Balance sheets are about showing that your can keep upright under conditions of environmental duress. By Bill Jamieson
Balance sheets are designed to answer a simple question: how much are we worth? This is a matter of calculating the value of the items that you own: your assets; and deducting the amounts you owe: your liabilities.
However, most of our affairs are a bit more complicated than that. Yet traverse the field of balance sheets and you will see that the same basic format can be applied to the full range of business activities: from one-person businesses to the consolidated accounts of huge multinational companies. In all cases the same principles apply: a balance sheet is indeed a “balance” between sources of funds and assets employed.
In all cases, the balance is achieved by expressing the difference between assets and liabilities as either net worth, capital, equity or shareholder funds. In the published accounts of large companies, shareholder funds may be subdivided into categories such as share premium, reserves and retained earnings, but these are largely accounting transfers that can be ignored. The important thing is the total of shareholder interest in the company.
But what is done in the case of the parent/subsidiary relationship: the situation in which one company holds most of the shares in one or more other companies? The only way to assess the financial position of such a group of companies is to prepare consolidated accounts. This cancels out inter-company trading and financing within the group and adds the remaining assets and liabilities in order to show the group’s financial position as if it were one big company.
A failure to prepare consolidated accounts can give rise to a lack of transparency in the group’s financial reporting. Profit can be inflated and borrowing understated by accounting transfers within the group. Such practices were major contributing factors to recent crises in Asian economies.
Anything that affects one side of the balance sheet must have an equal monetary effect on the other side, if the discipline of double-entry bookkeeping is to be observed. This applies particularly to asset valuations, in which any increase or decrease in asset values is reflected immediately in shareholder equity, and hence in the balance-sheet ratios that financiers and analysts use.
Valuations are thus important to any understanding of balance sheets. But the experts disagree on the proper way of going about valuations. Many techniques have been proposed, including discounting future cashflow back to present values, and “marking to market” all financial assets; but nothing has yet gained universal acceptance.
Other accounting disputes concern the treatment of goodwill, charging items direct to shareholder funds rather than against profit, and the treatment of tax losses and other taxation matters.
All this confusion is compounded by the format in which balance sheets are presented. Under the present accounting rules, assets and liabilities must be split into a current and a non-current portion. This means that the source of funds and the assets employed are not clearly stated, and the concept of “balance” is not made clear to the reader. It is only when balance sheets and other financial statements are recast into a more understandable form that we can grasp the significance of the data in them.
Despite all these shortcomings, the balance sheet is an essential element of financial analysis; so long as the uncertainties that surround asset valuations and other items are recognised. However, they should not be viewed in isolation. Cashflow statements and segmental analysis in the annual reports of all public companies flesh out the bare data of the balance sheet, and the compilation of a statement of movements in shareholder equity allows investors and analysts to see just how the business progressed (or regressed) during the year.
So understanding balance sheets (and the associated financial statements) is simply a matter of maintaining a sense of balance; realising that for every action there is a reaction. If you want to acquire assets, they have to be funded from somewhere.
Adapted from Balance Sheets: The Basics, by Bill Jamieson, Wrightbooks
How not to
How not to leave a message
A customer’s mobile phone has a diversion to a messaging service. If the phone is off or out of range, an answering service picks up the call and promises to pass on a message.
Recently, the customer’s mobile developed a fault that required it be to be sent to the company that sold her the phone. She gave her office number, and the service department promised to let her know when the phone was fixed.
A week passed with no news, so she phoned to inquire:
Company: Didn’t you get our message? We have phoned a couple of times and left messages.
Customer: What number did you call?
Company: We called your mobile.
Sure enough, when the customer got her mobile back there were two calls on the message bank telling her that the phone had been repaired and was ready to be collected.
How not to get a pay rise
A Nigerian laborer in 1967, while working on a building in Lagos, altered his paycheck from 9 4s 0d to 697,000,000. A fine strategy until he tried to cash it: his obvious mistake was to use rounded figures.
How not to create efficiencies
Few companies have risen to such heights of brilliance as the British car manufacturer Morgan. All attempts from management consultants to improve the factory’s internal operations have proved deliciously ineffective. Even simple suggestions, such as reconfiguring the factory floor to reduce double handling and long distances between phases of production, have been resisted.
As a result, Morgan has a backlog of five years on new cars. Which is clearly a clever marketing ploy, as the company is saying in its ads that customers can go on the waiting list for a small deposit.
How not to run a security system
A certain telecommunications company (lets call it Two.tel) called a customer recently. The conversation went like this:
Customer: Hello. Jane Doe speaking.
Two.tel: Hi, this is Daniel from Two.tel. Can I have your date of birth please?
Two.tel: So we know you are you and not an impostor.
Customer: But you just rang me and I said it was me. Why would I be an impostor?
Two.tel: Because you might be someone else trying to operate your account.
Two.tel: Anyway, I have to know because I have some information that will help you and I can’t give it to you unless you prove you are who you say you are.
Customer: But I don’t want it.
Two.tel: But you have to have it and our security people say we need your date of birth or password on the account.
Customer: But our security people say I shouldn’t give out information like that to a stranger on the phone in case they use it to call a telecommunications company and pretend they are me.
Two.tel: This was supposed to be one of those win-win situations. (Hangs up.)
This is the second time it has happened.
How not to be a loyal employee
The prize for the most trusting employee goes to a secretary working for the Thai company Alphatec. Chan Uswachoke, who was considered to be the whiz kid of the Thai stock exchange, ran the company. “A man of vision” according to Asian Business, and “Mr Chips” according to Asiaweek. Sadly, his attention to fiduciary probity was less than exemplary, as was his attention to protocol. When it became clear that he was insolvent he resigned by e-mail. His brother, Somkuan, persuaded the secretary to let him use her name for his share trading. She was shocked to discover that the account was $US1.6 million in deficit. Nor was she the only dupe. The board of directors, when questioned about the collapse, in an idiosyncratic version of corporate governance, said: “We trusted Mr Chan, so the board never questioned what he invested in.”
How not to protect intellectual property
In 1994, Indonesia was the stage for one of the best legal impressions of Alice in Wonderland ever performed. An Indonesian company had been producing fake Pierre Cardin leather goods. When the real Pierre Cardin entered the Indonesian market the Indonesian company sued for breach of trademark. The Indonesian company had registered the logo in Indonesia as its own, and claimed that the originator was now infringing its rights. The company had undertaken the same procedure with Dunhill and Levi-Strauss. In fact, it had taken out about 100 trademarks of famous international companies in all. Many of the affected companies preferred to settle out of court rather than face the lengthy legal process.