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
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Total Liabilities and Shareholders'
Equity
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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 |
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|
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).
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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).

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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.
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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.
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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.
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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.
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