The Balance Sheet
The accounting balance
sheet is one of the major financial statements used by accountants and
business owners. (The other major financial statements are the income
statement, statement of cash flows, and statement of
stockholders' equity) The balance sheet is also referred to as the statement
of financial position.
The balance sheet
presents a company's financial position at the end of a specified date. Some
describe the balance sheet as a "snapshot" of the company's financial
position at a point (a moment or an instant) in time. For example, the amounts
reported on a balance sheet dated December 31, 2011 reflect that instant when
all the transactions through December 31 have been recorded.
Because the balance
sheet informs the reader of a company's financial position as of one moment in
time, it allows someone—like a creditor—to see what a company owns as
well as what it owes to other parties as of the date indicated in the
heading. This is valuable information to the banker who wants to determine
whether or not a company qualifies for additional credit or loans. Others who
would be interested in the balance sheet include current investors, potential
investors, company management, suppliers, some customers, competitors,
government agencies, and labor unions.
In Part 1 we will explain the components of
the balance sheet and in Part 2 we will present a sample balance sheet.
If you are interested in balance sheet analysis, that is included in the Explanation
of Financial Ratios.
We will begin our explanation of the accounting
balance sheet with its major components, elements, or major categories:
·
Assets
·
Liabilities
·
Owner's
(Stockholders') Equity
Assets
are things that the company owns. They are the resources of the company that
have been acquired through transactions, and have future economic value that
can be measured and expressed in dollars. Assets also include costs paid in
advance that have not yet expired, such as prepaid advertising, prepaid
insurance, prepaid legal fees, and prepaid rent. (For a discussion of prepaid
expenses go to Explanation of Adjusting Entries.)
Examples of asset accounts that are reported on a
company's balance sheet include:
·
Cash
·
Petty
Cash
·
Temporary
Investments
·
Accounts Receivable
·
Inventory
·
Supplies
·
Prepaid Insurance
·
Land
·
Land Improvements
·
Buildings
·
Equipment
·
Goodwill
·
Bond Issue Costs
·
Etc.
Usually these asset accounts will have debit
balances.
Contra assets
are asset accounts with credit balances. (A credit balance in an asset
account is contrary—or contra—to an asset account's usual debit balance.)
Examples of contra asset accounts include:
·
Allowance
for Doubtful Accounts
·
Accumulated
Depreciation-Land Improvements
·
Accumulated
Depreciation-Buildings
·
Accumulated
Depreciation-Equipment
·
Accumulated
Depletion
·
Etc.
Classifications Of Assets On The Balance
Sheet
Accountants usually prepare classified balance sheets. "Classified" means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. The asset classifications and their order of appearance on the balance sheet are:
Accountants usually prepare classified balance sheets. "Classified" means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. The asset classifications and their order of appearance on the balance sheet are:
·
Current
Assets
·
Investments
·
Property,
Plant, and Equipment
·
Intangible
Assets
·
Other
Assets
An outline of a balance sheet using the balance
sheet classifications is shown here:
|
Example
Company
Balance Sheet December 31, 2011
|
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To see how various asset accounts are placed within
these classifications, view the sample balance sheet in Part 4.
Effect of Cost Principle and Monetary
Unit Assumption
The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though these parcels of land have appreciated to a current market value of $3,000,000.
The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though these parcels of land have appreciated to a current market value of $3,000,000.
There are two
guidelines that oblige the accountant to report $420,000 on the balance sheet
rather than the current market value of $3,000,000: (1) the cost principle
directs the accountant to report the company's assets at their original
historical cost, and (2) the monetary unit assumption directs the
accountant to presume the U.S. dollar is stable over time—it is not affected by
inflation or deflation. In effect, the accountant is assuming that a 1950
dollar, a 1990 dollar, and a 2012 dollar all have the same purchasing power.
The cost principle and
monetary unit assumption may also mean that some very valuable resources will
not be reported on the balance sheet. A company's team of brilliant scientists
will not be listed as an asset on the company's balance sheet, because (a) the
company did not purchase the team in a transaction (cost principle) and (b)
it's impossible for accountants to know how to put a dollar value on the team
(monetary unit assumption).
Coca-Cola's logo,
Nike's logo, and the trade names for most consumer products companies are
likely to be their most valuable assets. If those names and logos were
developed internally, it is reasonable that they will not appear on the company
balance sheet. If, however, a company should purchase a product name and
logo from another company, that cost will appear as an asset on the balance
sheet of the acquiring company.
Remember, accounting
principles and guidelines place some limitations on what is reported as an
asset on the company's balance sheet.
Effect of Conservatism
While the cost principle and monetary unit assumption generally prevent assets from being reported on the balance sheet at an amount greater than cost, conservatism will result in some assets being reported at less than cost. For example, assume the cost of a company's inventory was $30,000, but now the current cost of the same items in inventory has dropped to $27,000. The conservatism guideline instructs the company to report Inventory on its balance sheet at $27,000. The $3,000 difference is reported immediately as a loss on the company's income statement.
