In this article you will learn:
Each accounting process ends with the preparation of a set of basic accounting reports known as financial statements. These reports include:
Income statement and cash flow statement are flow reports as these reports demonstrate the activities of a business entity for a period of time, say a quarter or a year. Whereas balance sheet is a stock report that indicates the resources and obligations of an entity at a specific moment in time.
This article talks about what is balance sheet, balance sheet items, importance of balance sheet, types of balance sheet and how to prepare balance sheet.
What is Balance Sheet?
Balance sheet is one of the fundamental financial statements prepared by your entity. It is a “snapshot” of your company’s financial position at the end of a specified date.
Typically, you can group a standard balance sheet into three account categories:
- liabilities and
- owner’s equity or capital.
Thus, a balance sheet informs the stakeholders of your company as to what it owns and owes to third parties on a specified date; usually the end of a year or quarter. Additionally, it states your entity’s liquidity position and its capitalization.
As per statutory requirements, companies are required to file their balance sheets at least once a year.
Balance Sheet Formula
Now, in order to understand the effect of economic events on a balance sheet, you need to look at it from the following two perspectives:
1. Resources and Claims Aspect
According to Resources and Claims View, assets are the economic resources of your entity as of the date of balance sheet. These resources provide benefits to your entity in future. The liabilities and owner’s equity, on the other hand, are claims against your entity. Liabilities refer to the amounts owed by your entity to outside parties such as banks, creditors, vendors etc. Whereas owner’s equity refers to the claims of the owners such as you.
2. Sources and Use of Funds Aspect
The second perspective with which a balance sheet is viewed is the ‘Sources and Use Of Funds’. Accordingly, the left hand side of the balance sheet indicates the funds utilized to acquire resources. Such investments are made in order to achieve your entity’s objectives, that is, earning profits. While the right hand side of the balance sheet indicates sources through which funds are raised. These funds are raised either from the trade creditors and lenders or the owners of an entity. The funds obtained from trade creditors are shown under accounts payable while funds from lenders appear as long term debt. Owners’ equity section shows the funds supplied by the you as the owner of the entity. This includes the paid in capital and retained earnings.
Thus, with the Sources and Use of Funds View in the backdrop, we come to the following fundamental accounting equation or balance sheet equation or balance sheet formula:
Assets = Liabilities + Owner’s Equity
This means every rupee invested in your entity’s assets is either provided by its owners or creditors. And every rupee supplied by entity’s owners and creditors and is invested in some or the other asset.
Since now you know how to interpret a balance sheet, lets try to get into its components.
Balance Sheet Items
According to accounting equation, your business has to pay for whatever it owns (assets) by either obtaining funds from investors (owner’s equity) or borrowing money from lenders (liabilities).
This brings us to the three major balance sheet items: Assets, Liabilities and Owner’s Equity.
What Are Assets?
Assets are the economic resources that provide you benefits in future and are controlled by your entity. You can measure these resources objectively at the time of their acquisition.
Further, you can group assets into current assets and non-current assets.
Assets that can be consumed or converted into cash within the normal operating cycle of a business or within one year, whichever is longer, are current assets. Where the operating cycle of a business means the time it takes to buy or produce inventory, sell the finished products and collect cash for the same.
Although the operating cycle of a business usually represents one year, there are certain companies whose normal operating cycle is more than one year. Thus, current assets include: cash, marketable securities, accounts receivable, inventories and prepaid expenses.
Cash is the most liquid asset of an entity and thus is important for short-term solvency of the company.
The cash balance shown under current assets is the balance available with the business that can be promptly used to meet its day-to-day expenses.
It typically includes coins, currencies, funds on deposit with bank, cheques and money orders.
2. Marketable Securities
Marketable securities are investments made by the company that are both easily marketable as well as expected to be converted into cash within a year. These include treasury bills, notes, bonds and equity securities.
3. Accounts Receivable
Accounts receivables are the amounts that a company’s customers owe to it for the goods and services supplied by the company on credit.
The accounts receivables are presented in the balance sheet at net realisable value. Such amounts are determined after considering the bad debt expense.
Inventories are the sum of items that are either:
- Stocked for the purpose of sale in the normal course of business
- In the production process and would eventually be sold
- Shortly be consumed in the manufacturing of goods that would be sold eventually
It is important to note that the items that form a part of inventory are the goods that would be sold in the normal course of business. In case of merchandising companies, goods available for resale form a part of inventory.
Whereas, in case of manufacturing firms, goods available as raw materials, work-in-process and finished goods form a part of inventory.
5. Prepaid expenses
Prepaid expenses refer to the operating costs of a business that have been paid in advance. The time when such expenses are paid at the beginning of the accounting period, cash reduces in the balance sheet.
Simultaneously, a current asset of the same amount is created in the balance sheet by the name of prepaid expenses.
Fixed assets are the long term assets that are acquired for producing goods or providing services and not for the purpose of reselling them to earn profit. Such assets are non-current assets that are not readily convertible into cash in the normal course of business operations.
In other words, such assets have a useful life of more than one year. Further, fixed assets can be tangible and intangible.
Tangible Fixed Assets
Tangible Fixed Assets are physical assets that are measurable and are used by a business entity for the purpose of conducting its operations like producing goods or providing services.
These include Property, Plant and Equipment and Long Term Investments.
1. Property, Plant and Equipment
Property, Plant and Equipment are the long term tangible assets that cannot be easily liquidated and are acquired for the purpose of carrying out business operations.
These assets include Land, Building, Furniture and Fixtures, Machinery and Motor Vehicles.Such assets are represented net of accumulated depreciation in the balance sheet.
Long term investments appear on the asset side of the balance sheet and include business entity’s investments in the form of debt securities, equity, real estate and cash. These are the investments that are held by a business entity for more than one year.
