Balance Sheet From Pome By Gautam Koppala

Balance Sheet:

The first bookkeeping equation, whichever form it takes, establishes the essence of the Balance Sheet, a financial statement that describes for a reader the financial condition of a business (or an individual) at a point in time. You can think of it as a snapshot of an organization’s financial position.

Clearly, then, your net worth—the equity you have in your individualized assets or in your business—is a function of the resources you have and how you acquire and use them. If you can acquire those assets for less than they are worth or will generate, you will increase your net worth, or owner’s equity. The neutral of financial management is to increase what you own, your equity.

If that is the point of financial management, you might wonder why businesses use debt. If they didn’t owe anything, they wouldn’t have to subtract liabilities from assets. A swift look at the way people operate shows that this is an oversimplified view. The wise use of other people’s money will, after providing an appropriate return for its use, enhance your capability to increase your own net worth. And we all comprehend that: if we can, we borrow funds to buy a home because we anticipate that, over time, that home will increase in value beyond what we paid for it and what we could have attained by investing the funds. Using borrowed funds to make the buy will, therefore, increase our equity. The same is true for any productive or valuable quality that is properly chosen and managed.

The Balance Sheet is presented as of a specific date, most frequently the end of the financial year, and recognizes the effects of all of the financial activity that took place up through the Balance Sheet date. On the following pages we present and describe the basic elements of the Balance Sheet.

The first presentation, in Exhibit  Below, provides a line-by-line explanation of the key parts of a Balance Sheet.

Exhibit: The Balance Sheet—Annotated

In the Balance Sheet it would be reflected as:

Dr (Debit)

Cr (Credit)

Cash

0.00

Inventory

0.00

The reason that the credit is reflected first in this example is that in our Balance Sheet, cash comes before inventory.

If we had bought the inventory on credit, promising to pay for it at a later date, it would appear as:

Debit Inventory (an Asset) for 0.00 to reflect the value of the inventory acquired.

Credit Accounts Payable (a Liability) for 0.00 to reflect the value of the inventory that we now owe to the vendor.

In the Balance Sheet it would be reflected as:

Dr (Debit)

Cr (Credit)

Inventory

0.00

Accounts Payable

0.00

To begin, bear in mind that the Income Statement reflects activities that are intended to reward the shareholder; that is, to increase the wealth of the shareholders through the generation of profit. The wealth of the shareholder is reflected in the Equity section of the Balance Sheet. Recording credits to the Equity accounts, therefore, increases them. Generally, except for the direct understanding of stock, we only affect equity through transactions reflected in the Income Statement.

Therefore, to finally increase Equity, we must show Revenues in the Income Statement as credits, because if revenues exceed expenses, the result is profit that must reflect on the Balance Sheet as an increase in—a credit to—Equity.

If we show Sales as credits, then we must show Expenses as debits in order to generate accurate bookkeeping results. In its simplest terms then, we would show a understanding of that inventory on credit as follows:

Dr (Debit)

Cr (Credit)

Sales (Revenue)

0.00

Accounts Receivable (Asset)

0.00

Cost of Sales (Expense)

0.00

Inventory (Asset)

0.00

These two transactions both balance, but the Balance Sheet no longer appears to be balanced because we increased Assets by 0.00, but then decreased them only by 0.00. However, the Income Statement now shows a profit of .00, the difference between income and expenses. This profit, at the end of the bookkeeping period, is recognized through a journal entry that closes out the period’s income statement by removing the profit from the Income Statement through a debit and increasing the Equity on the Balance Sheet through a credit. Now the Income Statement result has been zeroed out, making it ready for the next bookkeeping period, and the Balance Sheet has been balanced. Think about the following:

Dr (Debit)

Cr (Credit)

BS

Accounts Receivable

0.00

BS

Inventory

0.00

IS

Sales

0.00

IS

Cost of Sales

0.00

IS

Profit

.00

BS

Retained Earnings (Equity)

.00

Now the Balance Sheet (BS) balances and the Income Statement (IS) reflects the activity of the period, shut out at the end of the period to the Balance Sheet.

Coming to Koppala and George conversation:

Balance Sheet – Assets

Koppala moves on to explain the equilibrise sheet, a financial statement that reports the amount of a company’s (A) assets, (B) liabilities, and (C) stockholders’ (or owner’s) equity at a specific point in time. Because the equilibrise sheet reflects a specific point in time rather than a period of time,

Koppala likes to refer to the equilibrise sheet as a “snapshot” of a company’s financial position at a given moment. For example, if a equilibrise sheet is dated December 31, the amounts shown on the equilibrise sheet are the balances in the accounts after all transactions pertaining to December 31 have been recorded.

