5.2 The Balance Sheet

The Accounting Equation and the Classified Balance Sheet

Recall that the income statement shows the performance of a firm over the course of time. The classified balance sheet shows the financial state of a company as of a specific point in time. It is a key distinction between the two statements. The classified balance sheet is prepared in sections that align with the accounting equation.

Remember, the accounting equation reflects the assets (items owned by the organization) and how they were obtained (by incurring liabilities or provided by owners). Liabilities are debts owed to other parties. Stated differently, every asset has a claim against it—by creditors and/or owners.

The classified balance sheet is thus broken down into three sections; assets, liabilities, and owner’s equity. If prepared correctly, the total assets on the balance sheet equals the total liabilities and owner’s equity sections of the balance sheet.

The classified balance sheet is considered or termed classified when the assets and liabilities within the balance sheet are grouped into even smaller sections: current and noncurrent (see Figure 5.6). Both assets and liabilities are broken down on the balance sheet into current and noncurrent classifications in order to provide more detail and transparency as well as abide by the convention of reporting in descending order of liquidity. Current assets are those that can be used or converted to cash within a year. Common examples of current assets include cash, inventory, accounts receivable, and short-term investments. Assets that will be in use longer than a year are considered noncurrent. Common examples of noncurrent assets include notes receivable, machinery and equipment, buildings, and land.

Just as we noted a few key differences in the income statements based on the type of firm, you may also notice a few slight differences in the balance sheet depending on the firm type. Clear Lake Sporting Goods is a retailer. Thus, you will see that their inventory for resale on their balance sheet is simply called “Inventory.” This is the goods they have purchased for resale but have not yet sold. A manufacturer, like Apple, Inc. in the Link to Learning sections, will have a variety of inventory types including raw materials, work in progress, and finished goods inventory. These represent the various states of the inventory (ready to use, partially complete, and fully completed product). A service firm, on the other hand, may not have inventory at all. If it does, it may be simple goods it uses to help deliver its service. For example, a cleaning company may keep an inventory of cleaning supplies.

Figure 5.6 Graphical Representation of the Accounting Equation Both assets and liabilities are categorized as current and noncurrent.

Clear Lake Sporting Goods has cash, accounts receivable, inventory, short-term investments, and equipment. It rents its facilities, so it has no buildings on its balance sheets. Of all its assets, only the equipment is long term. The assets section for Clear Lake’s classified balance sheet is shown in Figure 5.7.

Figure 5.7 Assets Section of Classified Balance Sheet

We’ve covered the assets side of the accounting equation; now let’s turn our attention to the other side of the equation and the other two sections of the balance sheet: liabilities and equity. Just like the assets section, the liabilities section is broken down between current and noncurrent. Current liabilities are those that will be due within a year. Common examples of current liabilities include accounts payable, wages payable, and unearned revenue. Noncurrent liabilities are those that are due more than a year into the future. Notes payable is a common noncurrent liability.

Clear Lake Sporting Goods has accounts payable and has collected payments from a few customers that it hasn’t yet shipped its product to (unearned revenue). It also owes money on a note payable. Its accounts payable and unearned revenue are both current liabilities. The note payable is not due for several years, thus making it a noncurrent liability (see Figure 5.8).

Figure 5.8 Liability Section of Classified Balance Sheet

The stockholders’ equity section of the balance sheet for corporations contains two primary categories of accounts. The first is contributed capital, which is funds paid in by owners. The second category is earned capital, which is funds earned by the corporation as part of business operations. On the balance sheet, retained earnings is a key component of the earned capital section, while the stock accounts such as common stock, preferred stock, and additional paid-in capital are the primary components of the contributed capital section.

Clear Lake Sporting Goods has just one contributed capital account—common stock—and one earned capital account—retained earnings. The equity section of its balance sheet is shown in Figure 5.9.

Figure 5.9 Stockholders’ Equity Section of Classified Balance Sheet

Importance of the Balance Sheet

Now that we have gone to all the work to carefully assemble a classified balance sheet, what do we use it for? The answer lies within the accounting equation itself. Think of the accounting equation from a “sources and claims” perspective. Under this approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, every asset has a claim against it—by creditors and/or owners. The balance sheet shows us what the firm has (its assets), who owns them (equity), and who the firm owes (its liabilities).

Limitations of the Balance Sheet

The balance sheet is indeed a very helpful financial statement, but it also poses challenges. First, assets on the balance sheet, under generally accepted accounting principles (GAAP), are recorded at historical cost. Historical cost is simply the cost paid for the item at the time it was purchased. Changes in market value of big-ticket items like land or buildings are not reflected in the balance sheet. Land remains at historical cost, and depreciable items like buildings are reflected at their current book value (historical cost less accumulated depreciation). If the asset has appreciated over time, the higher market value of the assets would not be seen on the balance sheet.

Estimates are another limitation of the balance sheet. Items on the balance sheet such as allowance for doubtful accounts and allowance for bad debt are based on estimates. The useful lives for calculating depreciation is another common estimate. If these estimates are incorrect, the net value of the asset can be under- or overstated.

Another key limitation is the fact that a balance sheet reflects balances at only one given point in time. This means that the account value could have been quite different on the day before or the day after the date of the balance sheet. For example, if a firm were concerned with certain ratios or investor/lender expectations of its cash balance, it could choose to not pay several vendor payments in the last week of December. Thus, on December 31, the firm reflects a high cash balance on its balance sheet. However, by the end of the first week of January, it has caught up on late vendor payments and again shows a low cash balance.

Finally, there are many possible things of value that are not recorded on the balance sheet. Internally generated assets and the firm’s human capital are two common examples. Internally generated assets can be anything from a website, a process, to an idea.