What is a balance sheet, and why is it prepared?
The balance sheet is prepared to report an organization's financial position at the end of an accounting period. A corporation's balance sheet says its:
Assets (resources that were acquired in past transactions)
Liabilities (obligations and customer deposits)
Stockholders' equity (the difference between the amount of assets and liabilities)
You can view the balance sheet as reporting the assets and the claims against those assets (liabilities and stockholders' equity). You can also view the balance sheet as reporting a corporation's assets and the amounts that creditors provided (the liabilities) and the amounts provided by the owners (the stockholders' equity).
A classified balance sheet reports the current assets in a section that is separate from the long-term assets. Similarly, current liabilities are reported in a section that is separate from long-term liabilities. This allows bankers, owners, and others to quickly compute the amount of an organization's working capital and current ratio.
The balance sheet has some limitations. For example, the property, plant and equipment are reported at cost minus the accumulated depreciation (except land). If these assets have increased value, the fair value is not reported because of the cost principle. Also, brand names and trademarks may have significant value but cannot be reported on the balance sheet unless they were acquired in a business transaction.
The balance sheet should be read with the other financial statements (income statement, statement of comprehensive income, statement of cash flows, and the statement of stockholders' equity changes), including the notes to the financial statements.
What does a balance sheet tell us?
Assets reported on the balance sheet are the company's resources such as cash, accounts receivable, inventory, investments, land, buildings, equipment, some intangible assets. Generally, assets are reported at their cost or lower due to the cost principle, depreciation, and conservatism. The cost principle also means that some precious aspects of the company are not listed as assets. For example, a company's outstanding reputation, effective management team, and excellent brand recognition are not reported as assets if they were not acquired in a transaction involving another party or entity.
Liabilities are a company's obligations as of the balance sheet date. They will include loans payable, accounts payable, accrued expenses not yet recorded in accounts payable, warranty obligations, taxes payable, and more.
Stockholder's equity or owner's equity reports the amounts invested by the owners plus the company's earnings that the owners chose not to withdraw as dividends or drawings.
The balance sheet classifications allow the reader to compute the amount of a company's working capital efficiently and to determine if a company is highly leveraged.
Every balance sheet that a company distributes should include notes (or footnote disclosures). These notes provide essential additional information concerning the company's financial position, including potential liabilities not included in the amounts reported on the face of the balance sheet.
How are the balance sheet and income statement connected?
The connection between the balance sheet and the income statement results from:
- The use of double-entry accounting or bookkeeping, and
- The accounting equation Assets = Liabilities + owner's equity
The income statement components have the following effects on owner's equity:
- Revenues and gains cause owner's (or stockholders') equity to increase
- Expenses and losses cause owner's (or stockholders') equity to decrease
Example:
To illustrate the connection between the balance sheet and income statement, let's assume that a company's owner's equity was Rs.40,000 at the beginning of the year, and it was Rs.65,000 at the end of the year. Let's also assume that the owner did not invest or withdraw business assets during the year. Therefore, the Rs.25,000 increase in owner's equity is likely the company's net income earned for the year. The details for the Rs.25,000 (revenues, expenses, gains, losses) will be reported on the company's income statement for the year.
Accountants refer to the income statement accounts (revenues, expenses, gains, losses) as temporary accounts because their balances will be closed and transferred to the owner's capital account at the end of the year.
What are balance sheet accounts?
Balance sheet accounts are one of two types of general ledger accounts. (The other accounts in the public ledger are the income statement accounts.)
Balance sheet accounts are used to sort and store transactions involving a company's assets, liabilities, and owner's or stockholders' equity. The balances in these accounts as of the final moment of an accounting year will be reported on the company's end-of-year balance sheet.
Balance sheet accounts are also referred to as permanent or real accounts because the balances in these accounts are not closed at the end of the accounting year. Instead, the ending balances will be carried forward to become the beginning balances in the next accounting year. (This is different from the income statement accounts, closed at the end of each accounting year and will begin the following year with zero balances.)
Example:
Examples of a corporation's balance sheet accounts include Cash, Temporary Investments, Accounts Receivable, Allowance for Doubtful Accounts, Inventory, Investments, Land, Buildings, Equipment, Furniture and Fixtures, Accumulated Depreciation, Notes Payable, Accounts Payable, Payroll Taxes Payable, Paid-in Capital, Retained Earnings, and others.
When does a negative cash balance appear on the balance sheet?