Intangible Fixed Assets
Whereas, intangible assets are the non-physical assets used by a business entity over a long period of time. These include Patents, Copyright and Goodwill.
Copyright is the exclusive right given to the owner of the work thereby deterring anyone to copy or imitate the original work of the owner. Thus, copyright is categorized as an intangible asset and is amortized over a period of time.
A Patent is a statutory right for an invention granted for a limited period of time to the patentee by the Government. This right is given in exchange of full disclosure of his invention for excluding others from using his product or invention in any form without his consent.
Thus, patent is an intangible asset that has a limited useful life and is recorded at cost in the balance sheet.
Goodwill is an intangible asset that relates to the purchase of one company by the other. Thus, goodwill arises when the purchasing company pays more for the acquired company than the fair value of its net assets. The amount by which the purchase price exceeds the fair value of the net assets is recorded as an asset of the acquiring company.
What Are Liabilities?
Liabilities are claims of your lenders, creditors and equity owners against your entity’s assets. These are the obligations of your entity to either transfer assets or provide services to the outside parties. Such obligations arise from the events that have occurred in the past.
Now, liabilities are further grouped into current liabilities and Other Liabilities.
Liabilities that are expected to be met or satisfied within the normal operating cycle of the business or within one year, whichever is longer, are current liabilities.
Here, the operating cycle refers to the time period elapsed between purchase of goods or services to be used in the manufacturing process and the final receipt of cash as a consequence of selling such goods.
Thus, current liabilities include:
1. Accounts Payable
Accounts payable, also termed as trade payables, are the amounts that a business owes to its suppliers for goods or services purchased on credit. Such amounts arise on account of time difference between receipt of services or acquisition to title of goods and payment for such supplies.
The time period for which such a credit is extended to business typically ranges between 30 – 60 days.
2. Accrued Expenses
Accrued liabilities also known as accrued expenses are the expenses that a business has incurred or recognized in its income statement but are not contractually due. Although, the cash for such an expense is yet to be paid, the company must recognize such an expense for the benefit received.
3. Current portion of long-term debt
This refers to the principal amount of debt that is due within one year or one operating cycle, whichever is greater. Such a long term debt may include bonds, mortgage notes and other long term debts. The balance amount remaining, after considering the current portion of long term debt, is reported as long term debt in the balance sheet.
4. Deferred Revenues
Unearned revenues are also known as unearned income, deferred revenue or deferred income. Such revenues refer to the cash collected by a business in advance of providing goods and services. This means that the business receives money for goods or services it is yet to supply.
Such revenue can be thought of as an advance payment of goods or services that a business is expected to produce or supply to the customer. Due to such an advance payment, the seller has a liability equal to an amount of revenue generated in advance till the time actual delivery is made.
The liabilities that do not meet the criteria for current liabilities fall under Other Liabilities head. All the non-current liabilities such as long-term debt come under other liabilities. In other words, such liabilities are the financial obligations that stand due for more than a year.
These liabilities include:
1. Long Term Borrowings
A business entity cannot meet its entire capital needs solely from the owner’s equity. Typically, business entities that are engaged in capital intensive activities need finance at various stages in order to ensure proper functioning of the business operations.
Thus, business entities need to avail loan either from a bank, financial institution or indigeneous lenders. So, any debt that becomes payable after 12 months with interest is covered under long term borrowings. Examples of long term borrowings include:
- Bonds or Debentures
- Long Term Loans
2. Deferred Tax Liabilities
Business entities are required to pay tax as per the profits earned by a company in a particular financial year. Needless to say taxes are paid when a company makes profit during a given period.
However, there can be cases when the amount of tax paid by a business entity during a given financial year is less than what it was liable to pay. Thus, the unpaid amount of tax in any given financial year must be paid in the next financial year by a business entity.
Accordingly, such a shortfall of tax is treated as deferred tax liability in the given financial year which becomes payable in the next financial year along with the next year’s tax.
3. Long Term Provision
Creating a provision means keeping aside a certain amount in an account to cover a future liability or decrease in the value of asset.Thus, a provision is not a form of saving, rather, it is acknowledgment of a liability expected to arise in future in advance.
The third head in balance sheet is the owner’s equity or capital. This section represents the amount that investors have invested in your firm. The owner’s equity is further divided into paid-in capital and retained earnings.
Owner’s Equity = Paid-In Capital + Retained Earnings
Thus, an increase in income or earnings of your entity leads to an increase in owner’s equity. While a decrease in earnings of your firm leads to a decrease in owner’s equity.
Now that you have an understanding of the various components of a balance sheet, you can read the fundamental accounting equation as:
Assets = Liabilities + Paid-In Capital + Retained Earnings
IV. Balance Sheet Format
Following is the balance sheet of Sharma Corporation as of December 2018.
|Current Assets||Amt in INR||Current Liabilities||Amt in INR|
|Marketable Securities||246||Bank Loan Payable||1,000|
|Accounts Receivable||9,944||Accrued Liabilities||876|
|Prepaid Expenses||389||Current Portion of Long Term Debt||500|
|Total Current Assets||22,651||Total Current Liabilities||9,519|
|Non-Current Assets||Non-Current Liabilities|
|Property, Plant, Equipment at Cost||26,946||Long Term Debt Less Current Portion||2,000|
|Less: Accumulated Depreciation||13,534||Deferred Income Taxes||824|
|Net Property, Plant, Equipment||13,412||Total Liabilities||12,343|
|Other Assets||Owner’s Equity|
|Patents and Trademarks||403||Additional Paid-In Capital||11,256|
|Goodwill||663||Total Paid-In Capital||12,256|
|Total Owner’s Equity||25,896|
|Total Assets||38,239||Total Liabilities and Owner’s Equity||38,239|