent, what is the minimum acceptable rate of return?
Answer Questions 1 to 4 here. Show your calculations.
Annuities
Answer Questions 1 and 2 here. Show your calculations.
Questions
1. Liz is retiring from the US Postal Service and will turn 70
next year. After 39 years of service, her monthly pension is
$7,500. She does not qualify for Social Security. Liz has

accumulated $700,000 in her thrift savings plan. The
government requires that she convert it to an annuity or move it
to a IRA. All of the money is pretax and tax can be avoided if
it is moved to the IRA. The annuity will be calculated based on
her life expectancy of 17.5 years after age 70. The current US
Treasury long-term bond rate is 3 percent. How much will she
get as an annuity monthly payment? Should Liz take the
annuity or move the money to the IRA? The tax regulations
require that she take out 4 percent of the amount each year.
2. Kathy plans to move to Maryland and take a job at
McCormick as the assistant director of HR. She and her
husband, Stan, plan to buy a house in Garrison, MD, and their
budget is $500,000. They have $100,000 for the down payment
and McCormick will pay for closing costs. They are
considering either a 30-year mortgage at 4.5 percent annual rate
or a 15 year mortgage at 4 percent. Calculate the monthly
payment for each. Property taxes and insurance will add $1,000
per month to which ever mortgage they choose. What should
Kathy and Stan do?

2 The Balance SheetLearning ObjectivesAfter reading th.docx

More Related Content

Similar to 2 The Balance SheetLearning ObjectivesAfter reading th.docx (20)

More from jesusamckone (20)

Recently uploaded (20)

2 The Balance SheetLearning ObjectivesAfter reading th.docx