8/12/24, 2:21 PM Module 3

Module 3

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Balance Sheet Introduction

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Contact Information

Taylor C. Weaver
Lecturer
[email protected]

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Overview

The balance sheet details a company’s assets, liabilities, and owner equityAs discussed in Module 2, owner
equity consists of both contributed capital (money directly invested by the owners or shareholders) and
retained earnings (profits generated by the company that are left in the business). Since profits are the result of
revenues minus expenses in any given period, increases to earnings are also, by definition, increases to
retained earnings and thus to equity. When revenue increases, profit increases, which means retained earnings
increases and equity increases. When expenses increase, profits decline, retained earnings decline, and equity
declines. Thus an increase to earnings is an increase to equity, likewise, a decrease in earnings is a decrease in
equity.

The accounting equation, A = L + E, is an immutable law of financial reporting. A = L + E is not only the
foundation for the balance sheet, it is in fact the methodological construct for the recording of all transactions of
the firm into separate accounts, which are then used to report on the condition and performance of the
company. It also means that it is not possible in financial reporting to change just one number. If one asset value
is increased, then either another asset account must decrease, or a liability or equity account must increase, or
some combination thereof. This has very important implications for understanding the effect of transactions on
the report. For example, when the rules require that an asset be decreased in value, there must be a
corresponding change in equity to keep the report in balance.

The balance sheet is “forever.” That is, the amounts shown on any particular line item of the balance sheet are
the culmination of all the transactions affecting that line item since the inception of the company. These line
items are referred to as “accounts.” For example, the cash account on a particular date is the result of every
cash inflow and cash outflow since the company first started.

A final important point to understand is the timing of when these transactions are reported. The balance sheet is
prepared using the “accrual” basis. This approach defines “transaction” as an exchange of value, independent of
the exchange of cash. Companies are thus required to record the effect of transactions when the value
exchange takes place, not when cash changes hands. Take revenue, for example. Revenue is recorded when
the company provides the goods or services to its customer, regardless of whether the customer has paid for
those goods. Inventory, the goods the company intends to sell, is added to the balance sheet when the
company receives the goods, regardless of whether or not they have paid for the goods. This is explored further
in Module 4.

In this module we will look at each of the major line items on the balance sheet. There are two important points
to keep in mind. First, each line item has a different valuation rule. The valuation rule explains how the number
was calculated, and more importantly, exactly what it is intended to represent. Understanding the different rules
is critical to understanding the second point, the judgment that is involved in determining each value on the
balance sheet. With one exception, each of the line items involves some level of judgment by management.
Understanding the specifics of this judgment is critical to knowing what the numbers mean and how to properly
use them in various legal contexts. For example, a restriction in a legal document regarding the total amount of

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debt that a company can incur is meaningless without restricting the judgment allowed by management in
calculating and reporting the amount of debt. Full comprehension of the valuation rules and judgment for each
line item is essential to being a sophisticated user of the financial information.

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As mentioned in the first module, the first thing to note on the balance sheet is the title, “Consolidated Balance
Sheet.” “Consolidated” means that this balance sheet includes all the balance sheets of every entity the reporter
controls, regardless of whether the reporting company owns 100% of that entity. Control is generally defined by
greater than 50% ownership of the entity. For example, note the first line item, “Cash and cash equivalents.” The
amount on this balance sheet includes not only ABC company's cash on hand, but also the cash on hand of any
entity of which ABC owns more than 50%. If ABC owns 60% of XYZ Co., and XYZ has $10 million in cash at the
balance sheet date, then all of the $10 million will be included on ABC's balance sheet.

Current Assets

“Current assets” appear first on the balance sheet. Current assets are those resources the company expects
to use in the next 12 months. This includes such things as cash, inventory, and receivables from customers.
More specifically, current assets are expected to be consumed or liquidated in the next 12 months. Liquidated
simply means to become cash. Within this category, current assets are presented in order of “liquidity,” meaning
how close they are to becoming cash.

Cash and Cash Equivalents: Cash Is Cash

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Cash is 100% liquid, by definition, and thus is always listed first. It is the one exception to the rule that there is
judgment involved in all of the line items on the financial statements. The valuation is simple: cash is cash. It
represents the total amount of cash in all the accounts of all the companies ABC controls. This is a purely
objective and measurable amount.

