The Balance Sheet

Defining the Balance Sheet

The balance sheet is a summary of the financial balances of a company.

Learning Objectives

Explain the fundamental elements of the balance sheet

Key Takeaways

Key Points

  • The balance sheet is often described as a snapshot of a company’s financial condition.
  • Unlike the other basic financial statements, the balance sheet only applies to a single point in time of the calendar year.
  • It shows the assets, liabilities, and ownership equity of the company, and allows for an analysis of the company’s financial health.

Key Terms

  • calendar year: The amount of time between corresponding dates in adjacent years in any calendar.
  • balance sheet: A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.

The Balance Sheet

In financial accounting, a balance sheet is a snapshot of a company’s (sole proprietorship, a business partnership, a corporation, or other business organization, such as an LLC or an LLP) financial situation. Assets, liabilities, and ownership equity are listed as of a specific date, such as the end of the company’s financial year. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business’ calendar year. A standard company balance sheet has three parts: assets, liabilities, and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as the equity (or the net assets, or the net worth, or capital ) of the company, and according to the accounting equation, net worth must equal assets minus liabilities.

Another way to look at the same equation is that assets equals liabilities plus owner’s equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner’s money (owner’s equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections “balancing. ”

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they cannot, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words, businesses also have liabilities.

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Example Domestic Balance Sheet: This balance sheet shows the company’s assets, liabilities, and shareholder equity.

Assets

Assets are resources as a result of past events and from which future economic benefits are expected to flow to the enterprise.

Learning Objectives

Define assets in financial accounting

Key Takeaways

Key Points

  • Anything tangible or intangible that can be owned to produce positive economic value is considered an asset. Examples are cash, inventory, machinery, etc.
  • Assets are recorded on the balance sheet. The accounting equation relating assets, liabilities, and owners’ equity is: Assets = Liabilities + Owners’ Equity.
  • Tangible assets are actual physical assets, and include both current and fixed assets. Examples are inventory, buildings, and equipment.
  • Intangible assets are nonphysical resources which give the firm an advantage in the marketplace. Examples are copyrights, computer programs, financial assets, and goodwill.

Key Terms

  • International Accounting Standards Board: The independent, accounting standard-setting body of the International Financial Reporting Standards Foundation.
  • tangible asset: Any asset, such as buildings, land, equipment etc., that has physical form.
  • intangible asset: Any valuable property of a business that is not does not appear on the balance sheet, including intellectual property, customer lists, and goodwill.

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset.

Simply stated, assets represent ownership of value that can be converted into cash (although cash itself is also considered an asset). The balance sheet of a firm records the monetary value of the assets owned by the firm. It is money and other valuables belonging to an individual or business. Two major classes are tangible assets and intangible assets.

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Comparison of Various types of Assets: Current assets vs. liquid assets vs. absolute liquid assets.

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Assets and Liabilities of the US: Assets and liabilities of the US as a fraction of the GDP 1945-2009.

Tangible assets contain various subclasses, including current and fixed assets. Current assets include inventory, while fixed assets include such items as buildings and equipment.

Intangible assets are nonphysical resources and rights that have a value to the firm because they give the firm some kind of advantage in the market place. Examples of intangible assets are goodwill, copyrights, trademarks, patents, computer programs, and financial assets, including such items as accounts receivable, bonds and stocks.

The accounting equation relates assets, liabilities, and owner’s equity:

Assets = Liabilities + Stockholders ‘ Equity (Owners’ Equity)

That is, the total value of a firm’s assets are always equal to the combined value of its “equity” and “liabilities. ” In other words, the accounting equation is the mathematical structure of the balance sheet.

Probably the most accepted accounting definition of asset is the one used by the International Accounting Standards Board. The following is a quotation from the IFRS Framework:

“An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. “

Liabilities

A “liability” is an obligation of an entity, the settlement of which may result in the yielding of economic benefits in future.