A negative cash balance results when the cash account in a company's general ledger has a credit balance. The credit or negative balance in the checking account is usually caused by a company writing checks for more than it has in its checking account.
When a company prepares its balance sheet, a negative balance in the cash account should be reported as a current liability which it might describe as checks written more than cash balance. The logic is that the company likely issued the checks to reduce its accounts payable. Since the company's bank will not pay the issued checks, the company still has the liability.
Example:
A negative cash balance in the general ledger does not mean that the company's bank account is overdrawn. Let's assume that a company writes checks for Rs.100,000 and mails them to suppliers in another state at the end of the day. Those checks might not clear the company's bank account until three or four days later. Therefore, the company's Cash account may show a negative Rs.40,000, but at the bank, the company's checking account balance could have a positive balance of Rs.60,000. If the company deposits at least Rs.40,000 tomorrow morning, the bank balance will be large enough for the bank to pay the Rs.100,000 of checks it had written.
Is the provision for doubtful debts an operating expense?
Some companies use Provision for Doubtful Debts as the name of the contra-asset account, which is reported on the company's balance sheet. Other companies use Provision for Doubtful Debts as the name for the current period's expense reported on the company's income statement.
Suppose Provision for Doubtful Debts is the account's name used for recording the current period's expense associated with the losses from average credit sales. In that case, it will appear as an operating expense on the company's income statement, and it may be included in the company's selling, general and administrative expenses.
Example:
Accounting textbooks avoid the use of the word "provision" and instead use the following terminology:
- The contra-asset account associated with accounts receivable will have the account title Allowance for Doubtful Accounts.
- The current period expense pertaining to accounts receivable (and its contra account) is recorded in the account Bad Debts Expense, which is reported on the income statement as part of the operating expenses.
Is a security deposit for a rental agreement recorded in a liability account?
The person paying the security deposit would credit the asset account Cash and debit the asset account Security Deposits. The person receiving the security deposit would debit the asset account Cash and credit the liability account Security Deposits Returnable.
Let's use an example. Monica pays the landlord Rs.500 as a security deposit as required by the lease for renting the apartment. If she causes no damage, she has a right to Rs.500 at the end of the lease. She gave up an asset (Cash of Rs.500) but had another asset: the right to Rs.500 at the end of the lease. The landlord receives Rs.500 but must return the security deposit at the end of the lease. The landlord received an asset (Cash of Rs.500) but is liable to return the Rs.500 at the end of the lease (unless there are damages).
As shown, a security deposit is an asset for one party, and the same security deposit is a liability for the other party.
Where is the premium or discount on bonds payable presented on the balance sheet?
The premium or discount on bonds payable is the difference between the amount received by the corporation issuing the bonds and the par value or face amount of the bonds. If the amount received is greater than the par value, the difference is the premium on bonds payable. If the amount received is less than the par value, the difference is the discount on bonds payable.
The premium and discount accounts are viewed as valuation accounts. The unamortized premium on bonds payable will have a credit balance that increases the bonds payable's carrying amount (or the book value). The unamortized discount on bonds payable will have a debit balance that decreases the carrying amount (or book value) of the bonds payable.
The premium or discount is to be amortized to interest expense over the life of the bonds. Hence, the balance in the tip or discount account is the unamortized balance.
The premium or the discount on bonds payable that has not yet been amortized to interest expense will be reported immediately after the par value of the bonds in the liabilities section of the balance sheet. Generally, if the bonds are not maturing within one year of the balance sheet date, the amounts will be reported in the long-term or noncurrent liabilities section of the balance sheet.
How should a mortgage loan payment be reported on a classified balance sheet?
The account Mortgage Loan Payable contains the principal amount owed on a mortgage loan. (Any interest that has accrued since the last payment should be reported as Interest Payable, a current liability, and the future claim is not reported on the balance sheet.)
Any principal to be paid within 12 months of the balance sheet date is reported as a current liability. The remaining amount of principal is registered as a long-term liability (or noncurrent liability).
Example:
Let's assume that a company has a mortgage loan payable of Rs.2,38,000 and must make monthly payments of approximately Rs.4,500 per month. Each monthly payment includes an Rs.3,000 principal payment plus an interest payment of approximately Rs.1,500. This means that during the next 12 months, the company will be required to repay Rs.36,000 (Rs.3,000 x 12 months) of the loan's principal. Therefore Rs.36,000 is reported as a current liability. The remaining principal of Rs.2,02,000 (Rs.2,38,000 minus Rs.36,000) is reported as a long-term (or noncurrent) liability since this amount will not be due within one year of the balance sheet date.