(A) Assets

Assets are things that a Project owns and are sometimes referred to as the resources of the Project. George readily comprehends this—off the top of his head he obloquy things such as the company’s vehicle, its cash in the bank, all of the supplies he has on hand, and the dolly he uses to help move the miscellaneous material.

Koppala nods and shows George how these are reported in accounts called Vehicles, Cash, Supplies, and Equipment. She mentions one quality George hadn’t considered—Accounts Receivable. If George delivers work packages, but isn’t paid immediately for the delivery, the amount owed to GG Org is an quality known as Accounts Receivable.

Pre paids:

Koppala brings up another less obvious asset—the unexpired portion of prepaid expenses. Suppose GG Org pays ,200 on December 1 for a six-month insurance premium on its Project vehicle. That divides out to be 0 per month (,200 ÷ 6 months). Between December 1 and December 31, 0 worth of insurance premium is “used up” or “expires”. The expired amount will be reported as Insurance Expense on December’s income statement. George asks Koppala where the remaining ,000 of unexpired insurance premium would be reported. On the December 31 equilibrise sheet, Koppala tells him, in an quality statement called Prepaid Insurance.

Other examples of things that might be paid for before they are used include supplies and annual dues to a trade association. The portion that expires in the current bookkeeping period is listed as an expense on the income statement; the part that has not yet expired is listed as an quality on the equilibrise sheet.

Koppala assures George that he will soon see a significant link between the income statement and equilibrise sheet, but for now she continues with her explanation of assets.

Cost Principle and Conservatism

George learns that apiece of his company’s assets was recorded at its original cost, and even if the clean market value of an item increases, an accountant will not increase the recorded amount of that quality on the equilibrise sheet. This is the result of another basic bookkeeping principle known as the cost principle.

Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism. For example, after a few months in business, George might decide that he can help out some customers—as well as acquire additional revenues—by carrying an inventory of packing boxes to sell. Let’s state that GG Org bought 100 boxes wholesale for .00 each. Since the time when George bought them, however, the wholesale price of boxes has been cut by 40% and at today’s price he could buy them for .60 each. Because the replacement cost of his inventory () is less than the original recorded cost (0), the principle of conservatism directs the accountant to report the lower amount () as the asset’s value on the equilibrise sheet.

In short, the cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less then their cost.

Depreciation

George also needs to know that the reported amounts on his equilibrise sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic bookkeeping principle known as the matching principle. Depreciation is used for assets whose life is not indefinite—equipment wears out, cars become too old and pricey to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the quality to Depreciation Expense on the income statement over its useful life.

As an example, adopt that GG Org’s van has a useful life of five years and was bought at a cost of ,000. The accountant might match ,000 (,000 ÷ 5 years) of Depreciation Expense with apiece year’s revenues for five years. Each year the carrying amount of the van will be reduced by ,000. (The carrying amount—or “book value”—is reported on the equilibrise sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the equilibrise sheet will report the carrying amount of the delivery van as ,000, after two years the carrying amount will be ,000, etc. After five years—the end of the van’s expected useful life—its carrying amount is zero.

George wants to be certain that he comprehends what Koppala is telling him regarding the assets on the equilibrise sheet, so he asks Koppala if the equilibrise sheet is, in effect, showing what the company’s assets are worth. He is surprised to hear Koppala state that the assets are not reported on the equilibrise sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense. The result is that a building’s market value might actually have increased since it was acquired, but the amount on the equilibrise sheet has been consistently reduced as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.

Another asset, Office Equipment, might have a clean market value that is much smaller than the carrying amount reported on the equilibrise sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants do not think about depreciation to be a valuation process.) The quality Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.

Short-term (current) quality amounts are likely to be close to their market values, since they tend to “turn over” in relatively short periods of time.

Koppala cautions George that the equilibrise sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company’s reputation—as excellent as it might be—will not be listed as an asset. It also means that Bill Gates will not appear as an quality on Microsoft’s equilibrise sheet; Nike’s logo will not appear as an quality on its equilibrise sheet; etc. George is surprised to hear this, since in his view these items are perhaps the most valuable things those companies have.

Koppala tells George that he has just learned an important lesson that he should remember when reading a equilibrise sheet.

Balance Sheet – Liabilities and Stockholders’ Equity

(B) Liabilities

The equilibrise sheet reports GG Org’s liabilities as of the date noted in the heading of the equilibrise sheet. Liabilities are obligations of the company; they are amounts owed to others as of the equilibrise sheet date. Koppala gives George some examples of liabilities: the loan he received from his aunt (Notes Payable or Loan Payable), the interest on the loan he owes to his aunt (Interest Payable), the amount he owes to the hardware store for items bought on credit (Accounts Payable), the consequence he owes an employee but hasn’t yet paid to him (Wages Payable).

