UNDERSTANDING FINANCIAL STATEMENTS

ASSETS

Most assets are little more than deferred expenses. Their value lies in the future sales they can generate. And, as with baking a cake, that takes the right proportion of ingredients . Assets are the things a company owns. All assets have value, but not all things of value are assets under present accounting rules ” only those that have a money value. This means that one will find no listing on a balance sheet for the trust customers might have in a company or the team spirit of the employees because those qualities cannot be measured in dollars.

What gives an asset its true value is not the materials and workmanship that went into its creation, but rather its ability to help generate a future stream of income. It is not the bricks and mortar, glass, and metal that make a fast food restaurant on a busy street an asset, but the sales that will result from operating the place. The same facility lying in the middle of a wheat field would be of no value at all. The dollar amounts shown on the balance sheet are the original costs ( accountants like to say the "historical costs") of the assets. From the original costs is deducted the accumulated depreciation, if any, against those assets.

THE INFLATION EFFECT

For the time being, balance sheets do not reflect the replacement costs of the assets, a fact that has inspired much derision of the accounting profession, especially in periods of high inflation. Beleaguered with various theories of value, accountants have at least picked one where the numbers can be verified . Every dollar on the balance sheet can be traced back to an invoice, contract, or some piece of paper in the files.

SUMMARY OF VALUATION METHODS

Historical Cost

Historical cost is the present basis of balance sheet values. We can all agree that a thing is worth what someone will pay for it, so for at least one moment in time this was the unquestioned value.

Liquidation Value

Liquidation value is the under-the- hammer price, as in a bankruptcy sale. Most assets sold off this way would bring only a small fraction of their balance sheet value. (Nine cents on the dollar is a historical average in bankruptcy liquidations.)

Investment or Intrinsic Value

This is the present value of all future income expected to be derived from the asset, discounted at a rate commensurate with business risk (typically 10% to 15%).

While most financial experts would agree that this is an asset's "truest" value, it is all based on the tricky task of estimating future income. When you apply mathematical precision to a "guess forecast," you also get another version of a guess estimate with angular numbers instead of round ones.

Psychic Value

Often a factor in mergers and acquisitions, psychic value looks to the buyer's state of mind rather than any characteristic of the asset. Unfortunately, trying to divine the hopes and dreams rattling around in the mind of a potential buyer is not any easier than estimating future income.

Current Value or Replacement Cost

These, as a result of double-digit inflation a while back, got a lot of attention from the Securities and Exchange Commission and the accounting profession, if not businesspeople themselves . The burden of their studies, however, was not that asset values are really much higher than stated, but that depreciation allowances based on historical costs understated the "true" expense, and thus led to overstated profits.

The current value issue, like inflation itself, is about as predictable as the common cold, and as frustrating to cure. Bad as historical costing is, CPAs just have not found anything they like better.

Assets versus Expenses

Granted that it may sound like a contradiction, assets and expenses are very much alike. Except for financial assets (discussed below) and land, assets are little more than prepaid expenses. The reason we just do not call them expenses is that they still have some juice left in them ” some power to generate future sales.

All expenditures ” except payments of debt ” result in either an expense or an asset. The distinction rests on how long the item purchased will be of use. If it will be used up by the end of the year it is an expense; if its usefulness extends beyond the present accounting year it is an asset. Therefore, money spent for wages , electricity, or travel results in an expense, while money spent to acquire carpeting, a lathe, or a jet liner creates an asset.

Some distinctions are not so easy. Money spent to incorporate a business may be listed as an asset (organization expense) on the theory that it will benefit the company throughout its life. On the other hand, it might be written off at once as just another legal expense. Most of the asset/expense decisions will be made by your CPA using established principles, but there are always some arguable cases. The key question is, do you want to bear the entire expense now or stretch it out? Since most managements exist at the sufferance of the bottom line, it is more than an academic issue. More often than not, if it is a borderline case, the course of action is to expense off what you can and still keep your job. Remember that the issue will not affect your cash balances ” the money has already been spent.

TYPES OF ASSETS

Assets may be classified according to their tangibility. This is not the usual way we distinguish them in financial reports , but it can add depth to our understanding of the nature of modern business.

Financial Assets

These include cash, marketable securities, accounts and notes receivable, and investments.

Cash is the premier asset ” it always gets the first position on the balance sheet. There is little need to explain why, for while other assets may interest us, cash generates something more akin to a fascination. I am reminded of something attributed to the Roman poet, Ovid, who is best known for writing "The Art of Love," and its antidote, "The Remedies of Love." He said: "How little you know this world if you fancy that honey is sweeter than cash in the hand." Now if the poet Ovid sounds a little like an economist, the economist John Kenneth Galbraith sounds a little like a poet when he discusses money: "It ranks with love as the source of our greatest pleasure , and with death as the source of our greatest anxiety."

