The balance sheet presents the financial position of a firm at a particular moment in time and contains three main sections: assets, liabilities and shareholders’ equity.
Assets are economic resources with the ability or potential to provide future benefits to the firm. Liabilities are creditors’ claims on the assets of the firm. Shareholders’ equity is the owners’ claim on the assets of the firm.
The basic equation of the balance sheet is: Assets = Liabilities + Shareholders’ equity
This equation must always hold true (hence the name BALANCE sheet)!
A firm will recognize an asset only if (1) the firm has acquired rights to its use in the future as a result of a past transaction or exchange, and (2) the firm can measure or quantify the future benefits with a reasonable degree of precision. While all assets represent future benefits, not all future benefits are assets.
Accountants must assign a monetary amount to each asset in the balance sheet. Several methods can be used to assign value:
Accounts receivables appear as the amount of cash the firm expects to receive but undiscounted since the firm expects to receive payment in a short period (e.g. days to several months).
Non-monetary assets such as inventory, equipment, building, and land appear at acquisition cost (less accumulated depreciation value which will be discussed later).
Assets are typically divided into two categories including current assets and noncurrent assets (or long-term assets).
Current assets include assets that the firm expects to turn into cash, sell or consume within one year
Examples of current assets include:
· Cash and cash equivalents
· Temporary investments in securities
· Accounts receivable from customers
· Merchandise Inventories, which includes: raw materials, supplies, Work-in-progress and Finished goods
· Prepaid operating costs such as prepaid rent or insurance
Noncurrent or long-term assets are assets that the firm expects to hold or use for longer than one year. Common noncurrent assets include:
· Long-term investments in securities
· Property, Plant, and Equipment (PP&E) also called ‘fixed assets” including:
o Furniture and Fixtures
· Intangible Assets, such as Patents
A liability is recognized when the firm receives a benefit or service and in exchange, promises to pay the provider of that good or service a reasonably definite amount in a reasonably definite time. Similar to the discussion of assets, all liabilities are obligations but not all obligations are liabilities.
Liabilities that require payments of specific amounts of cash due in less than one year appear on the balance sheet at the amount of cash the firm expects to pay to discharge the obligation. Obligations that require specific amounts of cash due in more than one year appear at the present value of the future cash outflows.
Liabilities that require delivery of goods or providing services rather than cash can appear on the balance sheet either at the cost of providing the goods or service or at the cash amount received for providing the future goods or services (depending on circumstances). For example, Liability for a product warranty for goods already sold appears at the expected cost of providing the warranty. Liability for advance payment for goods to be sold appears as the amount of cash received.
As with assets, liabilities are also typically divided into two categories: current liabilities and noncurrent liabilities (or long-term liabilities).
Current liabilities represent obligations a firm expects to pay within one year. Examples of current liabilities include:
· Notes payable to banks
· Accounts payable to suppliers
· Salaries payable to employees
· Taxes payable to governments
Noncurrent or long-term liabilities are liabilities that the firm expects to pay beyond one year. Common noncurrent liabilities include:
· Debt due or having maturities in more than one year (such as bonds, mortgages and certain long-term leases)
· Other long-term liabilities can include deferred income taxes and certain retirement obligations
While not its own balance sheet item, working capital is a key concept that is derived from the balance sheet as well as an important measure of a firm’s short-term financial health. Working capital is also sometimes referred to as net working capital and equals a firm’s current operating assets less its current operating liabilities.
Current operating assets = current assets – cash and cash equivalents
Current operating liabilities = current liabilities – short-term debt
Shareholder’s equity is generally made up of two types: contributed capital and retained earnings.
· Contributed capital reflects the funds invested by shareholders for an ownership stake and includes:
o Par value of common or preferred stock. In other words, the amount (usually a nominal amount) assigned to the common or preferred stock.
Note: Par value does not equal the market value of the stock
o Additional Paid-in Capital is the issuance of common or preferred stock, the amount received by the firm in excess of par value
· Retained earnings represent a firm’s earnings since its formation less the dividends paid out to the firm’s owners since formation. Retained earnings can often be negative, especially for a new company that loses money in its first few years of operation.
Also, if a firm acquires or buys back shares originally issued, the cost of those shares is classified on the balance sheet as “Treasury Shares” or “Treasury Stock”.