Learning Module 3
Analyzing Balance Sheets
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Explain financial reporting and disclosures related to intangible assets — finite vs indefinite life, amortisation, impairment, and IFRS vs US GAAP treatment of internally developed intangibles.
Explain financial reporting and disclosures related to goodwill — recognition in acquisitions, no amortisation, annual impairment testing, and analyst adjustments.
Explain financial reporting and disclosures related to financial instruments — three measurement categories: amortised cost, fair value through OCI, and fair value through profit or loss.
Explain financial reporting and disclosures related to non-current liabilities — long-term financial liabilities at amortised cost, and deferred tax liabilities from temporary timing differences.
Calculate and interpret common-size balance sheets (each item as % of total assets) and related liquidity and solvency ratios.
1 · Intangible Assets
Intangible assets are identifiable non-monetary assets without physical substance. An identifiable asset can be separated from the entity or arises from contractual/legal rights. Common examples: patents, licences, trademarks, customer lists, copyrights, franchises.
Amortised on a systematic basis over the best estimate of useful life. Amortisation method and useful life reviewed at least annually. Subject to impairment testing (same principles as PP&E). The amortisation expense reduces both the asset on the balance sheet and income on the income statement.
NOT amortised. Instead, at least annually: (1) review whether assuming indefinite life is still reasonable, and (2) test for impairment. Examples: certain brand names, perpetual licences. Impairment loss reduces asset value and hits income statement.
Internally generated vs purchased intangibles — key IFRS vs US GAAP difference:
• IFRS: Research phase costs → expensed. Development phase costs → capitalised IF: technical feasibility, ability to use/sell the asset, and ability to complete the project are all demonstrated.
• US GAAP: All R&D costs expensed immediately (no capitalisation). Exception: certain software development costs after technological feasibility established.
Both IFRS and US GAAP: Expense internally generated brands, customer lists, start-up costs, training, advertising, and reorganization costs.
Alpha Inc. example (IFRS): Project 1 (research phase — steering mechanism concept) → all EUR1,683K expensed. Project 2 (development phase — technologically feasible welding apparatus) → EUR1,410K capitalised (materials+services EUR620 + direct labour EUR320 + design/testing EUR470 = EUR1,410K). Administrative costs not capitalised under either standard. Under US GAAP: both projects expensed in full.
Analyst caution on intangibles: analysts often compute "tangible book value" by excluding intangibles from equity. However, arbitrarily zeroing out all intangibles is inadvisable — each should be evaluated individually for economic value.
SAP vs Apple contrast: SAP has EUR21,274M goodwill (50.1% of total assets) plus EUR2,967M other intangibles. Apple has only USD5,717M goodwill (1.5% of total assets). SAP's heavy goodwill reflects growth-by-acquisition strategy; Apple's low goodwill reflects organic growth strategy.
Key disclosures to examine: useful lives, amortisation rates and methods, impairment losses recognised or reversed, and the nature of each intangible asset class.
Off-balance-sheet intangibles: non-identifiable assets such as management skills, market share, brand reputation, customer relationships built internally are never recognised — though they are reflected in market value. Acquired firms' such assets may be recognised as goodwill.
2 · Goodwill
Determine total purchase price paid for the target company (acquiree).
Measure net identifiable assets acquired = Fair value of identifiable assets − Fair value of liabilities and contingent liabilities acquired.
Goodwill = Purchase price − Net identifiable assets. If purchase price < net identifiable assets → "bargain purchase" → gain recognised in profit and loss immediately.
Under both IFRS and US GAAP: Goodwill is capitalised on the balance sheet. It is NOT amortised. It is tested for impairment at least annually. An impairment loss is a non-cash charge against income in the current period, reducing the carrying value of goodwill and total assets. Important: after a goodwill impairment, total assets fall → ROA (net income / avg total assets) may increase in future periods despite no improvement in operations.
Safeway impairment example: Q4 2009 non-cash goodwill impairment charge = USD1,974.2M (net of tax USD1,818.2M). This was 82.6% of opening goodwill (USD2,390.2M) and 11.3% of total assets (USD17,484.7M). The impairment, driven by reduced market capitalisation and weak economy, implied previous acquisitions were worth significantly less than the prices paid.
Economic vs accounting goodwill: accounting goodwill = only recognised in acquisitions, based on purchase price allocation. Economic goodwill = present value of expected excess returns; reflected in stock price, not necessarily in book value.
