The first statistical document presented in any set of financial statements is generally the balance sheet. This statement while relatively straight forward in concept is probably one of the most misunderstood documents found within the financial statements in that most readers do not really understand what is being presented within the document. The financial health or lack thereof is represented within the confines of this document. Liquidity, ability to sustain operations, pay bills, continue operations, the burden of debt carried by the entity, the invested capital of the owners, and many other issues are reported within the balance sheet.
Generally accepted accounting as it is practiced in the United States as well as many other countries is predicated upon the concept that every transaction is self-equalizing. In other words, for every transaction or set of transactions that affect an account or series of accounts within the general set of accounts there is an equal and offsetting transaction or series of transactions reflected in another or other series of accounts. These transactions are reflected as debits and credits within those accounts that are affected.
Debits or credits have no specific meaning as to increase or decrease unless viewed in relationship to the nature of the account(s) that are specifically affected. Asset accounts typically increase with debits, and typically decrease with credits. Conversely, liability accounts increase in nature by the use of a credit to the account. A specific example of would be the receipt of cash by borrowing funds from some source. A debit would be reflected in the cash account, thereby increasing the balance of the account. The offsetting transaction from the acquisition of debt through the loan would be reflected with a credit to the loan account thereby increasing the new liability. The transaction would be self equalizing reflecting both an increase in cash as reflected by the debit to the cash account, and an increase to the loan account reflected by the credit to that account.
A credit to an asset account typically will reduce the asset value whereas a debit to a liability account decreases the amount owed. Again, it is important to know the nature of the account affected to determine whether a debit or credit is increasing or decreasing the value of the general ledger account.
A balance sheet is a reflection of the values attributable to each of the assets, liabilities, and net equity of an organization. The values are always reflected in historical dollars. The amounts indicated are reflected in the dollar values expended at the time of the transaction.
Cash accounts typically reflect the most current values of an entity, as the nature of cash is that there is a daily or near daily influx and outflow of current dollars. Accounts receivable, another asset categorized as a current asset reflects the dollar value of receivables owed to the entity dating back to the earliest dollar reflected within the accounts receivable. Typically receivables are a reflection of consummated sales that have yet to collect and thereby converted to cash, the most current of all assets. It is possible to have values reflected within receivables that maybe less valuable currently than when the actual sale of goods or services took place. This is a function of the time value of money. Simply stated, dollars reflected from prior periods do not have the same value as dollars today by the mere fact that the time value of money, otherwise called interest, has an eroding effect to all dated funds. The theory supporting the time value of money is that the use of a dollar today is more valuable than that use of a future dollar to be collected that cannot be put to use currently.
Inventories are reflected at the dollar cost value attributable to the acquisition of the inventory parts taken as a whole. Again, this is a historical value as inventories are accumulated over time. Many different inventory valuation methods exist based upon various approaches to the valuation. Each entity should be consistent in the approach to valuing the inventories held. At a later date we will provide you with a separate letter pertaining to inventory valuation in our series of letter discussions.
Fixed assets are recorded at the historical acquisition costs and depreciated over various periods of time depending upon the asset category. The values reflected are not intended to reflect or compare to market value(s) of the assets enumerated, but again, only the original acquisition costs reduced by depreciation from the date the assets were acquired.
Other assets such as lease deposits, intangible acquisition costs, prepaid expenses, etc. are all reflected at the original acquisition costs, plus or minus any changes that may have taken place since the assets were first acquired.
Assets as well as liabilities are given priority of listing based upon the nature of the assets or liabilities. The more current the asset or liability, the more likely that asset or liability will be listed in the balance sheet first in descending order. The grouping known as Current Assets generally consists of Cash, Accounts receivable, inventory, etc. ordered first to last in the order most likely to be turned into cash in the least amount of time. Next in order of assets are the Fixed Assets along with any accumulated depreciation to the date of the balance sheet, and finally Other Assets which lists all other non-current or fixed assets. Variances based upon industry and business exists, but most businesses follow this format closely.
The section of the balance sheet enumerated as Current Liabilities lists in order of the most current liabilities to the least current those accounts that reflect the obligations of the entity generally due within thirty-days to one year of the balance sheet date. By nature, Accounts Payable, which is the cumulative total of all of the current trade payables of the entity, is generally listed first, as these are the most current obligations that need to be met. Sales and payroll taxes are generally listed in order of due date, and the current portion of any long term debt is listed next along with any credit lines due banks or vendors. Again, the priority of listing is based upon the most current to least current of the obligations. Variances occur based upon industry and business type.
The Long Term Liabilities section enumerates obviously the long-term portion of any long term obligations, notes, shareholder loans, etc.
The Net Worth, or Equity section of the balance sheet lists the capitalized value of the entity along with retained earnings. The capitalized value is by definition the amount that the stockholders or owners of the entity paid the entity for the capital stock of the corporation, or in the case of a partnership or sole proprietorship, the dollar value of the capital contributed to the entity since the inception of business. Retained earnings is also found in this section of the balance sheet and enumerates the total net cumulative earnings or losses of the entity from the date of inception of the business to the date of the balance sheet. Much confusion exists among many readers of financial statements regarding Retained Earnings, and we have further discussion of the definition and makeup of this concept in another in our series of financial statement discussion letters.
Because all generally accepted accounting is based upon the self-balancing equation of
Assets – Liabilities = Equity
and the balance sheet reflects through its various accounts this theory, an interesting phenomena occurs in that the balance sheet must balance, henceforth the title of the document.
The entire area of financial reporting is complex and subject to many rules and regulations. The more you know about the subject area, the more we can help you to understand your business. To the extent that you have any questions regarding any of the issues enumerated herein, please feel free to call or leave a question for us at our Website.