WFU Law School
Law & Valuation
3.2 Balance Sheet

3.2.1 Balance Sheet Items

The balance sheet is a snapshot of a company's --

The balance sheet shapshot is at a particular point in time, such as at the close of business on December 31. The simplest corporate balance sheet possible, showing only totals and leaving out all detail, might look like this

ALBEGA CORPORATION
Balance Sheet
December 31, 20xx
Assets
$485,000
Liabilities
$ 285,000
Shareholders' Equity
$200,000

Total Assets

$485,000

Total Liabilities and Shareholders' Equity

$485,000

Balance sheet equation. Assets are always equal to the liabilities plus equity. You can see the balance sheet as a statement of what the company owns (assets) and the persons having claims to the assets (creditors and owners). Here is the balance sheet equation:

Assets = Liabilities + Shareholders' Equity
Assets
Liabililities
Shareholders' Equity

The equation reflects how information is organized on the balance sheet, with assets listed on the left and liabilities and equity on the right. Like the equation, the two sides of the balance sheet must balance.

Double entry bookkeeping. The balance sheet equation also reflects the way information is recorded in the company records. Too keep the equation in balance, company transactions are recorded using "double entry bookkeeping." Every transaction will cause two changes on the accounting statements -- that is, a transaction that affects one side of the equation will also affect the other side, unless there are two offsetting entries on one side. For example, a $2,000 increase in assets will also result in either:

  • an offsetting decrease in assets (if the new $2,000 asset was purchased with $2,000 cash)
  • an increase in liabilities (if the company borrowed the $2,000 to buy the asset)
  • an increase in equity (if the $2,000 came from contributions by the company's owners).

Reading balance sheet. Let's read a more detailed version of our balance sheet:

ALBEGA CORPORATION
Balance Sheet
December 31, 20xx
ASSETS
LIABILITIES
Current Assets Current Liabilities
Cash
$ 50,000
Accounts Payable
$ 60,000
Accounts receivable (net of allowance for bad debts of $5,000)
$175,000
Notes payable (including current portion of long-term debt)
$ 40,000
Inventory (FIFO)
$125,000
Income taxes payable
$ 25,000
Total current assets
$350,000
Total current liabilities
$125,000
Non-current Assets Long Term Liabilities
Plant
$ 50,000
5-year notes payable
$160,000
Property
$ 75,000
Total Liabilities
$285,000
Equipment
$ 50,000
 
Fixed assets
$175,000
SHAREHOLDERS' EQUITY
Less: Accumulated depreciation
($ 50,000)
Common stock ($1.00 par value; 1,000 shs authorized, issued + outstanding)
$ 1,000
Net fixed assets
$125,000
Paid-in capital in excess of par value
$ 49,000
Intangibles (patents)
$ 10,000
Retained earnings
$150,000
Total non-current assets
$ 135,000
Total Shareholders' Equity
$200,000
Total Assets
$485,000
Total Liabilities and Shs' Equity
$485,000

What do these balance sheet items (or accounts) represent?


Assets

The assets accounts show how the company has used the money it has obtained from lenders, investors, and company earnings. Technically, according to GAAP, assets are resources with "probable future economi benefits obtaine or controlled by an entity resulting from past transactoins or events." This leads to some non-intuitive results. Important resources like intellectual property or longstanding business relationships, though valuable to a business, are generally not reflected on the balance sheet.

Assets are grouped as monetary (cash and accounts receivables), liquid (whether they can easily be converted to cash), tangible or intangible.

In our example the asset categories are --
  • Current assets: cash and those items, such as accounts receivable, that are normally expected to be converted into cash within one year.
  • Non-current assets:
    • Fixed assets: the company's more or less permanent physical assets, such as its land, buildings, machinery and equipment
    • Intangible assets: goodwill, trademarks, copyrights, patents (reader beware!)

Current Assets

Cash. - This includes not only currency, which a company might keep in "petty cash," but also bank deposits, U.S. Treasury notes, money market accounts, and other "cash equivalents." If the company had to pay a ransom, how much could it pay today?

Accounts Receivable. - If a company sells goods or services on credit, the amounts owed to the company by customers are "accounts receivable." The company must, however, anticipate that some of the accounts receivable will not be received. An account, such as "allowance for bad debts," is set-off (subtracted) from the accounts receivable shown in the balance sheet. The allowance, often based on a percentage, is usually based on the company's past collection experience. This presents a fairer picture of how much the company will likely receive from its sales on credit.