Analyst adjustments for goodwill: (1) exclude goodwill from balance sheet data used to compute ratios, (2) exclude goodwill impairment losses from income data when evaluating operating trends.
Management judgment in goodwill: estimating fair values of intangible assets (e.g., software, customer lists) involves significant judgment. This affects not only goodwill but also the value allocated to amortisable intangibles, affecting future income statements.
3 · Financial Instruments
A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. The key question: how are subsequent changes in the value of a financial asset measured and where are gains/losses recognised?
Measurement Category | IFRS Description | US GAAP Equivalent | Balance Sheet Carrying Value | Where Unrealised Gains/Losses Go |
|---|---|---|---|---|
Amortised Cost | Cash flows are solely principal & interest; business model is hold-to-maturity | Held-to-maturity (HTM) debt securities; loans & receivables | Amortised cost (face value adjusted for discount/premium amortisation) | NOT recognised — unrealised gains/losses ignored. Only realised gains on sale and interest income hit P&L. |
Fair Value through OCI (FVOCI) | Business model involves both collecting cash flows AND selling; or irrevocable equity election at acquisition (IFRS) | Available-for-sale (AFS) — debt securities only (equity securities NOT permitted under US GAAP) | Fair value at period end | Unrealised gains/losses → Other Comprehensive Income (OCI) → Accumulated OCI in equity (bypasses income statement) |
Fair Value through P&L (FVTPL) | All equity securities (US GAAP); securities not in other categories; irrevocable election at acquisition | Trading securities (all equities, intent-to-sell debt) | Fair value at period end | Unrealised gains/losses → income statement → retained earnings |
EUR100M fixed-income investment example (coupon 5% semi-annual, EUR2.5M received, EUR2M unrealised gain in 6 months):
• Held-to-maturity (amortised cost): IS shows only EUR2.5M interest. Asset stays at EUR100M on BS. No unrealised gain anywhere.
• Available-for-sale (FVOCI): IS shows EUR2.5M interest. Asset at EUR102M on BS (fair value). EUR2M unrealised gain → OCI → Accumulated OCI in equity (not retained earnings).
• Trading (FVTPL): IS shows EUR2.5M interest + EUR2M unrealised gain = EUR4.5M. Asset at EUR102M on BS. EUR4.5M total → retained earnings.
US GAAP: all equity investments (except significant influence) at FVTPL — unrealised gains/losses on equity investments always hit the income statement under US GAAP (ASU 2016-01). Unlike IFRS, US GAAP does NOT allow equity investments at FVOCI.
Derivatives — typically measured at FVTPL. Value derived from an underlying factor (interest rate, exchange rate, commodity price, credit rating). Usually little/no initial investment required.
Apple's marketable securities: USD53.9B short-term + USD194.7B long-term = 66%+ of total assets. Classified as available-for-sale at fair value. Unrealised gains/losses in OCI. Predominantly US government/agency bonds and investment-grade corporate bonds.
4 · Non-Current Liabilities
A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. The key question: how are subsequent changes in the value of a financial asset measured and where are gains/losses recognised?
Long-term financial liabilities (bonds payable): Reported at amortised cost. If issued at par: carrying value = face value throughout. If issued at a discount (below par): carrying value increases from issue price toward face value as discount is amortised. If issued at a premium (above par): carrying value decreases toward face value. At maturity, carrying value = face value regardless of issue price. Apple's USD97.2B of long-term debt includes fixed- and floating-rate notes with varying maturities.
Deferred tax liabilities arise from temporary differences where taxable income is less than reported accounting income in a period → taxes actually paid are less than income tax expense recognised → the difference is a liability for future taxes. Most common cause: accelerated depreciation for tax purposes vs straight-line for financial reporting. In future years the difference reverses.
SAP: EUR240M deferred tax liabilities. Apple: USD31,504M deferred tax liabilities included in USD40,415M of "other non-current liabilities."
Non-current unearned revenue: both SAP (deferred income) and Apple (deferred revenue) show non-current deferred revenue — amounts representing goods/services to be delivered more than 12 months after the balance sheet date. These are liabilities until the performance obligation is satisfied.
Fair value option for liabilities: in certain cases (trading securities, derivatives, hedged instruments), liabilities are measured at fair value rather than amortised cost. Changes in fair value go through P&L.
