Part 4 Balance Sheet
Slide # 1 Balance Sheet
Also known as the “Statement of Financial Position,” the Balance Sheet is a snapshot of a company’s net worth at the end of the accounting periidod. The BBlalance Shee t reflects a single point in time, not a span of time like the Income Statement or Cash Flow Statement.
Since the Balance Sheet draws information from the other two statements, it is recommended that you complete it last.
The BBlalance Shee t fllfollows the fllfollow ing equation:
Assets = Liabilities + Owners’ Equity
Knowing this calculation must hold true allows you to check your work. If the equation does not balance, you may need to check your work on all three financial statements for completeness and accuracy.
Slide # 2 Balance Sheet
Assets = Liabilities + Owners’ Equity
So that you understand what this equation means, let’s look at the definition of the variables.
An Asset is property owned by the company expressed in terms of monetary value.
A Liability is an obligation, duty, or responsibility towards another party for a past transaction or promise of a future transaction.
Owners’ Equity is the leftover value of the business once you subtract Liabilities from Assets. You can think of this as the profit earned and kept in a business that essentially belongs to the owner (rather than to creditors). You can see this expressed as another form of the balance sheet equation.
Owners’ Equity = Assets – Liabilities
Slide # 3 Balance Sheet
Assets ‐ Liabilities = Owners’ Equity
Slide # 4 Balance Sheet
Matching Principle The concept of the matching principle is especially important for accrual accounting, but also helps clarify the nature of liabilities.
Since liabilities are tied to transactions, you can match each liability to the asset(s) that was realized from the same transaction. For instance, the company may take out a bank loan, which causes an increase in the asset called “cash” and a matching increase in the liability called “long‐term debt.”
Using the matching principle helps maintain the balance sheet equation. Since our examples use cash accounting, you will not need to worry about matching assets and liabilities but it is a good concept to know for more advanced accounting.
Slide # 5 Balance Sheet
Asset and Liability Vocabulary In reference to assets and liabilities, there are a few terms you’ll need to know: Tangible vs. Intangible Tangible assets or liabilities have a physical presence, such as inventory or equipment. Intangible assets or liabilities, like patents or trademarks, are more conceptual and hard to value in monetary terms.
Current vs. Long‐Term A current asset or liability is one that will be converted to cash or paid from cash in less than a year. Long‐term assets or liabilities will not be converted to cash or paid within one year. Many words are used interchangeably with long‐term, including non‐current or fixed. These terms relate to the concept of liquidity, which you can learn more about by clicking here.
Slide # 6 Balance Sheet
Liquidity When discussing liquidity, you might refer to the liquidity of an asset or to the liquidity of the whole company. In both cases, people tend to refer to the degree of liquidity rather than an absolute liquid or illiquid.
The degree to which an asset is liquid depends on how quickly it can be converted to cash without affecting its value. Cash is the most liquid of assets since it does not need to be converted. Conversely, land is pretty far down the liquidity scale since it takes awhile to fin d the riihght buyer and process contracts unless you are willing to accept a lower price.
A comppyany’s liqqyuidity is based on what ppgercentage of assets are tied up in short‐term versus long‐term. Liquidity standards are different from industry to industry. However, as stated before, a company ideally is liquid enough to pay for six months worth of operating expenses.
Slide # 7 Balance Sheet
Assets + Liabilities = Owners’ Equity
Slide # 8 Balance Sheet
Assets As stated before, assets are property owned by the company expressed in terms of monetary value. Assets can be tangible, intangible, current, or long‐term. Some examples of assets are cash, equipment, bonds, proprietary knowledge (“know how”), and land.
Assets on the Balance Sheet are first separated into current and long‐term. Then they are listed in order of liquidity, or how quickly the assets can be converted to cash. Therefore, as a general rule, current tangible assets are listed first and long‐term intangible assets are listed last.
Example: Liquidity Ranking Order these assets in most to least liquid: accounts receivable, land, a patent, cash.
Answer: 1. Cash does not need to be converted to anyygthing because it is already cash. Therefore it is the most current tangible asset you’ll find and the first one listed on the Balance Sheet. 2. Accounts Receivable is an expectation to receive cash from customers within 30‐60 days. It is a current tangible asset that is listed closely after cash. 3. Land is a long‐term asset that can be sold for cash, given some time to find a buyer. It is a long‐term tangible asset that is near the top of the order of long‐term assets. 4. A patent can be sold for cash but it takes a very specific buyer, like another company in the same industry. Since it takes longer to find the right buyer for a patent, it is listed near the bottom of long‐term assets. Slide # 9 Balance Sheet
Current Assets These are assets that will be converted to cash in less than a year and recorded at market value. Market value is the likely amount that will be received when converted to cash. They are listed in order from most to least liquid.