Cash equivalents are investments that are readily convertible into cash, such as money market accounts or a
certificate of deposit. Cash equivalents are distinguished from other investments in that they mature within the
next three months. They also have essentially no risk of changing in value. If ABC owned shares of another
public company and intended to sell those shares within the next three months, this would not be considered a
cash equivalent because the value of the shares is highly likely to change day to day. Instead they would be
classified as investments.

Short-Term Investments: Mark to Market

Investments are purchased with the hope that they generate income or the value will appreciate. Short-term
investments include equity investments in other companies (stock), debt instruments (bonds), or funds that
include these types of assets. To be considered a short-term investment:

The investment must be marketable. There must be a market for the investment where it could be
liquidated.
If in the form of equity, the investment can’t be more than 20% of the total equity of the underlying
company.
The company intends to liquidate (sell) the investment in the next 12 months.

The valuation rule for short-term investments is “mark to market.” That is, each time a balance sheet is
produced, the company must determine the then-current market value of the investment and adjust the asset
value up or down to that market value. For example, if ABC purchased 100 shares of Apple stock on June 30 at
$600 per share, the balance sheet on that date would indicate a short-term investment of $60,000 (100 shares *
$600). Six months later on December 31, ABC still owns the shares, but the price has decreased to $550 per
share. The December 31 balance sheet would show the investment at its then-current value, $55,000. This
decrease of $5,000 in the value of the asset would generally show up on the income statement as a decrease to
earnings and thus a decrease to equity. Changes in the market value of these investments often have a direct
effect on earnings and equity.

The judgment in the valuation of short-term investments comes in the determination of “market.” In the example
of shares of Apple stock, this is readily determinable by looking at the publicly available market data. There is a
large, robust, active market for Apple shares. However, this is not the only case. It's possible, for example, to
make a short-term investment in a private company whose shares are not regularly traded. Further, it's possible
that on the date of the balance sheet the markets were not functioning for some reason. In this and other cases,
the company must make a judgment call on the market value of the investment. This involves analytical models,

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estimates of future performance, analysis of similar markets, etc. Without a current market, the company is
required to make its best judgment on the value of each investment.

Accounts Receivable: Net Realizable Value

Most transactions between businesses are done on credit terms, meaning the goods and/or services are
provided to the customer with payment due to the company in the future. Typically, payment is due 30 to 60
days after the delivery. This is referred to as “sales on credit,” “credit sales,” or “sales on account.” Under the
accrual basis for reporting, the company providing the goods or service recognizes revenue on the income
statement at delivery, and it adds that amount to “accounts receivable.” Subsequent payment by the customer
reduces the amount in accounts receivable. The accounts receivable on the balance sheet represents the sum,
as of the date of the balance sheet, of all the amounts still owed to the company by its customers as a result of
these credit transactions.

The valuation rule for accounts receivable is net realizable value. This is the total of all amounts owed, less a
provision to cover anticipated losses that may occur from customers who do not ultimately pay the company.
This provision is referred to as the “allowance for doubtful accounts.” Thus, the balance sheet value for
accounts receivable is not the sum of all amounts owed (referred to as “gross accounts receivable”), but rather
what is referred to as “net accounts receivable” or “accounts receivable net.”

Gross Accounts Receivable

−
Allowance for Doubt
=
Net Accounts Receivable

Net accounts receivable is the reported value on the balance sheet; it is the amount the company expects it will
ultimately receive from every company that owes them money. The allowance for doubt is a reserve, an
estimate of future losses.

Gross accounts receivable is readily determined and involves little judgment. All companies have systems in
place to keep track of who owes money and who has paid, and these amounts can be reconstructed from
records if necessary. This is a relatively objective value. However, the allowance for doubt is an estimate based
on predictions of future events. By definition it involves judgment. There are several different approaches
companies generally take to make this judgment, each of which gives a different value, but in most cases the
estimate is based on such factors as:

Credit worthiness of each customer

Historical performance

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General conditions in the economy

Adequacy of collection systems

While this may seem very analytical, the fact is the company cannot know the exact amount that should be
reserved at any given point in time. The actual amount of the losses won’t be known for months or years. The
rules require the company to make a “fair” estimate of the required reserve. The auditors examine the details of
the analysis to determine if they agree that it’s fair. The reader relies on the integrity of the company and the
auditors in using the number.