Another liability is money received in advance of actually earning the money. For example, suppose that GG Org enters into an agreement with one of its customers stipulating that the customer prepays 0 in return for the delivery of 3 work packages apiece month for 6 months. Assume GG Org receives that 0 payment on December 1 for deliveries to be made between December 1 and Might 31. GG Org has a cash receipt of 0 on December 1, but it does not have revenues of 0 at this point. It will have revenues only when it earns them by delivering the parcels. On December 1, GG Org will show that its quality Cash increased by 0, but it will also have to show that it has a liability of 0. (It has the liability to deliver 0 of parcels within 6 months, or return the money.)

The liability statement involved in the 0 received on December 1 is Unearned Revenue. Each month, as the 3 work packages are delivered, GG Org will be earning 0, and as a result, apiece month 0 moves from the statement Unearned Revenue to Service Revenues. Each month GG Org’s liability decreases by 0 as it fulfills the agreement by delivering parcels and apiece month its revenues on the income statement increase by 0.

(C) Stockholders’ Equity

If the company is a corporation, the third section of a corporation’s equilibrise sheet is Stockholders’ Equity. (If the company is a sole proprietorship, it is referred to as Owner’s Equity.) The amount of Stockholders’ Equity is exactly the difference between the quality amounts and the liability amounts. As a result accountants often refer to Stockholders’ Equity as the difference (or residual) of assets minus liabilities. Stockholders’ Equity is also the “book value” of the corporation.

Since the corporation’s assets are shown at cost or lower (and not at their market values) it is important that you do not associate the reported amount of Stockholders’ Equity with the market value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders’ Equity as the corporation’s “net worth”.) To find the market value of a corporation, you should obtain the services of a professional familiar with your businesses.

Within the Stockholders’ Equity section you might see accounts such as Common Stock, Paid-in Capital in Excess of Par Value-Common Stock, Preferred Stock, Retained Earnings, and Current Year’s Net Income.

The statement Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset). Another statement Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders’ Equity and expenses will automatically cause a decrease in Stockholders’ Equity. This illustrates a link between a company’s equilibrise sheet and income statement.

Examining Your Company’s Balance Sheet

INSTRUCTIONS: Get a copy of your company’s Balance Sheet or the Balance Sheet of another company you are interested in. Compare the format of the Balance Sheet below with the one you are looking at. Identify the similarities and differences between this generalized Balance Sheet and that of a specific company. It is likely that your company’s presentation of the Balance Sheet is similar to the one presented here. Different companies might modify the presentation of the Balance Sheet to reflect the specifics of the company more clearly. For example, you might see Fixed Assets described as Property, Plant, and Equipment. Your company might break the classifications of assets and liabilities and equity into broader or narrower subcategories. To the extent that the examination of your company’s financial statements raises questions, ask someone in the bookkeeping or finance department to clarify what you have seen.

Exhibit: The Balance Sheet—An Substitute Presentation

Trial Balance

During the course of an bookkeeping period, a company records many, many such transactions, tracking apiece activity of the company through the financial records. When the period ends, the accountants summarize all of the transactions, determining the amounts to be recognized in apiece account. When all the accounts in the chart of accounts are listed with their respective balances in a single, sequential statement, it is called a Trial Balance. There might be several interim trial balances prepared before the books are closed, as the accountants seek to be sure that everything has been accounted for. A properly finished Trial Balance reflects everything that has occurred during the period and when added together totals zero. That is, the debits equal the credits and since they are all added together, they offset apiece other. Once this zero equilibrise has been achieved, the accountants recognize that by separating the Balance Sheet accounts from the Income Statement accounts, they have prepared two financial statements which when added separately, reach the same net amount, but with opposite signs, one positive and the other negative, one a debit equilibrise and the other a credit balance. If the company has made a profit, the Income Statement has a total that reflects a net credit, and the Balance Sheet has more assets than liabilities, by the amount of the net credit. The final entry made, then, is to clear the net credit from the Income Statement and to add to the Retained Earnings statement the profit for the period, bringing the Balance Sheet back into balance. From here the formal preparation and delivery of financial statements is only a function of printing the final results.

The Income Statement and Balance Sheet are the direct outcome of the bookkeeping system recording and reporting process. The preparation of the Statement of Cash Flows follows easily from the completion of the Balance Sheet. The Statement of Cash Flows, summarizes information reflected on the Balance Sheet into a standard structure, permitting analysts to comprehend and interpret how the company handled its cash during the period. Since cash and cash equivalents assist the completion of all business transactions, tracking the cash flows provides the analysts with a window into the company. Similarly, the Statement of Retained Earnings is also prepared after the preparation of the Balance Sheet and the Income Statement, completing the financial statement package for the period.

Balance Sheet From Pome By Gautam Koppala

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