Indicators of Balance Sheet Quality
High-quality financial balance sheet reporting is evidenced by four criteria. These criteria are completeness, unbiased measurement, and clarity of presentation. On this page, we discuss each of indicators of balance sheet quality in more detail. These criteria are used by financial analysts to evaluate the quality of a company’s reported accounting data.
Completeness of a balance sheet is compromised by the existence of off-balance sheet liabilities such as incorrect use of the operating lease classification, or the use of purchase agreements structured as take-or-pay contracts. Analysts need to restate the reported balance sheet by capitalizing operating leases and recording (significant) purchase contract obligations.
In the case of intercorporate investments, the equity method of accounting allows one-line consolidation for investments in associates. The equity method of accounting, when applied, typically results in certain profitability ratios (e.g. net profit margin, return on assets) being higher than under the acquisition method. Firms consolidating several subsidiaries with close to a 50% ownership stake by using the equity method would be a red flag that warrants further investigation.
The balance sheet reflects subjectivity in the measurement of several assets and liabilities:
- value of the pension liability (which is based on several actuarial assumptions)
- value of investments in debt or equity of other companies for which a market value is not readily available
- Goodwill value (there is room for subjectivity in impairment testing)
- Inventory valuation (there is room for subjectivity in testing for impairment)
- Impairment of PP&E and other assets
Overstatement of asset values (i.e., not recognizing adequate impairment losses) overstates profitability and equity.
While accounting standards specify which items should be included 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 versus those that are grouped together. Clarity of presentation allows an analyst to gather relevant information as well as to make comparisons across companies. Clarity should be evaluated in conjunction with information found in the notes of financial statements and supplemental disclosures.
We discussed three indicators of balance sheet quality that can be used by analysts to judge the quality of a company’s reported income statements.