What is an unpresented cheque, and does it require an adjustment to the balance sheet?
An unpresented cheque is a check that a company has written, but the check has not yet been paid by the bank on which it is drawn. An unpresented check is also referred to as an outstanding check or a check that has not yet cleared the bank.
In the bank reconciliation, the unpresented or outstanding check is deducted from the balance per the bank to arrive at the adjusted or corrected balance per bank.
Effect of unpresented cheque on the balance sheet
When a company writes a check, the company records it with a credit to the Cash account in its general ledger. Whether the check has or hasn't cleared the bank account, the company's Cash account balance is proper. Hence, the company's general ledger cash account will not require an adjustment for the unpresented or outstanding cheque reported on the balance sheet.
What is a classified balance sheet?
A classified balance sheet arranges the balance sheet accounts into a format that is useful for the readers. For example, most balance sheets use the following asset classifications:
- current
- long-term investments
- property, plant and equipment
- intangible assets
- other assets
Liabilities are usually classified as:
- current, or
- noncurrent or long-term liabilities
If a company earns a profit, which balance sheet items change?
Profit is the result of revenues minus expenses.
Since all business transactions affect at least two accounts, there will likely be an enormous number of changes to the balance sheet. Here are some of the changes:
Owner's equity or stockholders' equity will increase by the positive amount of net income
Accounts receivable will change by the amount of sales/services provided with credit terms
Inventory will decrease when goods are sold
Cash will increase when goods are sold for cash and when accounts receivable are collected
Cash will decrease when cash is paid for expenses, inventory, equipment, liabilities, etc.
Accounts payable will increase for expenses that were not paid with cash
Accumulated depreciation will change when an asset is depreciated
The list is just a few of the balance sheet changes when a company has profitable operations.
Is it okay to have negative amounts in the equity section of the balance sheet?
The equity section of the balance sheet is known as:
- Owner's equity if it is a sole proprietorship. The amount may be reported as a single amount described as the owner's capital. On the other hand, it is common for today's accounting software to show three amounts: owner's capital at the start of the year, current year net income, and the current year draws by the owner.
- Stockholders' equity if it is a corporation. The reported components may be paid-in capital, retained earnings, treasury stock, and accumulated comprehensive income.
Example:
A negative amount of net income must be reported if the current year's net income is reported as a separate line in the owner's equity or stockholders' equity sections of the balance sheet. The negative net income occurs when the current year's revenues are less than the current year's expenses.
If the cumulative earnings minus the cumulative dividends declared result in a negative amount, retained earnings would be negative. This negative (or positive) amount of retained earnings is reported as a separate line within stockholders' equity.
The owner's drawing account in a sole proprietorship will have a debit balance. Hence, if it is reported as a separate line, it is reported as a negative amount since the owner's equity section of the balance sheet has credit balances typically.
If a corporation has purchased its shares of stock, the cost is recorded as a debit in the account Treasury Stock. The debit balance will be reported as a negative amount in the stockholders' equity section since this section has credit balances typically.
Accumulated other comprehensive income can also be a negative (or positive) amount.
Should trademarks be included on the balance sheet?
A trademark should be reported on the balance sheet as an intangible asset. However, the cost principle prevents the reported amount from being more than the cost of acquiring and defending the trademark. A trademark that was developed internally (rather than purchased) might cost Rs.0, and therefore it will not be listed on the balance sheet.
Example:
Company X, a consumer products company, introduced a new product in 1960. It registered the trademark in 1960 for a small fee that was immediately expensed. Since then, Company X has been very effective in promoting this trademarked brand. Consumers now pay a premium price for this recognized and superior product. A competitor offers to purchase the trademark from Company X for Rs.300 crore in cash. If Company X does not sell the brand, Company X will not list the trademark as an asset. (Recall that the trademark's cost was Rs.0.)
If Company X were to sell the trademark to Company Y for Rs.300 crore, Company Y would report the brand on its balance sheet at Rs.300 crore. The reason is that there was a transaction for Rs.300 crore, and Company Y's cost of the brand was indeed Rs.300 crore.
For any further queries related to this or anything else, visit
TAXAJ.
TAXAJ Corporate Services LLP
Address: 1/11, 1st Floor, Sulahkul Vihar, Old Palam Road, Dwarka, Delhi-110078