Indicators of Balance Sheet Quality

Completeness, unbiased measurement, and clear presentation indicate high financial reporting quality of the balance sheet. Moreover, a strong balance sheet has an optimal leverage amount, adequate liquidity, and economically successful asset allocation. Balance sheet strength is assessed using ratio analysis. Here we discuss high financial reporting quality of the balance sheet.

Completeness

The exclusion of significant amounts of off-balance sheet obligations leads to an understatement of a company’s leverage. Purchase contracts, which are a form of take-or-pay contracts, are a common source of off-balance sheet obligations. Take-or-pay contractual provisions obligate a party to either take delivery of goods or pay the penalty.

The use of the equity method of accounting may reflect off-balance-sheet liabilities. The equity method of accounting would result in specific profitability ratios, such as the net profit margin, which is also called return on sales being overstated. Firms operating numerous unconsolidated subsidiaries with close to a 50% ownership stake by using the equity method would be a cause for concern for an analyst.

Unbiased Measurement

Since the reporting of balance sheet items is prone to subjectivity, the aspect of unbiased measurement is of importance in financial reporting quality. The following are examples of this aspect:

Understating impairment charges for assets such as inventory, property, plant, and equipment overstates profit in the income statement as well as the assets on the balance sheet. Additionally, companies with large amounts of reported goodwill but with a market value of equity less than the book value may indicate inappropriate goodwill impairments.

Further, understating valuation allowance for deferred tax assets understates tax expenses and consequently overstates assets on the balance sheet.

Companies whose value of investments in debt or equity, in which a market value is not readily available, would base the valuation of those investments solely on management estimates. Companies with such significant investments call for closer scrutiny.

Finally, a company’s pension liabilities require making assumptions such as the discount rate at which future values are valued. The variation of these assumptions should be examined.

Clear Presentation

Although accounting standards specify which items should appear in the balance sheet, they do not typically specify how such items must be presented. Companies have discretion regarding which items they present as a single-line item and those to be grouped. In these cases, the analyst should refer to the company’s notes for more information about the components. For example, in referring to the inventory note, in an inflationary environment, the inventory is carried on the balance sheet at a cost that is substantially lower than its current cost. This information would provide the analyst with the comfort that the inventory is unlikely to be overstated. Consulting with the notes also aids the analyst to make comparisons across companies.

Question

A balance sheet with substantial amounts of off-balance-sheet debt would most likely lack which aspect of financial reporting quality?

     A. Completeness.

     B. Unbiased measurement.

     C. Clear presentation.

Solution

The correct answer is A.

The existence of off-balance- sheet liabilities (obligations) such as debts compromises the completeness of a balance sheet.

B is incorrect. Unbiased measurement is essential for assets and liabilities whose valuation is subjective. These include impairment of property, plant, and equipment and other assets, valuation of pension liabilities, valuation of the goodwill, and inventory valuation.

C is incorrect. Although accounting standards specify which items should appear in the balance sheet, they do not typically specify how such items must be presented. Companies have discretion regarding which items they present as a single-line item that are to be grouped. In these cases, the analyst should refer to the company’s notes for more information about the components.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (k) Describe indicators of balance sheet quality.