While the cost principle and monetary unit assumption generally prevent assets from being reported on the balance sheet at an amount greater than cost, conservatism will result in some assets being reported at less than cost. For example, assume the cost of a company's inventory was $30,000, but now the current cost of the same items in inventory has dropped to $27,000. The conservatism guideline instructs the company to report Inventory on its balance sheet at $27,000. The $3,000 difference is reported immediately as a loss on the company's income statement.
Effect of Matching Principle
The matching principle will also cause certain assets to be reported on the accounting balance sheet at less than cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it will collect only $48,500 due to some customers' financial problems, the company will report a credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful Accounts with a credit balance will mean that the balance sheet will report the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts Expense.
The matching principle will also cause certain assets to be reported on the accounting balance sheet at less than cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it will collect only $48,500 due to some customers' financial problems, the company will report a credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful Accounts with a credit balance will mean that the balance sheet will report the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts Expense.
The matching principle also requires that the cost
of buildings and equipment be depreciated over their useful lives. This means
that over time the cost of these assets will be moved from the balance sheet to
Depreciation Expense on the income statement. As time goes on, the amounts
reported on the balance sheet for these long-term assets will be reduced. (For
a further discussion on depreciation, go to
Liabilities
are obligations of the company; they are amounts owed to creditors for a past
transaction and they usually have the word "payable" in their account
title. Along with owner's equity, liabilities can be thought of as a source
of the company's assets. They can also be thought of as a claim against
a company's assets. For example, a company's balance sheet reports assets of
$100,000 and Accounts Payable of $40,000 and owner's equity of $60,000. The
source of the company's assets are creditors/suppliers for $40,000 and the
owners for $60,000. The creditors/suppliers have a claim against the company's
assets and the owner can claim what remains after the Accounts Payable have
been paid.
Liabilities also include amounts received in advance
for future services. Since the amount received (recorded as the asset Cash) has
not yet been earned, the company defers the reporting of revenues
and instead reports a liability such as Unearned Revenues or Customer Deposits.
(For a further discussion on deferred revenues/prepayments see the Explanation
of Adjusting Entries.)
Examples of liability accounts reported on a
company's balance sheet include:
·
Notes
Payable
·
Accounts
Payable
·
Salaries
Payable
·
Wages
Payable
·
Interest
Payable
·
Other
Accrued Expenses Payable
·
Income
Taxes Payable
·
Customer
Deposits
·
Warranty
Liability
·
Lawsuits
Payable
·
Unearned
Revenues
·
Bonds
Payable
·
Etc.
These liability accounts will normally have credit
balances.
Contra liabilities
are liability accounts with debit balances. (A debit balance in a liability
account is contrary—or contra—to a liability account's usual credit balance.)
Examples of contra liability accounts include:
·
Discount
on Notes Payable
·
Discount
on Bonds Payable
·
Etc.
Classifications Of Liabilities On The
Balance Sheet
Liability and contra liability accounts are usually classified (put into distinct groupings, categories, or classifications) on the balance sheet. The liability classifications and their order of appearance on the balance sheet are:
Liability and contra liability accounts are usually classified (put into distinct groupings, categories, or classifications) on the balance sheet. The liability classifications and their order of appearance on the balance sheet are:
·
Current
Liabilities
·
Long
Term Liabilities
·
Etc.
To see how various liability accounts are placed
within these classifications, click here to view the sample balance sheet in
Part 4.
Commitments
A company's commitments (such as signing a contract to obtain future services or to purchase goods) may be legally binding, but they are not considered a liability on the balance sheet until some services or goods have been received. Commitments (if significant in amount) should be disclosed in the notes to the balance sheet.
A company's commitments (such as signing a contract to obtain future services or to purchase goods) may be legally binding, but they are not considered a liability on the balance sheet until some services or goods have been received. Commitments (if significant in amount) should be disclosed in the notes to the balance sheet.
Form vs. Substance
The leasing of a certain asset may—on the surface—appear to be a rental of the asset, but in substance it may involve a binding agreement to purchase the asset and to finance it through monthly payments. Accountants must look past the form and focus on the substance of the transaction. If, in substance, a lease is an agreement to purchase an asset and to create a note payable, the accounting rules require that the asset and the liability be reported in the accounts and on the balance sheet.
The leasing of a certain asset may—on the surface—appear to be a rental of the asset, but in substance it may involve a binding agreement to purchase the asset and to finance it through monthly payments. Accountants must look past the form and focus on the substance of the transaction. If, in substance, a lease is an agreement to purchase an asset and to create a note payable, the accounting rules require that the asset and the liability be reported in the accounts and on the balance sheet.