Learning Objectives

Define liabilities in financial accounting

Key Takeaways

Key Points

  • Liabilities in financial accounting need not be legally enforceable, but can be based on equitable obligations or constructive obligations.
  • Liabilities on the balance sheet are split into two categories: current liabilities, and long-term liabilities.
  • Current liabilities are those expected to be liquidated within a year.
  • Long-term liabilities are those which will not be liquidated in the coming year.

Key Terms

  • liabilities: An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.
  • current liabilities: In accounting, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year, or the operating cycle of a given firm, whichever period is longer.

In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. A liability is defined by the following characteristics:

  • Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time
  • A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand
  • A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement
  • A transaction or event obligating the entity that has already occurred

Liabilities in financial accounting need not be legally enforceable, but can be based on equitable obligations or constructive obligations. An equitable obligation is a duty based on ethical or moral considerations. A constructive obligation is an obligation that is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation. Examples of types of liabilities include money owing on a loan, money owing on a mortgage, or an IOU. Liabilities are debts and obligations of the business they represent that creditors claim on business assets. Liabilities are reported on a balance sheet and are usually divided into two categories:

  • Current liabilities: these liabilities are reasonably expected to be liquidated within a year. They usually include payables such as wages, accounts, taxes, and accounts payables, unearned revenue when adjusting entries, portions of long-term bonds to be paid this year, short-term obligations (e.g., from purchase of equipment).
  • Long-term liabilities: these liabilities are reasonably expected not to be liquidated within a year. They usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and long-term product warranties.
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Liabilities of the United States: Liabilities of the United States as a fraction of GDP (1960-2009)

Owners’ Equity

Shareholders’ equity is the difference between total assets and total liabilities.

Learning Objectives

Define owners’ equity

Key Takeaways

Key Points

  • Shareholders ‘ equity tells you the “book value”, i.e., what is left over for shareholders after the company has paid off all its debt.
  • Shareholders’ Equity = Total Assets – Total Liabilities.
  • If liabilities exceed assets, then negative equity exists.
  • Ownership equity may include both tangibles and intangibles, such as intellectual property or goodwill.

Key Terms

  • shareholders’ equity: The remaining interest in assets of a company, spread among individual shareholders of common or preferred stock.
  • owners’ equity: the remaining interest in all assets after all liabilities are paid
  • equity financing: funding obtained through the sale of ownership interests in the company
  • capital surplus: A balance sheet item under shareholders’ equity. Increases by the value above an original par value per share that newly-issued shares are sold for.

In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists.

In an accounting context, shareholders’ equity (or stockholders ‘ equity, shareholders’ funds, shareholders’ capital or similar terms) represents the remaining interest in assets of a company, spread among individual shareholders of common or preferred stock.

At the start of a business, owners put some funding into the business to finance operations. This creates a liability on the business in the shape of capital as the business is a separate entity from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and assets. After liabilities have been accounted for, the positive remainder is deemed the owners’ interest in the business.

This definition is helpful in understanding the liquidation process in case of bankruptcy. At first, all the secured creditors are paid against proceeds from assets. Afterward, a series of creditors, ranked in priority sequence, have the next claim/right on the residual proceeds. Ownership equity is the last or residual claim against assets, settled only after all other creditors are paid. In such cases where even creditors could not get enough money to pay their bills, nothing is left over to reimburse owners’ equity; which is thus reduced to zero. Ownership equity is also known as risk capital or liable capital.

In financial accounting, equity capital is the owners’ interest on the assets of the enterprise after deducting all its liabilities. It appears on the balance sheet/statement of financial position, one of the four primary financial statements. Ownership equity includes both tangible and intangible items (such as brand names and reputation/goodwill). Accounts listed under ownership equity include (for example):

  • Share capital (common stock)
  • Preferred stock
  • Capital surplus
  • Retained earnings
  • Treasury stock
  • Stock options
  • Reserve
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Sample Balance Sheet: Sample of a small business’s balance sheet, showing owners’ equity.