Inventory. - For a manufacturing company, inventory includes goods used in the business at various stages of production: raw materials, work in process and finished goods. Other companies have other types of inventory. For example, a retail store has in inventory only the purchased goods it sells. Service companies have no inventory. The generally accepted method of inventory valuation is to record the inventory at its cost or market value, whichever is lower (here "market value" is not retail value, but what it would cost the company to replace the inventory).


Inventory

Things get trickier for the cost of goods in various stages of the manufacturing process. Two common ways to measure the "cost" of inventory purchased at different times and at varying prices are --


(a) First-in, first-out ("FIFO "). Under the FIFO method of valuation, inventory items purchased first are deemed to be sold first. Under this method, the most recent purchase prices are deemed to represent the cost of the items remaining. For example, suppose that the purchases and sales of a particular item are as follows:Under FIFO, the cost of the ending inventory (300 items) would be $250 ($.90 each for 100 and $.80 each for 200). When prices are rising, FIFO results in inventory being shown on the balance sheet at the highest possible amount.

 
Quantity
Cost per item
Total Cost
Jan. Purchase
100
$ .60
$ 60
Mar. Purchase
500
.70
$350
June Purchase
300
.80
$240
Sep. Purchase
100
.90
$ 90
Total purchases
1,000
$740
Less sales
700
Ending inventory
300
??
??

(b) Last-in, first-out ("LIFO "). Under LIFO, the items of inventory purchased last are deemed to be sold first -- so the cost of the ending inventory is deemed the cost of the items purchased first. In our example, the cost of the ending inventory (300 items) would be $200 ($.60 for each 100 items and $.70 each for 200 items).

 

Non-current Assets - Fixed Assets

Fixed assets -- such as land, buildings, machinery and equipment -- are typically shown on the balance sheet at their cost, less accumulated depreciation.

Historical cost. How are assets valued for purposes of the balance sheet? There are several possibilities:

  • historical cost (how much the company paid to acquire it)
  • current market value
  • value in use
  • liquidation value based on its sale after use.

Assets are typically recorded on financial statements at their historical cost expressed in dollars.


Depreciation. What is depreciation / depletion / amortization? these are all terms that refer to alloocating the cost of along-lived asset to consecutive accounting periods as expenses until the full cost is fully accounted for.

  • "Depreciation" describes the allocation of the cost of certain fixed assets over their estimated useful lives. (Land is not depreciated, since its useful life for accounting purposes is unlimited.)
  • "Depletion" describes the case of "wasting assets," such as oil and gas fields.
  • "Amortization" is used for intangible assets, such as patents or trademarks. Amortization of R&D expenses is controversial. Under GAAP such expenses are expensed currently, even though they may have long-term payoffs.

When a fixed asset is depreciated, the cost of the asset is allocated over its expected useful life, and each annual installment of depreciation is added to an account called "accumulated depreciation. " On the balance sheet, accumulated depreciation is set-off against the total fixed assets (shown at their total cost at time of purchase).

Notice that the balance sheet does not reflect appreciation in the value of assets, such as when there is inflation.

How is depreciation calculated? There are two common methods:

  • Straight-line method. - The straight line depreciation method, the most common, calculates depreciation by dividing the cost of the asset, less its salvage value, by its estimated useful life.
  • Double declining balance method. - The double declining balance method calculates depreciation by taking twice the straight-line depreciation percentage rate and multiplying this percentage rate by the initial cost of the asset (in the first year) or by each declining balance amount (in succeeding years). The asset is not depreciated below a reasonable salvage value.

The double declining balance method is a kind of accelerated depreciation since it produces more depreciation in the initial years of an asset's life than does the straight-line method. For tax purposes accelrated dpereciation has the advantage of reducing taxable income during early years of asset;s life -- and as we know, tax savings now are worth more than tax savings later.


Example

A wine press purchased for $50,000 has an estimated useful life of 5 years and a salvage value of $10,000. What is its annual depreciation using a straight-line method? a double-declining balance method?

Year
Depreciation
Depreciation
Straight-line
Double-declining
1
(50,000 - 10,000) / 5 = $ 8,000
50,000 x 40% = $ 20,000
2
(50,000 - 10,000) / 5 = $ 8,000
(50,000-20,000) x 40% = $12,000
3
(50,000 - 10,000) / 5 = $ 8,000
(30,000-12,000) x 40% = $7,200
4
(50,000 - 10,000) / 5 = $ 8,000
$ 800
5
(50,000 - 10,000) / 5 = $ 8,000
$0
Annual %
20%
varies

The annual depreciation using a straight-line method is $8,000 -- that is, 20% per year,

The annual depreciation using a double-declining method varies. After three years, the cumulative depreciation is $39,200. Assuming a salvage value of $10,000, the last depreciation amount of $800 comes in the fourth year when the salvage figure is reached.