Slide # 10 Balance Sheet
Current Assets Cash and Equivalents is always the first entry on the Balance Sheet. The cash figure is taken directly from the last line of the Cash Flow Statement. This number should always be positive. Since small businesses rarely deal with cash equivalents, we will not discuss them here. However, if you’re curious about cash equivalents, click here for more information.
Next is Accounts Receivable, which is the amount of money owed to the company by customers for services or products already delivered. It is reasonable to expect these accounts to be paid within 30‐60 days since that is the routine time extended for trade credit.
The next most liquid current asset is Ending Inventory, which is taken from the Income Statement under the Cost of Goods Sold. Inventory should be valued at the lower of cost or market value, which we have assumed equal for this module. In later accounting classes, you’ll find out much more out inventory valuation.
Add these three types of current assets and any others the company might own for Total Current Assets.
Slide # 11 Balance Sheet
Cash Equivalents Examples of cash equivalents include money market accounts, treasury bills, commercial paper, and marketable securities. These assets can be converted to cash in three months or less and are unlikely to change in value. Accordingly, they are considered as equal to cash in liquidity and value. They are separated from other short‐term investments that mature in 12 months and could change in value, as well as from long‐term investments.
Slide # 12 Balance Sheet
Long‐Term Assets These are assets that will not be converted to cash within a year and are recorded at the purchase price or Fair Market Value (FMV) – whichever is less. Like current assets, they are also listed in decreasing order of liquidity.
Slide # 13 Balance Sheet
Long‐Term Assets Property, Plant, and Equipment is the cost of long‐term assets less the accumulated depreciation. There are two ways to show this value on the Balance Sheet:
1. Show the net value of these assets with depreciation already deducted.
2. Show the purchase/historic price of these assets on one line and subtract the accumulated depreciation on a separate line.
We will use the second approach.
Slide # 14 Balance Sheet
Long‐Term Assets Since companies should use consistent, comparable accounting methods from year‐to‐ year, use current and past financial statements to find the figures you need.
To fin d the figure for PtProperty, Plan t, and Equipment you must adjust the amount from the previous year for purchases and sales made in the current year. Start with the Property, Plant, and Equipment from last year’s Balance Sheet. From that figure, add the purchases that you find in the Investing Activities section of the Cash Flow Statement.
To find the Accumulated Depreciation, you must adjust the figure from the previous year for depreciation expensed this year. Start with the Accumulated Depreciation figure from last year’s Balance Sheet. Then add the depreciation expensed this year under Operating Expenses of the Income Statement.
Slide # 15 Balance Sheet
Details About Long‐Term Assets Here are some caveats to keep in mind. You will not necessarily need to know this information for the activities that follow but may find it useful in the future:
. Land is not depp,reciable, though the buildings on it are.
. At the end of an asset’s usable life, its accumulated depreciation will equal the original cost. Therefore, eventually the sum of Property, Plant, and Equ ipment and Accum ulated Depreciation equals zero, unless the company owns land (which is not depreciable) or continues to buy more long‐term assets.
. If a company is in business long enough, it will likely sell some long‐term assets. This can complicate calculations, since you’ll need to subtract the cost of the asset and the related accumulated depreciation from the appropriate entries on the Balance Sheet.
Slide # 16 Balance Sheet
Other Long‐Term Assets There are some assets that don’t fit into the conventional categories we have already discussed. Although these assets are usually not held by small proprietorships, here is a list of a few:
Patents, Copyrights, and Trademarks Legal ownership of symbols, proprietary knowledge, or intellectual property.
Another Comppyany’s Stocks or Bonds
Goodwill This is an intangible asset that reflects some intrinsic value that a company possesses. It arises when one company acquires another at a cost higher than the value of the assets. What would make a company worth more than what it owns? The acquiring company might value intangibles like brand recognition, superior management, or an existing presence in new markets.
Slide # 17 Balance Sheet
Total Assets Once you add current and long‐term assets, you are finished with the assets portion of the Balance Sheet. Next you will learn about liabilities.
Slide # 18 Balance Sheet
Assets + Liabilities = Owners’ Equity
Slide # 19 Balance Sheet
Liabilities The technical definition of liabilities is an obligation that arises from a past transaction or event that will require the transfer or use of assets, services, or other transfer of economic benefit in the future.