Accounts receivable are the monies due from customers. Nearly all firms that sell to other businesses sell on open account credit, so receivables usually represent one of the larger kinds of assets you need to run a company. Receivables are "claims on money," and as such are maybe halfway to being cash. Some people are fond of reminding us that you still have to collect the account before you have something, but the average amount that ends up as bad debts is only about a third of a percent.

Other cash claims such as receivables from and investments in affiliated companies may or may not be financial assets, depending on how readily redeemable they are. Like a loan to your brother-in-law, these may be more in the nature of gifts than financial assets.

Financial assets make a shiny impression on those you deal with; they give you tactical flexibility; they invite opportunities to knock on your door; and they give you a sense of security and well-being. On the other hand, these financial assets are given to you (management) to do something with besides bathe in their glow, and by themselves they produce limited income. Later we will discuss the question of how much cash is too much. Unlike property and equipment, financial assets do not wear out or become obsolete. They do, however, suffer from inflation and, in the case of marketable securities, from fluctuation in market price.

Physical Assets

These include the inventory, land, buildings , equipment, and anything else you can paint. Most physical assets are subject to depreciation ” the process of writing off (accountants say "expensing") the assets over their useful life.

Exceptions are inventory, which is not kept long enough to depreciate (that is, it had better not be), and land, which is assumed not to depreciate (but do not try convincing the folks in the vicinity of Mt. St. Helen's).

Physical assets ” other than these two ” can be viewed as lost costs or prepaid expenses. Their value is manifest not in their cost, size , sturdiness, or beauty, but in their ability to create customers.

Operating Leverage

For the past 250 years , business has gradually increased its physical assets in proportion to the people it employs, through the process we call automation ” the substitution of machines for people. This is referred to as operating leverage. In general, higher operating leverage (a higher assets to people ratio) results in higher profits in expansion and higher losses in a sales decline. That factor, so often neglected in capital budgeting decisions, can have a profound effect on a company's long- term prospects.

Determining the Value of Inventory

Businesses use three principal methods to assign a value to their inventories: FIFO, LIFO, and the weighted average method. We may think of inventory as a reservoir of goods for sale. At the beginning of the year it stands at a certain level; during the year we add to it by purchasing or manufacturing more goods; from it we take the goods that we sell. And at the end of the year, we measure the level at which it stands. The value of our inventory is what it cost us to make (not what we think we can sell it for), but during the year costs may have fluctuated because of inflation or changes in the supply of and demand for the raw materials or goods we purchase. Moreover, in most companies businesspeople are not sure which goods ” the higher costing or the lower costing ” were sold and which remain in inventory at the end of the year. Therefore, the amount at which we value our ending inventory as well as the cost of goods sold during the year will depend on the valuation method we choose.

FIFO

The First-in First-out (FIFO) method assumes that the oldest goods on hand are the first to be sold, and the inventory remaining consists of the latest goods to be purchased or made. This is a very reasonable assumption since most companies will sell their products in roughly the same chronological order they acquired them.

LIFO

The Last-in First-out (LIFO) method assumes that the latest goods acquired were the first ones sold, and the year-end inventory consists of the oldest goods on hand. In most of the firms that use LIFO, this is clearly a fiction . The reason it is accepted is to defer the payment of income taxes. How that works can be explained in a three-step thought process:

1. The history of the world is inflation; we have always had it (except for brief periods), and there is no sign of it disappearing .

2. In inflation, the goods purchased or made earlier in the year are likely to cost less than those acquired near the end of the year. By assuming the year-end inventory comprises the old lower-cost goods, we tend to understate the value of the inventory. Conversely we tend to overstate the cost of goods sold by assuming that the products delivered were the new higher-cost goods.

3. By overstating the cost of goods sold we will understate profits, and with lower reported profits we will have lower income tax payments.

Weighted Average

With this method, the goods remaining in inventory will be valued at the same average cost as those that have been available for sale during the year.

Depreciation

One of our most useful financial concepts ” for setting prices, providing funds to replace capital assets, and postponing taxes ” is depreciation. Depreciation is the value a fixed asset loses through our use of it and the passage of time. In business, we recognize that depreciation, along with the cost of labor, materials, and taxes, is an expense of running the company. Accountants recognize (record) depreciation in an unimaginative, mechanical way that approximates real life in the long run but may vary widely from it in the short.

