The balance sheet, also known as the statement of financial position, is a snapshot of a company's financial condition at a single point in time. It presents a summary listing of a company's assets, liabilities, and owners' equity. The balance sheet is prepared as of the last day of the business year. Therefore, it corresponds to the end of the time period covered by the income statement.
One must examine several accounting concepts to understand the balance sheet, its purpose, and its contents. First of all, the balance sheet represents the accounting equation for a company. The accounting equation is a mathematical expression that states the following:
Assets = Liabilities + Owners' Equity
Stated more fully, this means that the dollar total of the assets equals the dollar total of the liabilities plus the dollar total of the owners' equity. The balance sheet presents a company's resources (e.g., assets, or anything the company owns that has monetary value) and the origin or source of these resources (i.e., through borrowing or through the contributions of the owners). Expressing the same dollar amount twice (once as the dollar total of the assets, then as the dollar total of where the assets came from or who has an equity interest in them) shows that the two amounts must be equal or balance at any given point in time.
An interesting observation about the balance sheet is the valuation at which assets are presented. The average person would assume that the assets listed on the balance sheet would be shown at their current market values. In actuality, generally accepted accounting principles require that most assets be recorded and disclosed at their historical cost, or the original amount that the company paid to obtain ownership or control of the assets. As time passes, however, the current value of certain assets will drift further and further away from their historical cost. In an attempt to present useful information, financial statements show some assets (for which there is a definite
|Table 1 Sample Balance Sheet|
|Assets||Liabilities and owners' equity|
|Current assets||600,000||Current liabilities||280,000|
|Fixed assets||90,000||Long-term debt||500,000|
|Total assets||1,680,000||Total liabilities and owners' equity||1,680,000|
market value) at their current market value. When there is no specific market value, historical values are used.
A simple example of a balance sheet appears in Table 1.
As a category, assets include current assets, fixed or long-term assets, property, intangible assets, and other assets.
Current Assets. Assets can be viewed as company-owned or controlled resources from which the organization expects to gain a future benefit. Examples of assets for a typical company include cash, receivables from customers, inventory to be sold, land, and buildings. To make the balance sheet more readable, assets are grouped together based on similar characteristics and presented in totals, rather than as a long list of minor component parts.
The first grouping of assets is current assets. Current assets consist of cash, as well as other assets that will probably be converted to cash or used up within one year. The one-year horizon is the crucial issue in classifying assets as current. The concern is to present assets that will provide liquidity in the near future. Current assets should be listed on the balance sheet in the order of most liquid to least liquid. Therefore, the list of current assets begins with cash. Cash includes monies available in checking accounts and any cash on-hand at the business that can be used immediately as needed. Any cash funds or temporary investments that have restrictions on their withdrawals, or that have been set up to be spent beyond one year, should not be included in current assets.
Temporary investments known as trading securities are short-term investments that a company intends to trade actively for profit. These types of investments—common to the financial statements of insurance companies and banks—are shown on the balance sheet at their current market value as of the date of the balance sheet. Any increase or decrease in market value since the previous balance sheet is included in the calculation of net income on the income statement.
The next category on the list of current assets is accounts receivable, which includes funds that are to be collected within one year from the balance sheet date. Accounts receivable represents the historical amounts owed to the company by customers as a result of regular business operations. Many companies are unable to collect all of the receivables due from customers. In order to disclose the amount of the total receivables estimated to be collectible, companies deduct what is known as a contra account. A contra account has the opposite balance of the account from which it is subtracted. The specific account title might be “allowance for uncollectible accounts” or “allowance for bad debts,” and its balance represents the portion of the total receivables that will probably not be collected. The expense related to this is shown on the income statement as bad debt expense. The net amount of accounts receivable shown is referred to as the book value. Other receivables commonly included on the balance sheet are notes receivable (due within one year) and interest receivable.
Inventory is shown next in the current asset section of the balance sheet. If the company is a retailer or wholesaler, this asset represents goods that a company has purchased for resale to its customers. If the company is a manufacturer, it will have as many as three different inventory accounts depending on the extent to which the goods have been completed.
Inventory classified as raw materials represents the basic components that enter into the manufacture of the finished product. For a tractor manufacturer, raw materials would include the engine, frame, tires, and other major parts that are directly traceable to the finished product. The second type of inventory for a manufacturer would be goods in process. This category represents products that have been started but are not fully completed.
After the goods are completed, they are included in the final inventory classification known as finished goods. The value assigned to inventory is either its current market price or its cost to the manufacturer, whichever is lower. This is a conservative attempt to show inventory at its original cost, or at its lower market value if it has declined in value since it was purchased or manufactured.
