THE BALANCE SHEET
The Accounting Equation
In the last lesson 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 what we OWN. They are things of value--primarily tangible things like buildings, trucks, equipment, land, and cash that are used to run business. 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 what we OWE. 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 one of the primary financial statements, the Balance Sheet.
The Balance Sheet
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. The various categories listed on the Balance sheet are called accounts, and are defined below.
ASSETS – what we OWN. There are two main types of assets:
1. 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 – When we pay our first and last month’s rent, the final month will not be used for some time. Expenses that are paid now but will not be used until a future date are prepaid expenses. 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.
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1. Fixed Assets Think of these as the long-terms assets of the company—land, building, equipment, vehicles—that are most likely to be kept longer than a year. The most common Fixed Assets are: · Land--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. · Equipment, vehicles, etc. used in course of business. Depreciation is an adjustment to a balance sheet entry that reflects the declining value of an asset over time—things wear out. Every year, a portion of the original cost of the asset is deducted from the value listed on the balance sheet. The original cost of the asset is…well, the original cost. The amount deducted in one year is called the depreciation expense. The sum of every year’s depreciation expense for that asset is called accumulated depreciation. The original cost of the asset minus the accumulated depreciation is called the net value of the asset: Net value = Cost – Accumulated Depreciation Depreciation 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: |
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Land Building Cost Less Accumulated Depreciation Net Value Total Fixed Assets |
25,000 - 0
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100,000
25,000
125,000 |
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Our accountant told us that GAAP rules said we had to depreciate the building “straight line” over five years (land is not depreciated), 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: |
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Land Building Cost Less Accumulated Depreciation Net Value Total Fixed Assets |
25,000 -10,000 |
100,000
15,000 115,000 |
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Two years’ worth of allowable depreciation has accumulated on the building, reducing its net value or “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”. Depreciation is applied to all tangible assets except land. After listing our current and fixed assets, we can state the following equation: Total Assets = Current Assets + Fixed Assets |
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