We must recognize the expense of depreciation in order to correctly price our products and get a true picture of profits or losses. Suppose we bought an ice cream machine for $2000 and started selling cones for 50 cents, after determining that our out-of-pocket expense to make them was 30 cents. It is obvious we are not making a profit of 20 cents on each cone even though we have that much extra in our pocket, because the 2000-dollar machine is gradually wearing out and losing its value (especially when making my favorite, pecan-praline, because the little crunchies in there wear it out faster). It is possible that at a half a buck a cone we will wind up losing money.

Useful Life Concept

Under present accounting practices, a company that buys equipment or some other fixed asset must estimate the number of years it will use the item and what salvage or residual value it will have when the company is finished with it. The depreciable amount, that is, the cost minus the salvage value, is apportioned to expenses over the useful life of the asset in either equal or formulated amounts.

Because depreciation is a legitimate expense, because it does not involve a cash payment to anyone , because it is based upon estimates of future wear and tear, and because a variety of depreciation methods are acceptable to tax authorities and CPAs, the depreciation process is almost an irresistible invitation to tax strategies and fiscal manipulation. The manipulators are themselves manipulated by the government, which frames depreciation rules so as to encourage businesses to buy new production equipment. (Not all organizations, however, bother with depreciation. A list of those that do not would include tiny companies with too little income to deduct depreciation from, as well as giant nonprofit institutions that neither charge for their services nor pay any taxes.)

Understanding depreciation can be tricky. In the typical business it has four different applications, each one giving a separate and sometimes opposite aspect, and it is easy to be exactly wrong about depreciation. Here are the four viewpoints:

Depreciation as an Expense

Depreciation reduces profits. It always makes them lower. It never adds to or in any other way benefits the bottom line. Got that? In that way, depreciation is like rent, salaries, income tax, or any other expense: the more you have of it, the lower your net income. Yes, depreciation is a non-cash expense, but in the preparation of the income statement or the profit plan of the future, depreciation expense reduces profits.

Depreciation as a Valuation Reserve

The word depreciation is also found in the phrases "accumulated depreciation" or the slightly old-fashioned "reserve for depreciation." In this guise, it represents the total amount of depreciation expense recorded for an asset since it was acquired.

Accountants have a peculiar way of recording depreciation. You might think that the accounting entry would be something like this:

Debit	Depreciation expense	XXX
Credit	The asset	XXX

Not so. For reasons best known to themselves, accountants like to preserve the original cost of the asset. And so they create a valuation reserve that accumulates the depreciation expensed each year; the accumulation is then deducted on the balance sheet from the original cost of the fixed assets to produce a book value. Here is the accounting entry:

DR	Depreciation expense	XXX
CR	Accumulated depreciation	XXX

As you can see, accumulated depreciation has a credit balance; it is located, however, in the fixed asset section of the balance sheet as a negative figure ” a subtraction from the original costs of the assets. As a credit nestled in among the debits it is spoken of as a contra account or, being where it is, a contra asset.

Do not think of accumulated depreciation as any sort of cash fund. It is simply a number, which when deducted from the original cost of the assets, gives their current book value, that is their undepreciated value. The depreciation of an asset continues until (a) the accumulation equals the depreciable amount, or (b) the asset is disposed of, in which case both the asset and the accumulated depreciation are written off the books.

Depreciation as a Tax Strategy

Imagine your income tax for this year. Imagine an expense that you could legitimately deduct. Now imagine this expense could be varied up or down within a certain range, thereby giving you some flexibility in "setting" your income and, therefore, your income tax. If you have any imagination left, think of this expense as existing merely on paper and not requiring any cash. Can you see how, by adjusting this non-cash expense upward, you can actually save yourself cash by lowering your income tax bill? This is the magic of depreciation. Increase any other expense and you have less cash; increase this one and you have more.

Behind the enchantment, however, lie some essential truths ” realities that are frequently overlooked ” to the extent, that is, that real life permits such a thing:

1. Depreciation is not so much a saving of cash as a recovery of cash already spent. Money had to be laid out in the first instance to acquire the assets. In recognition of this some countries ” and to a very minor extent our own ” permit depreciating the entire cost of the asset in the year it is acquired.

2. When an organization accelerates its depreciation, it is merely borrowing tax deductions from future years, so that the cash saved out of reduced taxes is ” in theory, at least ”only a loan that will have to be repaid when the company has used up all of its deductible expense.

Depreciation as Part of Cash Flow

A simplified definition of cash flow is profit + depreciation. The idea behind it is to measure the extra cash generated by a business ” cash received from sales minus cash paid out for expenses. Depreciation expense reduces profits in the first place, but since it is a non-cash expense it is restored to profits when estimating cash flow.

