# Notes to The Financials

The defensive interval ratio is cousin to the quick ratio. Think you've got to be quick on defense. The defensive interval ratio tells you how long a company can hang on for it's dear life before having to dip into it's non-current bucket of resources.

# Balance Sheet Assets

Allowance for decline in market value of noncurrent equity investments is classified as an asset.

# Balance Sheet Assets: Property, Plant and Equipment

**Let's talk about INTEREST CAPITALIZATION on Land and Buildings Constructed for a Company's own use**

If we build a building we'll be using ourselves, we can capitalize the interest on any debt we had to take out to construct that building. The capitalizable interest will be the lesser of actual interest incurred or the avoidable interest. To calculate avoidable interest, the first step is to calculate our Weighted Average Accumulated Expenditures by taking the money spent and multiplying it by the number of months left in the year divided by 12 months. Did you catch that? The Weighted Average Accumulated Expenditure is based on how much of the year is LEFT! So if we paid money for land in January, we'd multiply it's cost by 12 over 12, and if we paid the contractor in September, we'd multiply that payment by 4 over 12. Once you add all the payments together after weighting them by the number of months that were remaining in the year when they were paid, multiply that weighted average accumulated expenditure by the actual interest rate on the debt. This, my friend, is your avoidable interest.

Watch out! If the construction covers multiple years, which, duh, it probably will, in calculating the current year's average accumulated expenditures, you also have to take into account expenditures made in previous years. And the interest capitalized in previous years is compounded. So if we're calculating year two's average accumulated expenditures, and we paid $10 in year one, which included in that $10 is capitalized interest, then we would add $10 multiplied by 12 months over 12 months to the average accumulated expenditures made in year two when calculating the avoidable interest.

If a company moves into a new building and decides to sell its old digs, the old building gets moved on the Balance Sheet from being classified as Property, Plant, and Equipment to being classified as a Current Asset. Assets held for sale are no longer depreciated. Assets held for sale are reported at net realizable value.

# Balance Sheet Assets: SIGNIFICANT INFLUENCE: THE EQUITY METHOD

The equity investment framework is used for investors who are in the game at twenty to fifty percent. Because if I'm twenty to fifty percent into you I can significantly influence you. T accounts are your friend when it comes to solving investment problems. For the Equity Investment T Account, we're going to Debit Original Cost. We're also going to Debit our pro-rata share of the Investee's Income. On the other side of the T Account, we're going to reduce our investment in this other company by crediting our pro-rata share of the investee's dividends. We're also going to reduce our Equity Investment account by crediting the amortization of the Fair value over the Book Value. For the

Now moving from our Balance Sheet perspective to our Income Statement perspective, we're going to use our Equity Income T Account. So Equity Investment goes on the Balance Sheet and Equity Income goes on the Income Statement. For the T Account called Equity Income, we're going to reduce our Equity Income by Debiting the Amortization of the Fair Value over Book Value. And we're going to increase our Equity Income by crediting our Pro-rata share of the Investee's Income.

Let's Talk About How to Apply the Equity Method:

Grab your Handy Manny hard hat 'cause we're gonna use a tool to avoid looking like a fool. Organize the data from the problem into a framework you can make sense of.

Step 1. The top line is the price paid for the entity as a whole, which is what? The fairest fair value of them all.

Step 2. Hit rock bottom with the Net Book Value of Asset Book Value Minus Liability Book Value.

Step 3. The third section gets filled in with identifiable assets revalued to Fair Market Value

Add up to get Net Fair Market Value, which leads you to the Promised Land of figuring out the Unidentifiable assets like Goodwill.

So Price Paid up top, Net Book Value on Bottom, Fill in Identifiable Assets revalued to Fair Market Value, Add up to get Net Fair Market Value, and Goodwill is yours for the taking!

# Balance Sheet Assets and Liabilities: Bonds

Held to Maturity investments in bonds are reported at amortized cost. The discount or premium at purchase is amortized during the term of the bonds so that the carrying value is equal to face value at maturity. This is the amount to be received at maturity.

The purchase price used for calculations should NOT include any accrued interest. Accrued interest is not included in the investment carrying value.

For straight line method of amortization, take the premium or discount and divide it by the total number of months that the bond is held. Then multiply the total premium or discount by the ratio of the number of months in the time period you are trying to calculate the expense for, over the total number of months that the bond is held.

So if Park buys 200 $1,000 face value bonds from Ott for $220,000, including accrued interest of $5,000, on October 1, 2004 and you want to figure out the bonds' carrying value on December 1, 2005. Then you will subtract the accrued interest of $5,000 from the cash paid of $220,000 for a purchase price of $215,000. To calculate the premium to be amortized, subtract the face value of the bonds, which is $200,000, from the purchase price of $215,000 to get the $15,000 premium that we want to amortize over the term of the bond. The bond was bought on October 1, 2004 and matures on January 1, 2011. That's a total term of 6 years plus 3 months or restated in months, that's 75 months. So for the straight line method, take the total premium of $15,000 and divide it by 75 months to get $200. So every month the bond premium is amortized $200. From October 1st, 2004, to January 1, 2006, there are 15 months. So multiply $200 by 15 months to get $3,000 as the amount of the premium amortized between October 1, 2004 and January 1, 2006. If you subtract the premium amortized of $3,000 from the purchase price of $215,000, you get $212,000, which is the carrying value of the bond on January 1, 2006.

**Let's discuss BONDS WITH DETACHABLE STOCK WARRANTS over a warranted cup of coffee**

For bonds issued with detachable stock warrants there is a formula that is helpful to memorize. To calculate the allocation to the bonds, take the cash exchanged and multiply it by the ratio of the Bond's Market Value divided by the sum of the Bond's Market Value and the Stock Warrants Market Value.

**SERIAL BONDS**

Serial bonds mature at intervals rather than on one single date.

**DEBENTURE BONDS**

Debenture bonds are NOT secured but rather backed only by the general credit of the issuing firm. Think living in debt is not a secure way to go about life. Debenture bonds can be serial bonds. In other words, debenture bonds can mature serially.

# Alert! New Section Balance Sheet Equity: Dividends

**Stock Dividends**

Small stock dividends (less than 25%) are capitalized at the fair value of stock issued and large stock dividends (greater than 25%) are capitalized at the par value of stock issued.