 
 

Intangible Assets

This item has become more important as intellectual property (patents, trademarks, copyriyrights) has become the darlings of the information age. Typically, IP is carried at its acquisition or development cost.

Vapor. But intangible assets, particularly goodwill, raise tricky issues. Are these unseen, untouchable assets just vapor? On the one hand, it is easy to overstate their value, particularly since there usually is no ready market to compare. On the other hand, intangible assets may represent an importan part of the company's overall business value. (For example, some business valuatiors hav calculated that the Coca-Cola trademark -- forget the secret formula -- is worth a real $80 billion.) exists

Goodwill. What about goodwill -- that is, the value the business derives from brand names, reputation, management quality, customer loyalty or recognized location? Typically, goodwill is not accounted for. Classified as an intangible asset, goodwill is recorded on a company's books only when it is acquired in a business acquisition. Sometimes, goodwill is valued as the difference between the price paid for a company as a going concern and the fair market value of its assets minus liabilities.

 

Liabilities

The second portion of the balance sheet consists of the company's liabilities -- usually separated into current liabilities and long-term liabilities. Liabilities can be understood as the opposite of assets -- they represent obligations of the business. Not all obligations to make a payment in the future are reflected on the balance sheet. For example, an obligation to pay employees' rising health care costs may be a signficant commitment , it might not be represented on the balance sheet if sufficiently uncertain. Or the prospect of paying clean-up fees for a toxic site owned by the business may not make it to the balance sheet, though it may be described in a note.

  • Current liabilities: those debts that are to be paid within 12 months. These include accounts payable, short-term notes payable and income taxes payable. Also included are accrued expenses payable, such as for employees wages and salareis, insruance premiums, attorney fees, and taxes due.
  • Long-term liabilities: any debt that is not due within one year, such as long-term debts and notes. In the case of a debt that is partially due within one year and partially due in future years, the portion of the debt payable within one year is shown as a current liability and the rest as a long-term liability.

One important potential drain on a business are contingent liabilities, such as possible products liability claims or securities fraud exposure. These are not carried on the balance sheet -- but check the footnotes!

See FASB n. 7.


Owners' Equity

The third and final portion of a balance sheet represents the owners' equity. In a sole proprietorship (a business with one owner), the ownership account is known as "proprietor's equity"; in a partnership, the ownership account is "partners' capital."

In a corporation, the ownership accounts are divided into three categories, reflecting accounting conventions found in state corporation statutes. Accountants, however, use their own nomenclature for these accounts [the corporation statutory term in in brackets] --

  • Common stock [stated capital]. This is calculated by multiplying the number of shares of stock outstanding by the par value of each share. In our balance sheet above, the par value of the corporation's common stock is $1.00 per share and 1,000 shares have been issued, yielding a stated capital of $1,000. (Par value is an arbitrary dollar figure assigned to stock to determine stated capital; some corporation statutes -- particularly Delaware's -- restrict a corporation's distributions based on stated capital.)
  • Paid-in capital in excess of par [capital surplus]. This is the difference between what shareholders paid the corporation for their stock and the stock's par value. In our example, the corporation sold 1,000 shares of common stock for $50 each -- $1,000 shown in common stock and $49,000 shown in paid-in capital in excess of par value. (Some corporation statutes also restrict distributions based on capital surplus).
  • Retained earnings [earned surplus]. This shows the total profits and losses of the corporation since its formation, decreased by any dividends paid the shareholders. If the corporation has had losses rather than profits, retained earnings is negative (indicated by placing the number in parenthesis). That is, as the business makes or loses money, this is the item that gets adjust (up or down) to balance the "balance sheet."

One way to see equity is as permamnent non-debt capitalization of the business -- that is, captial assets and accumulated profits less any distribtuions to the owners. Each year the equity account changes with the ebb and flow of revenues and expenses -- creating a link between the income statement and balance sheet.

Note on Corporate "Stock"

Common stock represetent the residicual ownerhsip of a coproation.

Preferred stock has prior claim to distribtuions (payments related to stock ownership) ahead of common stock. The balance sheet will include notes about the nature of these preferences.

 
3.2 Balance Sheet

©2003 Professor Alan R. Palmiter

This page was last updated on: March 29, 2004