Footnotes1
The footnotes to the financial statements are an integral part of the financial report and are critical to
understanding the numbers in the financial statements. Footnotes explain the judgment used to prepare the
numbers. For example, HP footnotes include the following:

This detailed information lets the reader understand how the accounts receivable value on the balance sheet
was calculated, including the allowance for doubtful accounts. Without this information, the reader has no way to
analyze and understand the numbers. Footnotes typically run more than 30 pages, explaining the details behind
all the reported numbers on the face of the financial statements.

1 HP Annual Report, 66 (2020).

Inventory: Lower of Cost or Market

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Inventory represents the goods the company has available that it intends to sell to its customers. These goods
have been purchased by the company at some point prior to the date of the balance sheet. Inventory represents
the value of the goods that have not yet been sold. The valuation rule for inventory is lower of cost or market.
This simply means that the balance sheet value is the lower of (i) what it originally cost the company to acquire
the inventory it has on hand (“cost”) and (ii) what it would take to buy the material at the date of the balance
sheet (“market”). This rule is sometimes referred to as “LCM.”

Different types of companies will have different types of inventory. A common way to distinguish a business is
based on what it sells to its customer base:

Service businesses provide a service as opposed to a product. This includes law firms, consultants, and
wireless phone providers.
Retailers sell a product, but they add no value to that product. They buy goods from one company
(“vendor”) and sell those same goods to a customer, typically the consumer.
Manufacturers buy materials from a vendor, add value to that material, and then sell it to a customer.

Determining the cost of inventory is different for each type of firm. Service companies often have little or no
inventory. Their value is provided by the employees, and they provide no product to the customers and thus
need no product. Retailers have a significant amount of inventory, and for them the cost is simply the price they
paid for the goods on the shelf.

For manufacturers, determining the “cost” of inventory is more complicated. The money a manufacturer spends
in adding value to the material it purchases from its vendors is all included in “cost.” Cost, then, for a
manufacturer includes three elements:

Raw Materials: the price of the raw goods that go into the product. In the case of a computer
manufacturer for example, this includes the cost of the screws, wires, computer chips and plastic it buys
from its vendors.
Direct Labor: the money paid to the employees who work in the factory and directly manufacture the
product.
Overhead: the general costs of the factory, including such things as utilities, rent on the factory, and
supervisory personnel.

While tracking all these costs in total is relatively straight forward, significant judgment is involved in allocating
costs to specific elements of inventory.

This is best seen by example. Suppose the computer manufacturer spends $100,000 per month on utilities in its
factory. In that month it manufactures several different types of computers. At the end of the month, some have
been sold and some remain. The balance sheet inventory value is based on the cost of only those that remain.
How should the $100,000 be allocated among the many different types of computers—between the ones that
are still here and the ones that have been shipped out? There is no definitive answer to this question, and in fact
there are several different approaches to determine this.

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Another issue arises when the company has a high volume of low-cost parts remaining in inventory for which it
paid different prices. For example, the computer manufacturer might have hundreds of thousands of tiny screws
that it paid anywhere from $.02 to .05 for over the year. It’s virtually impossible to keep track of which screws are
which and to know for sure how much each individual screw remaining at end of the year actually cost. The
company must estimate the cost.

Determining “market” can be equally problematic. Market is the price to purchase the same part at the date of
the balance sheet. But many specific parts don't have a definitive market. Cost depends on geography, volume
discounts and many other factors. Like cost, the company must estimate market to determine which is lower. In
many cases, cost and market are not definitively knowable.

Once these estimates are made, the company is required to reserve for the possible future obsolescence of
inventory. This is similar to the approach to accounts receivable discussed above. The inventory value on the
balance sheet is:

Gross Inventory (lower of cost or market)

−
Reserve for Obsolescence
=
Net Inventory

The reserve for obsolescence is the company’s judgment on how much of the inventory might become obsolete
before the company can use it to manufacture and sell a product. It is an estimate based on an analysis of the
industry, technological trends, and future product plans. As with all reserves, the company is required to make a
“fair” estimate of amount required, and the auditors examine the analysis to determine if they agree that it is
“fair.” Whether or not the estimate is “correct” cannot be determined until some point in the future.

Long-Term Assets

Long-term assets are assets that are intended to be used for more than 12 months. Long-term assets are said
to be “capitalized,” which means that the value of the asset appears on the balance sheet rather than the
alternative—charging the cost to the current period’s earnings as an expense. The general valuation rule for
long-term assets is acquisition cost minus accumulated depreciation. The sum of these acquisition costs is
referred to as the “gross” value of the asset. With some exceptions, this gross amount is reduced by the
accumulated charges made to reflect the decline in value of the asset since its purchase; this is referred to as
“accumulated depreciation.” “Net” asset refers to gross value minus accumulated depreciation. It is the net
amount that appears on the balance sheet.