The positive role of depreciation in cash flow is so impressive that it often leads people to the mistaken notion that depreciation is a benefit to profits, also. As you can see, however, it is merely a restoration of money that was taken from profits in the first place. It is sort of like what they do when they make white bread ” they mill out 65 nutrients and put back a half dozen and call the bread "enriched."

Investing in a business is not unlike making a loan to someone. When a payment is made to you on the loan, only part of it is interest income; the rest is principal, for the balance due you afterward is less. In a similar way, the surplus cash generated by a business comprises "interest" and "principal." Profit is like the interest income, but the rest of the cash flow ” represented by depreciation expense ” is a partial return of the original investment, for the value of the assets is now less. The most common methods of depreciation are:

Straight Line

This is the standard method used by most companies for financial (but not tax) purposes.

Straight line depreciation is the easiest to compute and understand. You simply spread the amount to be written off equally over the years of useful life. The formula is:

Suppose, for example, you purchased an office copier for $5000, estimated its useful life at 4 years, and thought you could afterward trade it in for $1000. The depreciation would be:

($5000 - $1000)/4 yr = $1000 per year

Sum-of-the-Years' Digits (SYD)

This is a modest form of accelerated depreciation. That is, it makes the charges heavier in the early years, lighter in the later. There are two reasons we may want accelerated depreciation. First, it more nearly matches the way the market value of used equipment drops ; just think of the drop in value of a new car the minute you drive it out of the showroom. Second, there may be a tax advantage to speeding up the deductions.

The calculation of SYD is a cunning little arithmetic exercise that has nothing to do with real life except that it gets the job done. We start by adding the years' digits in the estimated useful life. Sticking with our copier example, the calculation would be:

1 + 2 + 3 + 4= 10

The 10 becomes the denominator in a fraction, the numerator of which for the first year is the last number in the sum: 4. The fraction is applied to the depreciable amount, thus:

(4/10) — $4000 = $1600

The second year's calculation is: (3/10) x $4000 = $1200 and so on through each digit until a total of 10/10, or 100 of the depreciable amount has been expensed.

As you can see, the first year's depreciation under SYD is significantly greater than under straight line. More expense means less income and income tax. Since the total deductible amount is $4000 in either case, however, SYD will have to compensate later on for the big numbers in the early years.

Getting the sum of the years' digits can be tedious if it is a big number, such as 15 years, so here is a formula you can use. Where N = the number of years' useful life,

SYD = [N(N + 1)]/2

For example,

[15 — (15 + 1)]/2 = 240/2 = 120

Double Declining Balance (DDB)

This method, which accelerates depreciation even more than SYD, also has the blessing of the IRS. It depreciates at twice the rate of the straight line method, applied to the full cost. In our example, you can see that the rate of the straight line depreciation was 25% per year, because the useful life is 4 years and 4 x 25% = 100%. If the useful life had been 5 years, the rate would be 20%, and so on. Under DDB this rate is doubled and applied to the beginning book value each year. For the first year in our example, the depreciation is:

(25% x 2) x $5000 = $2500

As you can see, we have stopped kidding around; we are really talking depreciation now. At the end of Year 1 the book value of our copier is:

$5000 - $2500 = $2500

and the second year's depreciation is 50% x $2500 = $1250.

The calculations continue in that manner until the book value is reduced to the salvage value. That usually means there is no depreciation at all in the last years.

Unit of Production

This is a non-accelerated method based on usage ” the number of units produced or the hours of use. Suppose you thought your copier would give you a half million copies before you traded it in, and the first year you got 100,000 copies. The depreciation under this method would be:

— $4000 = $800

Replacement Cost

Replacement cost is a theoretical method not used for either financial or tax purposes; the depreciation is based on future replacement rather than original cost. If you thought that at the end of five years you would have to pay $10,000 to replace your copier, you might consider the "true" depreciation cost to be:

[$10,000 - $1000]/5 = $1800 per year

Keep in mind, though, that this method is not authorized for financial reporting or income tax purposes.

Advantages of Accelerated Depreciation

Depreciation expense is known as a non-cash expense because there is no out-of-pocket payment associated with it, as there is with almost every other expense. Of course, a payment is made at the time the asset is acquired. Afterward, however, the amount or rate of depreciation has no effect on a company's cash except as it affects profits and profits affect the amount of income tax that is paid.

By selecting an accelerated method of depreciation, a company can postpone the payment of some taxes that would be paid using the standard straight line method. This postponement is very like an interest-free loan from the government.