Copyright © 2008, The McGraw-Hill Companies, Inc.
Balance Sheets and Valuation
It is a common and entirely understandable mistake to assume that the value of the
assets shown on the balance sheet correspond to the actual value of those assets. Hilbert
Hotels lists $725,000 worth of land on its balance sheet—doesn’t this mean that the land
owned by the company is worth $725,000? Surprisingly, the answer is no. Most assets
are listed on the balance sheet at cost, not at their current market value. The land owned
by Hilbert Hotels could be worth far more, or far less, than $725,000. In most circum-
stances, this amount would indicate that the land in question was originally purchased
for $725,000.
With many items, though, even this “cost” is not exactly what we would normally
assume it to be. The cost on the balance sheet is reduced as the funds spent to acquire the
asset are counted against income as they are depreciated. Depreciation is covered in some
detail in Chapter 8.4; we will give a brief explanation of how this works below. Land is not
depreciated, but many other assets are.
Suppose that 7 years ago, Hilbert Hotels bought laundry equipment for $500,000, which
was expected to be used for 10 years. Rather than count this expense entirely in the year in
which the equipment was bought, the company instead might divide the total expense up
over the equipment’s useful life. It would then count $50,000 of this expense in each of these
10 years, to match the expense of acquiring this equipment up against the time when the equip-
ment is being used. After 7 years, the company has then counted 7($50,000) $350,000 of the
expense of the equipment as expenses against income. This means that the remaining “cost”
of the equipment is $500,000 $350,000 $150,000. This equipment then would be listed
on the balance sheet as an asset worth $150,000. Note that this is not in any way intended to
be an estimate of how much the equipment would sell for today; it simply indicates that the
company’s accounting attributes $150,000 of unused value to that laundry equipment.Example 12.2.3 Suppose that Zarofi re Systems purchased computer workstations
for $450,000 two years ago. The expected life of the workstations is 5 years and no
salvage value is assumed, and so they are taking depreciation for them at a steady
rate of $90,000 per year. What will the value of this asset be on the company’s balance
sheet? How much are the workstations actually worth?Zarofi re has taken 2($90,000) $180,000 in depreciation on these workstations. So on
the balance sheet they are listed with a value of $450,000 $180,000 $270,000.
From this information, it is not possible to determine the actual fair market value of these
workstations.Example 12.2.4 After 5 years, what will be the value of the workstations on the
company’s balance sheet? What will the workstations actually be worth?After 5 years, Zarofi re will have taken 5($90,000) $450,000 in depreciation. So the entire
cost will have been taken as an expense against income. This leaves their balance sheet
value at $0. Even though the workstations are listed as having no value on the balance sheet,
they may or may not be actually worthless at that time.Vertical and Horizontal Analysis of Balance Sheets
Vertical and horizontal analyses of balance sheets can be done in much the same way as
we did them with income statements. For the vertical analysis, each item on the asset side
of the balance sheet is listed as a percent of total assets; each item on the liabilities and
equity side is listed as a percent of the total liabilities and equity. Note, though, that since
total assets equal total liabilities and equity, we will end up dividing everything by the same
number.
For horizontal analysis, the idea is the same as for income statements. The current
period’s values are listed next to the prior period’s. For each category we then compute the
change both as an amount and as a percent.12.2 Balance Sheets 501