Contingent Liabilities
Three examples of contingent liabilities include warranty of a company's products, the guarantee of another party's loan, and lawsuits filed against a company. Contingent liabilities are potential liabilities. Because they are dependent upon some future event occurring or not occurring, they may or may not become actual liabilities.
Three examples of contingent liabilities include warranty of a company's products, the guarantee of another party's loan, and lawsuits filed against a company. Contingent liabilities are potential liabilities. Because they are dependent upon some future event occurring or not occurring, they may or may not become actual liabilities.
To illustrate this, let's assume that a company is
sued for $100,000 by a former employee who claims he was wrongfully terminated.
Does the company have a liability of $100,000? It depends. If the company was
justified in the termination of the employee and has documentation and
witnesses to support its action, this might be considered a frivolous lawsuit
and there may be no liability. On the other hand, if the company was not
justified in the termination and it is clear that the company acted improperly,
the company will likely have an income statement loss and a balance sheet liability.
The accounting rules for these contingencies are as
follows: If the contingent loss is probable and the amount of
the loss can be estimated, the company needs to record a liability on its
balance sheet and a loss on its income statement. If the contingent loss is remote,
no liability or loss is recorded and there is no need to include this in the
notes to the financial statements. If the contingent loss lies somewhere in
between, it should be disclosed in the notes to the financial
statements.
Current vs. Long-term Liabilities
If a company has a loan payable that requires it to make monthly payments for several years, only the principal due in the next twelve months should be reported on the balance sheet as a current liability. The remaining principal amount should be reported as a long-term liability. The interest on the loan that pertains to the future is not recorded on the balance sheet; only unpaid interest up to the date of the balance sheet is reported as a liability.
If a company has a loan payable that requires it to make monthly payments for several years, only the principal due in the next twelve months should be reported on the balance sheet as a current liability. The remaining principal amount should be reported as a long-term liability. The interest on the loan that pertains to the future is not recorded on the balance sheet; only unpaid interest up to the date of the balance sheet is reported as a liability.
Notes to the Financial Statements
As the above discussion indicates, the notes to the financial statements can reveal important information that should not be overlooked when reading a company's balance sheet.
As the above discussion indicates, the notes to the financial statements can reveal important information that should not be overlooked when reading a company's balance sheet.
Owner's Equity—along
with liabilities—can be thought of as a source of the company's assets. Owner's
equity is sometimes referred to as the book value of the company,
because owner's equity is equal to the reported asset amounts minus the
reported liability amounts.
Owner's equity may also be referred to as the residual
of assets minus liabilities. These references make sense if you think of the
basic accounting equation:
|
Assets = Liabilities
+ Owner's Equity
|
|
and just rearrange the terms:
|
|
Owner's Equity = Assets
– Liabilities
|
"Owner's Equity" are the words used on the
balance sheet when the company is a sole proprietorship. If the company
is a corporation, the words Stockholders' Equity are used instead of Owner's
Equity. An example of an owner's equity account is Mary Smith, Capital
(where Mary Smith is the owner of the sole proprietorship). Examples of
stockholders' equity accounts include:
Both owner's equity and stockholders' equity
accounts will normally have credit balances.
Owner's Equity vs. Company's Market
Value
Since the asset amounts report the cost of the assets at the time of the transaction—or less—they do not reflect current fair market values. (For example, computers which had a cost of $100,000 two years ago may now have a book value of $60,000. However, the current value of the computers might be just $35,000. An office building purchased by the company 15 years ago at a cost of $400,000 may now have a book value of $200,000. However, the current value of the building might be $900,000.) Since the assets are not reported on the balance sheet at their current fair market value, owner's equity appearing on the balance sheet is not an indication of the fair market value of the company.
Since the asset amounts report the cost of the assets at the time of the transaction—or less—they do not reflect current fair market values. (For example, computers which had a cost of $100,000 two years ago may now have a book value of $60,000. However, the current value of the computers might be just $35,000. An office building purchased by the company 15 years ago at a cost of $400,000 may now have a book value of $200,000. However, the current value of the building might be $900,000.) Since the assets are not reported on the balance sheet at their current fair market value, owner's equity appearing on the balance sheet is not an indication of the fair market value of the company.
Owner's Equity and Temporary Accounts
Revenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company performs a service and increases its assets, owner's equity will increase when the Service Revenues account is closed to owner's equity at the end of the accounting year.
Revenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company performs a service and increases its assets, owner's equity will increase when the Service Revenues account is closed to owner's equity at the end of the accounting year.
Conclusions :
Balance sheet accounting is one of the main
financial statements used by accountants and business owners who serve the
company's financial position at the end of the specified date. This is valuable
information for bankers who want to determine whether a company is eligible for
additional credit or loans.
Source :