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Assets are generally presented in a few different categories. Each one has slightly different applications of the
general valuation rule.

Property, Plant, and Equipment

This includes all the assets with physical substance and is commonly referred to as “fixed assets.” Examples
of fixed assets are buildings, vehicles, and technology systems—essentially, any physical resource. Acquisition
cost includes not only the direct cost of the asset, but also the additional expenditures needed to put the asset in
service. These include sales tax, delivery fees, and installation costs. Some firms build fixed assets themselves
rather than purchase them from an outside firm. In this case all the costs associated with building the asset are
capitalized, meaning they are included in the balance sheet gross value.

After an asset has been placed in service, typically the company incurs expenses related to the ongoing use of
the asset. For example, if the company purchases a truck, over the life of the truck the company may purchase
new tires, replace the brakes, or overhaul the engine. These ongoing costs are classified as either
maintenance costs or betterment costs. Maintenance costs are ongoing, normal costs of operations that do
not extend the life or improve the asset. Betterment costs make the asset more productive, increase the
expected life of the asset, or make the asset more efficient to use. Betterment costs are added to the asset
value on the balance sheet as they are incurred. Maintenance costs are charged to earnings.

Depreciation of Fixed Assets

Fixed assets have a useful life of greater than one year. Over that useful life, the company spreads the cost of
using the assets and the decline in the assets’ value. This is referred to as depreciation. Each year, the
company takes a charge to earnings for depreciation and reduces the value of the assets accordingly. This
reduction actually occurs by increasing accumulated depreciation, a negative amount based on all such charges
to date. Thus, at any given point in time, the net amount of the fixed assets on the balance sheet is:

Gross Assets: Acquisition Cost + Betterments

-
Accumulated Depreciation
=
Net Assets

Obviously, as accumulated depreciation increases each year, net assets decline over the life of each asset.
There are other terms for this concept based on the nature of the asset. Intangible assets like copyrights and
patents (see below) are amortized, and natural resources are depleted. But the concept and the valuation work
the same way; this is just terminology.

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The actual decline in value in any given year is a judgment. This judgment is based on certain approved
methods available to the company. In fact, there are several different approved methods, including straight line
(equal charges each year) and accelerated (more depreciation early in the life of the asset, less in the later
years). The company gets to choose which methods it feels appropriate for each type of asset it owns. In the
United States, most companies use straight line depreciation. The other judgment made by the company is the
useful life of the asset. This is estimated at acquisition. The longer the estimated useful life, the less the
depreciation charges will be in each year.

Land is a special type of long term asset. It is assumed that land is not used up over its life, and thus land is not
depreciated. In fact, under IFRS rules, land is treated as a fair value asset, much like investments discussed
above in current assets. In the United States, land is presented at historical acquisition cost and stays on the
balance sheet until sold, without depreciation.

There are two important points then to remember regarding depreciation (or amortization or depletion). First, the
actual amount each year is based on the method employed by the company and the estimated useful life. The
company may use any method it prefers. The useful life must be reasonable; the auditors look at the estimate to
test for reasonableness. The company thus has great flexibility in the effect of depreciation on the balance sheet
and income statement in any given year. Second, depreciation is always a non-cash expenditure. That is, it
reduces earnings in the period but does not reduce the cash balance. Almost all other expenses eventually
reduce the amount of cash. But in the case of depreciation, the cash is reduced when the asset is paid for. This
will be an important point in the next module.

Intangible Assets
Intangible assets are assets that will be employed for more than a year and lack physical substance. This
includes intellectual property rights (patents, copyrights, etc.) and goodwill (see below). Intellectual property
assets are treated just like fixed assets and presented at acquisition cost less accumulated amortization. This is
often quite different than the actual value of the patent or copyright. In the United States, Research and
Development costs, the costs associated with internal expenditures for the design of new products or patents,
are not considered an intangible asset but are, in fact, charged to earnings in the year the costs are incurred.
Under IFRS, development costs are capitalized and included in intangible assets.

Goodwill is always the result of merger or acquisition activity by the company. It is the amount paid for the
company acquired minus the value of the assets obtained in the acquisition. The amount paid to acquire another
company (“valuation”) is most often based on not just the value of the assets being acquired, but the brand
value, market reputation, and future potential of the business being purchased. Goodwill represents the
unidentifiable part of this valuation.

