The Balance Sheet (Part I)Accounting is essentially about the complexities involved in creating and maintaining adequate record for business transactions. The Income Statement is an example of a very popular accounting data source that records transactions affecting a company's revenue and profitability. The balance sheet on the other hand provides a record of a company's assets, liabilities and equity.
It is important to understand that the balance sheet does not relate to a specific period of trading (as is the case with the income statement) but instead shows the actual balances of balance sheet items at a particular point in time.
The balance sheet included in a company's 10K at the end of the company's fiscal year will be shown as at that date, and not for the 12 months period ending on that date. This is an important point to note, as it helps to clarify exactly how the balance sheet should be reviewed and analyzed.
The "accounting process" is a rule-based process that involves different "principles", different “books" and different rules. The double entry rule is the best known and the most profound, and once adhered to, extracting a balance sheet from accounting data becomes fairly easy.
As stated elsewhere on this site, many of us think first of the income statement when assessing the financial condition of a company, due mainly to the fact that this is where the company's revenue, expenses and profit are reported. This approach however is unfortunate; as the balance sheet can more often than not, provide greater insight into a company's viability than the income statement. Think balance sheet when you're about to learn about the financial condition of a company. Profitability is good, but liquidity, liability and worth are better!
In the old days, the balance sheet was presented in a T format with Assets listed on the right side and Capital/Equity and Liabilities shown on the left. This approach gave way to the vertical style, which is used extensively today. While the vertical style has many advantages, the T format works well for beginners as it fits into the T account format generally used to teach the double entry system. It must be made abundantly clear though, that unlike the income statement, the balance sheet does not form part of the double entry system of accounting. The double entry system precedes the preparation of the balance sheet, which is made up of a summary of the balances drawn from the different accounts prepared using the double entry system. The typical balance sheet is divided into three distinct sections, namely:
- Assets Current Assets
- Liabilities Current Liabilities
Current Assets, which are shown first, are included on the balance sheet in descending order based on the level of liquidity (the ease with which an asset can be converted to cash) and starts with Cash and Cash Equivalents. Cash Equivalents are short-term investments (such as treasury bills, certificate of deposit etc.) and other similar holdings that are easily converted to cash.
Cash is unique because it represents actual money owned by the company. Other assets will have to endure at least one process before they can be converted to cash, and may lose value in that conversion process.
Accounts Receivable for instance has to be collected before it becomes cash, and during that conversion process, a $1 in accounts receivable may be converted for only $0.95. Of note also is the fact that the conversion process will also cost the company, as collection officers may have to be employed to assist in the process.
Accounts/Trade Receivable (A/R). Credit to customers is an important business practice in business-to-business trade. When a company sells its products and allows the buyer to pay for the product some time in the future, the amount by the buyer is shown on the seller's balance sheet as accounts receivable. Because most trade receivable debts are payable within a short time (most companies offer 30-day credit term), the debt is considered to be very liquid.
Not all buyers will pay for the products they bought and sellers in anticipation of this eventually, may record reserves against such non-payment in its accounting process. This reserve is known as Bad Debt provision and is charged against the company's profit. On the balance sheet, accounts receivable is shown net of accumulated bad debts provision.
Inventory represents either the raw material to be used for producing items for sale, and/or items already in the manufacturing process and/or finished goods ready for sale to customers. Inventory is a fairly liquid asset because it is expected to be sold and converted to cash in a short time. Of course, unlike accounts receivable, inventory is usually two steps away from cash, as the inventory item is first converted to accounts receivable (when it is sold on credit) and then the accounts receivable is collected , before it becomes cash. Inventory may also be sold for cash (cash on delivery or cash before delivery), in which case the inventory item is just as liquid as accounts receivable.
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More Bal Sheet Info
Total Assets - Total Liabilities = Equity (A - L = E)
The double entry system of accounting ensures that A = T + E or A - L = E always hold true, and basically ensure a balanced balance sheet.
Assume that you decided to start a business with $10,000 in cash.
The cash is your asset and when you take it to the business it will be included as your equity in the company.
You borrowed $3,000 from the bank and used it to buy equipment.
Your balance sheet:
Total Assets $13,000
Bank Loan $3,000
Total Liab./Equity $13,000
The balance sheet is balanced as Total Assets equals Total Liab plus Equity or expressed another way, A = L + E. Clean Balance Sheet: A balance sheet with very low debt level. Off-balance sheet financing: Financing raised by the company that does not appear on the balance sheet.