The final group in the current assets section of the balance sheet is prepaid expenses. This group includes prepayments for such items as office supplies, postage, and insurance for the upcoming year. The total for these items is shown at historical cost.
Fixed or Long-Term Assets. These assets differ from those listed under current assets because they are not intended for sale during the year following the balance sheet date; that is, they will be held for more than one year into the future. Such asset investments are classified under the headings of held to maturity for investments in debt instruments such as corporate or government bonds, and available for sale for investments in equity (stock) instruments of other companies or debt securities that will not be held to maturity.
Held-to-maturity investments are disclosed in the balance sheet at their carrying value. The carrying value is initially equal to the historical cost of the investment; this amount is adjusted each accounting period so that, when the investment matures, its carrying value will then be equal to its maturity value. These adjustments are included in the calculation of income for each accounting period.
Available-for-sale investments are adjusted to market value at the end of each accounting period, and these adjustments are included in the calculation of owners' equity.
Property. Sometimes listed under the expanded heading “property, plant, and equipment,” this section of the balance sheet includes long-term, tangible assets that are used in the operation of the business. These assets have a long-term life and include such things as land, buildings, factory and office equipment, and computers. Land is listed first because it has an unlimited life and is shown at its historical cost. The other assets, such as buildings and equipment, are shown at book value. Book value is the original cost of the asset reduced by its total depreciation since being placed into service by a company. This net amount is frequently called net book value, and it represents the remaining cost of the asset to be depreciated over the remaining useful life of the asset.
Several methods are used to calculate depreciation (e.g., straight-line and accelerated), and each uses a mathematical formula to determine the portion of the original cost of the asset that is associated with the current year's operations. Note that depreciation is not an attempt to reduce a long-lived asset to its market value. Accountants use market value on the balance sheet when it is readily available and required for use by generally accepted accounting principles. However, in the case of many property items an unbiased estimate of market value may not be available. As a result, accountants use the asset's historical cost reduced by the depreciation taken to date to indicate its remaining useful service potential.
Intangible Assets. Some long-lived assets of a company represent legal rights or intellectual property protections that are intangible by nature. Examples of this type of asset include a company's patents, copyrights, and trademarks. Each of these assets has a legally specified life and expires at the end of that period, although a few can be renewed. Accountants attempt to measure this decline in usefulness
by amortizing the historical costs of these assets. This concept is the same as recording depreciation for items of tangible property discussed above.
One special type of intangible asset is known as goodwill. Goodwill is acquired when one company purchases another company and pays more than the estimated market value of the net assets held by the purchased company. The buying company might do this for a number of reasons, but it is often necessary in order to encourage the previous owners to sell and to guarantee that the acquisition is successful. The difference between the purchase price and the market value of the assets also can be attributed to intangible factors in the purchased company's success, such as proprietary processes or customer relationships. Like other intangible assets, the historical cost of goodwill is amortized over its future years. Historically, accounting rules set a maximum life of 40 years for goodwill, but in the twenty-first century 20 years is often used as the maximum amount of time.
Other Assets. This final section covering the disclosure of assets on the balance sheet is a miscellaneous category that includes any long-lived asset that does not fit in any of the categories defined above. This category might include such assets as long-lived receivables (from customers or related companies) and long-lived prepaid insurance premiums (those paid for coverage beyond the next year from the balance sheet date). Another example is a deferred charge (such as a deferred tax asset), or an amount that has been prepaid based on generally accepted accounting principles and holds future benefit for the company.
Liabilities include current liabilities and long-term debt.
Current Liabilities. Current liabilities are debts that come due within one year following the balance sheet date. These debts usually require cash payments to another entity. They often have the word “payable” as part of their name. Accounts payable are amounts owed to suppliers by a company that has purchased inventory or supplies on a credit basis. Interest payable represents interest that has accrued on notes payable or other interest-bearing payables since the last payment was made by a company; this type of payable might be included in a general group known as accrued expenses. Other current liabilities include estimated warranty payments, taxes payable, and the current year's portion of long-term debt that is coming due within one year from the balance sheet date.
Long-Term Debt. Long-term debts are those that come due more than one year following the balance sheet date. They include bonds payable, mortgage payable, and long-term notes payable, all of which have a specific maturity date. Deferred income taxes payable might also be disclosed in this category. The latter item is rather technical and controversial; it arises when accounting rules used in preparing the financial statements for reporting to owners differ from rules used on income tax returns for income tax authorities. Deferred income taxes payable typically result from an item being deducted on the income tax return (as allowed by tax rules) before it is reported as an expense on the income statement (as allowed by generally accepted accounting principles). When these timing differences reverse in future years, the deferred income taxes payable category is removed as the actual payment to tax authorities is made.