Goodwill Example
When one company buys another, the valuation is typically much higher than the value
of the assets of the company being acquired. Take, for example, a pizza shop. Let's

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assume this pizza shop is quite popular and sells over $1,000,000 per year. After
expenses, the profit to the owner is over $150,000. A business like this would be
reasonably valued at $500,000.

Consider the assets of this pizza business. Assets would include inventory (dough,
sauce, pepperoni and onions), kitchen equipment, furniture, and maybe a big sign for
the front door. It's reasonable to assume that total value of these assets would be
approximately $50,000.

Why would a buyer pay $500,000 for a business with assets of $50,000? Because the
value of a business lies not in the assets themselves, but in what the business does
with the assets. Value is based on intangibles like market reputation, brand value,
customer loyalty, etc. We call these intangibles “goodwill.” If ABC Company purchased
this business for $500,000, ABC would add the $50,000 of assets to its assets and
show $450,000 of goodwill.

Note that goodwill only arises when one company purchases another. For the original
pizza shop owner, only the $50,000 of assets is included in their balance sheet.

Goodwill does not include internally produced intangible brand value or market reputation. Marketing costs
(advertising, promotion) that establish the value in the market are, like research and development costs,
expensed in the period the money is spent. Thus, the value of a company is often significantly more than the
value of its assets on the balance sheet. For example, a technology company may spend millions of dollars
developing new patents and marketing its technology to customers. All of these costs are charged to earnings
when the expenditures take place, reducing earnings in those years. When the company sells its new
technology in subsequent years, profits are very high since much of the cost is on prior years' income
statements. It is thus difficult to assess the value and performance of these types of firms using any one year’s
financial statements.

Goodwill is a fair value asset. It is not subject to the same deprecation rules as fixed assets or other intangibles.
Instead, at each balance sheet date, it is evaluated to see if it has diminished in value, in which case it is said to
be impaired and is adjusted down accordingly. This adjustment is charged to earnings in the period. Determining
the current fair value of the goodwill from an acquisition done several years ago is problematic to say the least,
and close to impossible if the acquired firm has been integrated into and absorbed by the acquiring company.
Typically, this determination of current value involves outside consultants, investment bankers, and valuation
specialists. But it is the definition of a judgment-based value and the subject of much discussion between the
company and its auditors, who must determine if the company’s judgment “fairly presents” the value of the
asset.

Capital Base
An important part of understanding a company’s balance sheet is looking at the
proportion of short-term and long-term assets. Intellectual property companies like
Apple and Google tend to have mostly short-term assets. They have no need for

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factories, distribution systems, and other long-term assets. Compare this to a

manufacturer (Proctor & Gamble), an airline (Southwest), or a telecommunications
company (Verizon). These types of companies require significant investments in
infrastructure.

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Liabilities and Equity

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Assets are the value (under the reporting constraints discussed) of the resources of the firm. Liabilities and
equity represent the sources of capital employed to purchase those assets. Liabilities are obligations to
outsiders (non-owners). Equity is the claims of the owners on the assets after the liabilities are satisfied, and it
represents the capital invested into the business by the owners. While there is less judgment involved in most of
the values on this side of the balance sheet, it is important to understand the meaning of the important line
items.

Current Liabilities
The complement to current assets, “Current Liabilities,” are obligations due to outsiders within the next 12
months. They commonly include such things as:

Accounts Payable: the amount due to vendors based on invoices already received by the company that
have yet to be paid. The amount is equal to the total face amount on the invoices, and the only real issue
is whether or not the company has included all the invoices received and unpaid.
Accrued Expenses: amounts due in the next 12 months for which no invoice has been received. This
could include charges by vendors who have yet to send an invoice (for example, the telephone bill for the
current month) or wages due to workers for services performed that will be paid in the next payroll. The
company estimates these obligations based on underlying data (hours worked * hourly rate) or history
(average of the last three months’ phone bills). Often the estimates involve significant judgment. For
example, a technology company successfully introduces a new product that is sold with a one-year
warranty. Accrued warranty represents the estimated costs to be incurred over the next year as some of
the products are returned and repaired or replaced. This can be difficult to estimate given the new
product has no performance history on which to base the estimate.
Interest Payable or Taxes Payable: amounts due to banks for interest on outstanding debt, or to
governments for taxes due. These amounts can be very difficult to precisely measure, given often-
sophisticated debt arrangements and increasingly complex taxation rules.

