Basics of Accounting - The Balance Sheet

The Accounting Equation
In the lesson 7  we were introduced to basic accounting terms such as Debit, Credit, Asset, Liability, and Net Worth (in a small business, known as Owners Equity), but we did not define or categorize many of these terms.  In this lesson, we will be examining the Balance Sheet, which is comprised of three main categories of accounts – Assets, Liabilities, and Owners Equity.

• Assets are things of value that are OWNED.  They are primarily tangible things like buildings, trucks, land, and cash, but more rarely they can also be intangible things such as “goodwill”, which is what we believe the value of a business is above what was paid for it.  Obviously, we can’t be sure this is correct until the business is actually sold.
• Liabilities are things that are OWED.  These are generally debts that have been incurred in the process of acquiring assets (in other words, we borrow part of the purchase price of an asset).
• Owners Equity is, very simply, the difference between Assets and Liabilities.  It will be a positive number in a normal successful business.

These three categories of accounts are the major components of what is called the Accounting Equation, which is:

                                            ASSETS = LIABILITIES + OWNERS EQUITY

This is also the formula for the primary financial statement, the Balance Sheet.

The Balance Sheet
Definition:    The Balance Sheet reports the value of the firm’s assets, liabilities, and owners equity at a specific point in time.  It can be viewed as a “snapshot” of the financial condition of the company.

Figure A below shows the structure of a Balance Sheet – Assets are listed on the left, with a total for Assets at the bottom.  Liabilities are listed on the top right, with Owners Equity directly below Liabilities.  At the bottom of the right side is Total Liabilities and Owners Equity, and this total ALWAYS is the same number as for Total Assets.  This is, after all, a Balance sheet. 

It is easy, by the way, to always have a Balance Sheet that balances, because the equation that says “Assets = Liabilities + Owners Equity” can be re-written as “Assets – Liabilities = Owners Equity”.  In the typical scenario we can measure Assets and Liabilities, so we can calculate Owners Equity.

Definitions of Accounts

ASSETS – what we OWN.

Current Assets
Let’s look first at the left, or Asset, side of the Balance Sheet.  The first group of Assets is called “Current Assets”.  These are items that are the most liquid (closest to cash), and are generally items that will be converted to cash within one year.  They may be a number of specific assets, but for our purposes I have listed the most common:

·         Cash – about as close to cash as you can get.

·         Accounts Receivable – money people owe us for goods or services.  We have made the sale, but the customer hasn’t paid yet.  These types of debts are usually meant to be paid (converted to cash) within 30 days.

·         Inventory – is the merchandise we have purchased to re-sell to our customers.  We list them on the Balance Sheet at our cost (how much we paid, not how much we’ll sell them for).  When customers buy the merchandise, the cost of the sold inventory is removed from the Inventory account and put into cash, or if we sold on account the amount of the selling price becomes an Account Receivable – one step closer to cash.

·         Prepaid Expenses – rent is generally paid in advance, so on November 1^st we paid rent and have the right to use our rented space all through November.  What if on November 10^th we decide to move – are we simply out the rent money?  No, we can sub-lease (rent) the space to someone else for at least the remainder of the month.  The “rent” we paid becomes an asset that declines in value each day until, at month end, drops to zero.

Insurance is similar.  We pay fire and theft insurance (among other types of insurance) at the beginning of the period, and if we cancel before the end of the period we are entitled to a refund.

Current Assets can be looked at as the “money flow” of the company – buying and selling merchandise, paying rent, etc.  The next group of Assets are those things used to make the machine that starts the money flowing.

Fixed Assets
These are the things needed in order to produce the business operations that lead to cash, and are called “fixed” because in many ways they are “fixed” in place – buildings, land, and equipment.  They can also be delivery trucks, airplanes, etc., which aren’t “fixed” but; well, I think you get the idea.  The most common Fixed Assets are:

• Land – which is pretty self-explanatory.  A business must operate somewhere, and must either pay rent or own the land on which it operates.  If the land is owned, it is listed on the Balance Sheet at the original purchase price – not what is owed, not what the current market price might be.  Using the original value is called “cost-based”.
• Buildings – sit on the land, and are usually owned along with the land on which they sit.  They are also listed at cost. 

Depreciation: Here we need to introduce the concept that Fixed Assets other than land generally drop in value over time and must be replaced.  Under GAAP and IRS rules a certain portion of a Fixed Asset may be “depreciated” each year, until the asset reaches a “book value” (as in ‘on our books’ at the cost of the item less all of the accumulated depreciation) of zero. 