5 · Common-Size Balance Sheets & Ratios
Vertical common-size analysis expresses each balance sheet item as a percentage of total assets. This removes size differences and enables time-series and cross-sectional comparisons.
Item | A (%) | B (%) | C (%) | Insights |
|---|---|---|---|---|
ASSETS (Common-Size) | ||||
Cash + marketable securities | 58.5 | 6.2 | 33.9 | A & C are liquid; B has minimal cash |
Accounts receivable | 15.4 | 32.3 | 15.4 | B has high A/R — collection risk? |
Inventory | 3.1 | 29.2 | 3.1 | B holds heavy inventory |
PP&E, net | 23.1 | 23.1 | 47.7 | C is capital-intensive (manufacturer?) |
Goodwill | 0.0 | 3.1 | 0.0 | B has made acquisitions; A & C organic growth |
LIABILITIES & EQUITY (Common-Size) | ||||
Current liabilities | 0.0 | 76.9 | 6.2 | B's payables = 76.9% of assets — very high! |
Long-term debt | 0.3 | 0.3 | 92.3 | C is highly leveraged — solvency risk |
Total liabilities | 0.3 | 77.2 | 98.5 | A is almost debt-free; C is 98.5% debt-financed |
Shareholders' equity | 99.7 | 22.8 | 1.5 | A very conservative; C very thin equity cushion |
Liquidity analysis: Company A has strong liquidity — cash-rich, no current liabilities. Company B has poor liquidity — USD2.5M current liabilities vs only USD0.2M cash; must collect receivables, sell inventory, or raise capital. Company C appears liquid in the short term (cash > current liabilities) but faces serious solvency risk (98.5% debt-financed).
BALANCE SHEET RATIOS
🔵 LIQUIDITY RATIOS — SHORT-TERM ABILITY TO PAY
Ratio | Formula | Indicates |
|---|---|---|
Current ratio | Current assets ÷ Current liabilities | Overall short-term liquidity |
Quick (acid test) | (Cash + Mktable securities + Receivables) ÷ CL | More stringent — excludes inventory |
Cash ratio | (Cash + Marketable securities) ÷ CL | Most stringent — only liquid assets |
🟦 SOLVENCY RATIOS — LONG-TERM FINANCIAL RISK
Ratio | Formula | Indicates |
|---|---|---|
Long-term debt-to-equity | Long-term debt ÷ Total equity | Long-term leverage |
Debt-to-equity | Total debt ÷ Total equity | Overall financial leverage |
Total debt ratio | Total debt ÷ Total assets | Proportion financed by debt |
Financial leverage | Total assets ÷ Total equity | Overall leverage multiplier |
SAP Group 2017 ratio examples: Current ratio = EUR11,930 / EUR10,210 = 1.17 (decreased from 1.20 in 2016). Quick ratio = (4,011 + 990 + 5,899) / 10,210 = 1.07 (decreased from 1.11). Cash ratio = (4,011 + 990) / 10,210 = 0.49 (slightly improved from 0.50). LT debt-to-equity = 5,034 / 25,540 = 19.7% (improved from 24.6%). Financial leverage = 42,497 / 25,540 = 1.66 (improved from 1.68). All solvency ratios improved in 2017.
Liquidity vs solvency: liquidity = ability to meet short-term obligations (current ratio, quick ratio, cash ratio). Solvency = ability to meet long-term obligations (debt ratios, financial leverage). A company can be liquid but insolvent (short-term OK, long-term unsustainable) — Company C example.
Cash ratio = most stringent liquidity test: only cash and marketable securities vs current liabilities. Quick ratio is more stringent than current ratio but less than cash ratio (excludes inventory but includes receivables). The current ratio is the least stringent (includes all current assets).
Impairment write-downs affect ratios: goodwill impairment → reduces equity (numerator and denominator effects) → debt-to-equity increases; reduces total assets → total asset turnover increases (if revenue unchanged).
Cross-sectional ratio limitations: different accounting methods, diversified companies spanning multiple industries, and seasonality limit the comparability of ratios across companies and sectors. Judgment is required to assess whether differences are meaningful.
S&P 500 sector patterns: Energy and utilities have highest PP&E (capital-intensive). Financial companies have highest total liabilities. IT companies have highest equity ratios (least leverage). Telecom and utilities have highest long-term debt.