From the course: Accounting Foundations

Limitations of the balance sheet

From the course: Accounting Foundations

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Limitations of the balance sheet

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- All right. I'm a little embarrassed to tell you this, but I have to tell you the whole truth. The balance sheet is not perfect. There are some limitations, so I better tell you what those limitations are. Better that you hear it from me than from somebody else. Now first, when you look at a balance sheet, most of the numbers that you see are not market values. They're costs. You say, okay, well what's the big deal? Well, it could be a huge deal. Let's say you've got a company that has some land that it bought 50 years ago for $5,000 and the land now, 50 years later, is worth $2 million. Well, what's going to be reported in the balance sheet? The amount reported in the balance sheet is the original cost. The $5,000 cost from 50 years ago, not the current market value. This often misleads people, because of when they look at the balance sheet, they think they're seeing market values. No, most of the numbers in the balance sheet are original cost, not current market value. So that's the first limitation in the balance sheet. The second limitation is worse. Some very valuable economic assets are not reported at all on the balance sheet, especially intangible assets. For example, what are the most important economic assets of Apple? Well, first, the Apple logo, the Apple name. Think how much you'd have to pay to buy the worldwide rights to use that name Apple. It'd be tens of billions of dollars, maybe hundreds of billions. Same thing with the logo. And even more valuable intangible asset is the relationships that Apple has with all its customers around the world. If you're an Apple user, you're loyal, and if Apple comes out with a new product, you're going to buy the thing. That customer loyalty is a valuable asset for a company to have. An existing base of loyal users, that's an asset that may be worth several hundred billion dollars, maybe even more than a trillion. So those crucial economic assets, the logo, the name, those customer relationships, for how much are they recorded in Apple's Balance sheet, zero. Because Apple never had to pay to buy those economic assets, their accounting costs is zero. Apple never had to pay anybody else to buy its name, it just developed that name. Apple didn't have to pay anybody else to buy its logo, the company created the value of that logo. Apple didn't have to buy its relationships with customers, the company created those valuable relationships itself. So the intangible assets that a company grows itself, that it creates itself, these organic homegrown intangibles, they're recorded at zero on a balance sheet, and for many companies, these assets are the most important ones they've got. The name Apple, the name Microsoft, the name IBM, the name McDonald's or Coca-Cola, all of these names are worth tens of billions of dollars, and yet, they are all recorded at zero on the balance sheets of their respective companies. This exclusion of homegrown intangibles can cause a big discrepancy between a company's recorded accounting value and its actual market value. For example, as of September 28th, 2024, Apple's total recorded assets were $365 billion. At the same time, the actual market value or market capitalization of the company was almost $3.5 trillion. In other words, the actual value of the company was almost 10 times as much as it's recorded accounting assets. Clearly the balance sheet isn't capturing all of the value of Apple. Okay, now those are the limitations of the balance sheet. Now, you know the truth. The balance sheet's great, but it's not perfect.

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