Example: We bought a building (and the land on which it sits) for $125,000 five years ago.  At the time of purchase we estimated that we paid $100,000 for the land, and $25,000 for the building.  The original Balance Sheet entries looked like this:

          Land                                                                                       $100,000

          Building                                                $25,000

          Less Accumulated Depreciation              ($0) $  25,000

          Total Fixed Assets                                                               $125,000

Our accountant told us that GAAP rules said we had to depreciate the building “straight line” over five years, which means that we divide the cost of the building by five and take an equal amount off of the original cost each year.  In two years, our Balance Sheet entry changed to:

          Land                                                                                       $100,000

          Building                                                $25,000

          Less Accumulated Depreciation      ($10,000)*            $  15,000

          Total Fixed Assets                                                               $115,000

Where *shows that two years worth of allowable depreciation have accumulated on the building, reducing it’s “book value” to $15,000.  At the end of five years, the “book value” will drop to zero.

Does this mean that the “actual” value of the building is zero?  No, but the GAAP is clear in most cases that you must use this method of valuation unless an actual sales transaction has taken place that can then be used as the basis for a new “market value”.

Back to Fixed Assets:

• Truck – or machine tools, or cars, or boats.  These are listed at cost, with depreciation accumulated as described above.

And remember:   Total Assets = Current Assets + Fixed Assets

LIABILITIES – what we OWE.

Current Liabilities
Current Liabilities are generally the debts we have to pay soon, at least within a year.  As with Current Assets, we list the items in order of urgency.

• Accounts Payable – are generally the monthly expenses of the business, such as rent, utilities, merchandise purchases, etc.
• Note Payable – is a short-term loan, typically from a bank, that must be paid back, with interest, within a year.

There are many other possible Current Liabilities, and they all have the same characteristics; they are money to be paid back within a year and they are usually for short-term items like rent or inventory.  Fixed Assets are generally financed with longer term loans, as explained in the next category.

Long-term Liabilities
These are loans that are going to be paid back over a period of years, and are generally for Fixed Assets such as buildings & land (mortgages) or trucks and the equipment (long-term notes or contract payable).

• Long-term Contract – just a quick definition: a contract is an obligation that is paid back in equal monthly or yearly payments until the balance is zero.  Each payment consists of part principle (part of the original loan) and part interest (the cost of the loan).  Notes are obligations to pay back a borrowed sum at some time in the future (a year, five years, etc.) all at once in a payment that includes the original borrowed money, plus interest.

And remember:   Total Liabilities = Current Liabilities + Long-term Liabilities

OWNERS EQUITY
In our simple Balance Sheet example I have shown the business as a proprietorship.  The Owners Equity is listed as one amount that is the difference between the Assets and the Liabilities.

In Corporations, there are two items listed in this category, which is called “Capital” rather than Owners Equity, but is still Assets – Liabilities.  The two categories are:

• Common Stock – which is the original investment made to start the Corporation.
• Retained Earnings – which is profit left in the company after dividends are paid. (Dividends are essentially a portion of the profit divided by the number of shares of stock, and are a way to pay all of the “owners” of the company their share of the disbursable profits.)

Managers of Corporations, however, would be silly to disburse all profits to shareholders, because then they would have no money to replace old equipment, or for investments in new buildings, etc.  Some of the profit, then, is “retained” in the business.

On the other hand, if the business has been losing money it is possible to have negative retained earnings.

And finally:   Total Assets = Total Liabilities + Owners Equity

The total of Liabilities and Owners Equity is placed at the bottom of the right side of the Balance Sheet, and will always equal the Total Assets number to its left.

Please look at these links for more background information on the Balance Sheet: http://www.businesstown.com/accounting/basic-sheets.asp
http://ohioline.osu.edu/cd-fact/1154.html

Figure A
Joe Jones
Dba Joe Jones Company

BALANCE SHEET
As of December 31, 2001

ASSETS                                            LIABILITIES

Current Assets:                                Current Liabilities:

Cash                                                  Accounts Payable
Accounts Receivable                       Note Payable          

Inventory                                          Total Curr. Liabilities:

Prepaid Expenses                                      

Total Current Assets:                       Long-term Liabilities:

                                                           Long-term Contract

Fixed Assets:                                    Total LT Liabilities:

Land                                                  Total Liabilities:

Building                                                 

Truck                                                 Owners Equity:

Total Fixed Assets:                                                                      

                        TOTAL ASSETS:                             TOTAL LIABILITIES
                                                                                    and OWNERS EQUITY:

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