Long-Term Debt

As the title implies, this is the amount due to the providers of long term debt. This is the principal amount only,
and it does not include any interest that is or will become due. It is valued at what amount it would take to satisfy
the obligation on the date of the balance sheet. This value is often not straightforward. Bank arrangements can
be very complex, and include such things as warrants (the right of the bank to buy shares of the company’s
stock) and conversion rights (the right of the bank to convert the debt into shares of the company’s stock).

Long-term debt includes bonds that have been issued by the company. Bonds are marketable debt instruments
that trade in a capital market much like the stock market. Like stock, the market value of the bonds changes

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every day. This can have a complicating effect on the balance sheet of the company issuing the bonds.

Equity

Equity is generally classified into three categories, all of which represent the capital provided to the company by
the owners or shareholders.

Contributed Capital: This is the amount of cash put into the company by the shareholders. Often, this is
referred to on the balance sheet as “common stock” or “preferred stock,” two types of equity. This money
may have been raised in the private equity markets, an “IPO” or initial public offering, or follow-on offerings. It is
valued at the amount originally invested and does not change based on changes in the market value of the
shares. Often, the amount is broken into “par value” and “additional paid in capital.” Par value is an outdated
legal concept that was developed when securities markets were largely unregulated. It is essentially the
minimum value of the equity as committed to by the company that receives the funds from the investors.
Companies are required to always have available at least the par value. Additional paid in capital is the amount
received by the company in addition to the par value.

For example, a company might issue 1 million shares of $1.00 par value common stock that it sells on the
market for $20 per share. The company would receive a total of $20 million. On the balance sheet, this $20
million would be represented as:

Common stock at par $ 1,000,000

Additional paid in capital $19,000,000

Today, many states have no minimum for par value or allow for the issuance of no par value shares. In the case
of no-par stock, the board of directors is required to treat a portion of the selling price of the shares as “stated
capital,” which is equivalent to par value.

Twitter Inc. went public in November of 2013. The company “raised” $1.82 billion,
selling 70 million shares of stock for $26.00 per share in its IPO. Where do these
numbers come from? Why 70 million shares and why $26.00 per share? These two
numbers were chosen by the company. Twitter decided how much they wanted to raise
and how many shares they would issue. They could just as well have issued 35 million
shares at $52 per share. The market is essentially indifferent to this decision, within
reasonable limits for the per share price.

The market does very much care about the implied total valuation of Twitter. This is the
primary decision by the capital markets: what is the total value of Twitter at the moment
of the IPO? The 70 million shares they sold were out of a total of 546 million shares, or

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about 13% of the total equity. The original investors kept the other 87% of the equity;
only the 13% is currently available to the public. The market paid $1.82 billion for this
13%, which means the market valued the total equity of Twitter at about $14
billion. Twitter decided to sell 13% of the equity and decided how many shares to divide
that 13% between. They could have sold more or less than the 13%, and divided that
over more or less than 70 million shares.

The shares had a par value of $.000005 each, or 1/2000 of one cent. On Twitter's
balance sheet, the equity section would show as

Common stock at par value (70 million * .000005) $350

Additional paid in capital $1,819,999,650

Retained Earnings: “Earnings” is another word for profit or net income. “Retained earnings” then is the sum
of all the profits earned by the company since inception that it chose to leave in the business, or to retain. The
alternative is for the company to distribute some portion of the accumulated earnings back to the shareholders;
this distribution is referred to as a dividend. Dividends are typically in the form of cash to the shareholders, but
may be paid in additional shares of stock. In general, the owners (or the board of directors that represents the
owners) will determine each year how much of the earnings will be left in the company to fund the acquisition of
assets and how much will be distributed. We'll see in Module 4 that “earnings” is a highly judgmental concept,
making retained earnings one of the most amorphous values on the balance sheet.

Other Comprehensive Income/Loss: Commonly referred to as “OCI,” this represents the gain or loss
associated with certain specific transactions or items, including gains or losses on certain types of financial
instruments or arising from some forms of currency translation. These are fairly technical accounting issues and
often not material. What’s important to note is that some very specific gains or losses do not appear as charges
to earnings on the income statement (and thus are not included in retained earnings), but rather are charged
directly to the equity section of the balance sheet.

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