This final section of the balance sheet is one of the most difficult to comprehend. It is known as stockholders' equity for a corporation and consists of several possible subdivisions: paid-in capital, adjustments for changes in value of certain investments in stocks of other companies, and retained earnings.
Paid-in capital discloses the investment made in the corporation by the stockholder-owners. It will include the amount paid into the corporation by the stockholders for different types of equity instruments that have been issued by the corporation, such as preferred stock equity and common stock equity. Paid-in capital usually is separated into two parts—the par value of the stock and the amount paid in excess of the par value—as required by generally accepted accounting principles.
The adjustments for market value changes in available-for-sale investments in other companies section is shown as a component of owners' equity. These adjustments also are reported in comprehensive income because they reflect a change in owners' equity that is not a part of net income. Changes in the value of trading securities, which are short-term investments, are included in the calculation of net income, whereas changes in value of available-for-sale securities are reported only in owners' equity and the statement of comprehensive income.
The last category usually found under the heading of owners' equity is retained earnings. This amount represents any earnings (or the difference between total net income and net loss) since the inception of the business that have not been paid out to stockholders as dividends.
Returning to the aforementioned accounting equation, a user of financial statements can better understand that owners' equity is the balancing amount. If assets are considered a company's resources, they must equal the “sources” from which they came. The sources for assets are a company's creditors (as seen in the total of the
liabilities) and its owners (as seen in the total for owners' equity). As such, the retained earnings section does not represent a fund of cash; instead it represents the portion of each asset that is owned by the stockholders. The remaining portion of each asset is owed to creditors in the form of liabilities.
BALANCE SHEET SUMMARY
It is important to keep in mind that the balance sheet does not present a company's market value. Whereas some assets are presented at market value, others cannot be disclosed at market value because no such specific market value exists. The changes in the value of the assets that are required to be adjusted to market value for each balance sheet are included in either net income or comprehensive income, depending on the nature of the asset and the purpose for which management chose to acquire it.
Another important consideration about the balance sheet is the manner in which both assets and liabilities are separated into current and noncurrent groups. Not all companies will have all of the classifications discussed above, but all will have both current and noncurrent items. The user of the balance sheet studies this separation to compare a company's current liquidity needs and resources to its long-term solvency status.
In the first decade of the twenty-first century Enron and a number of other companies took advantage of off-balance-sheet accounting to appear stronger financially. Using off-balance-sheet accounting, a company did not have to include certain assets and liabilities in its balance sheet. These assets were “off-sheet” and thus not considered part of the financial statements. In some types of off-balance-sheet accounting, companies moved debt to a company called a special purpose entity (SPE)—as was the case with Enron—or a variable interest entity (VIE).
Companies rarely use this practice anymore due to a requirement from the Financial Accounting Standards Board (FASB) stipulating that companies must list SPEs on their balance sheets. This law as spelled out in Section 401(a) of the Sarbanes-Oxley Act (2002), which states that annual and quarterly financial reports must disclose all material off-balance-sheet transactions, arrangements, and obligations. Late in the first decade of the twenty-first century, the FASB changed its standards regarding off-balance-sheet accounting and required additional disclosures for SPEs. The changes aimed at providing greater transparency in financial asset transfers as well as a firm's ongoing involvement with those assets. In general, companies were subsequently required to disclose much more information about their transferred financial assets, including gains and losses resulting from transfers.
While Sarbanes-Oxley has led to greater transparency in balance sheets, it is not a panacea; during the subprime mortgage crisis that began in late 2006, many banks interpreted the rules in such a way that risky loans were kept off their balance sheets. The resulting economic recession of 2008 and 2009 prompted passage of the Fraud Enforcement and Recovery Act of 2009, which created a Financial Crisis Inquiry Commission aimed at examining off-balance-sheet activities, among other issues.
Balance sheets are nonetheless an important tool to help managers, lenders, and investors analyze a company's financial status and capabilities. They are particularly useful in helping to identify trends in the areas of payables and receivables. However, it is vital to remember that the document only presents a company's financial situation at a given point in time. It does not provide any information about the past decisions that helped the company to arrive at that point, or about the company's future direction or potential for success. For this reason, the balance sheet should be considered along with other required financial statements, as well as historical data, when evaluating a company's performance. In the meantime, hiring a competent bookkeeper or certified public accountant will help ensure the numbers reflected in a company balance sheet are as accurate as possible. Colleges and business development centers across the country frequently offer basic courses in balance sheet preparation for business managers of all stripes.
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