In layman’s term, liabilities are a company’s financial obligations, debts, or potential losses. An obvious example of a liability is a bank loan that will have to be paid back. Liabilities also occur when a customer gives a deposit for an order, employees pay into a company‐run pension plan, or supplies are received on account.
Just like assets, liabilities are separated into current or long‐term and listed in decreasing order based on when they are due.
Slide # 20 Balance Sheet
Current Liabilities CtCurrent liabiliti es are obliga tions tha t are expecttded to be paid or resolved within a year. The following are the current liabilities you are likely to see in the correct order:
Accounts Payable lists debts your business owes suppliers, vendors, or even the IRS.
Employment Taxes Payable, Wages Payable, and Other Short‐Term Debts Payable are items that could be included under Accounts Payable or as separate entries on the Balance Sheet. These are items that would likely be due on a recurring basis, for wages, or quarterly, for payroll taxes and social security payment, with the last quarterly payments normally due in mid‐January of the next accounting period.
Notes Payable are debts that are longer‐term than Accounts Payable but usually due in less than a year. An example of a note would be a 180‐day loan from the bank.
Sum these entries for Total Current Liabilities. Slide # 21 Balance Sheet
Long‐Term Liabilities Long‐term Liabilities are obligations that will not be paid or resolved within a year. The following are long‐term liabilities you are likely to see in the correct order:
Long‐term Debt normally includes mortgages, automobile loans, and other types of equipment or furniture loans that extend over one or more years.
Other Long‐term Liabilities would be miscellaneous obligations, like bonds payable, that are due beyond a year.
Sum these entries for Total Long‐Term Liabilities.
Slide # 22 Balance Sheet
Total Liabilities Sum current and long‐term liabilities to calculate Total Liabilities.
Slide # 23 Balance Sheet
Loan Amortization: Calculating Loan Interest Payments, Principal Payments, and the Remaining Loan Principal Balance When you borrow money from an institution, you have to pay the lender interest over the life of the loan. The amount of interest to be paid is determined by the length of the loan, the interest rate, and whether the loan is a fixed rate or variable rate interest loan. Normally, loan ppyayments are made monthly and include a portion of the payment for interest and the rest of the payment to be applied toward the principal balance. The amount of interest paid each year declines as the remaining principal balance declines, with more of each subsequent payment allocated to ppprincipal.
Amortization software programs determine the amount of interest that must be paid for each payment period, normally monthly, and the principal payment amount for the interest rate, the payment period, and the length of the loan. Amortization schedules can be produced to show the monthly interest payable and the principal amount payable for the length of the loan. In addition to commonly used personal money management software, such as Quicken and Microsoft Money, one can access many free online loan calculators to obtain an amortization schedule.
Slide # 24 Balance Sheet
Loan Amortization: Calculating Loan Interest Payments, Principal Payments, and the Remaining Loan Principal Balance
One online source that can be accessed for an amortization calculator is from Yahoo.com, found at: http://www.amortization‐calc.com/
We used this calculator to determine the amount of interest and principal that would be paid on a $250,000 loan for ten years (120 months), for a fixed rate 6% loan paid monthly. You are encouraged to access this calculator and enter the information so that you produce the following results (we used the annual desired amortization schedule to produce yearly amounts so we would not have to manually sum the 12 monthly figures). The results are on the next screen.
Slide # 25 Balance Sheet
Loan Amortization: Calculating Loan Interest Payments, Principal Payments, and the Remaining Loan Principal Balance
The monthly payment for principal and interest would be $2,776 or $33,312 a year for 10 years. This payment does not include property taxes or insurance payments that a business would also be responsible for each year. Your results should look like this:
Slide # 26 Balance Sheet
Loan Amortization: Calculating Loan Interest Payy,ments, Principal Payy,ments, and the Remaining Loan Principal Balance Here is a summary of the amortization table from the calculator: Year Beginning Payment Interest Paid Principal Ending Balance Amount Paid Balance Year 1 $250,000 $33,312 $14,488 $18,818 $231,182 Year 2 $231,182 $33,312 $13,327 $19,979 $211,203 Year 3 $211,203 $33,312 $12,095 $21,211 $189,992
The amount of the interest paid for a Year 1 ($14, 488) included in the Income Statement as an item of General and Administrative Expense. The amount of principal paid for Year 1 ($18,818) is shown on the Cash Flow Statement in the amount of “Repayment of Long‐Term Debt.” This same amount ($18,818) is also subtracted from the prior year Long‐Term Debt value ($250,000) to obtain the remaining amount of Long‐Term Debt (principal) for that year ($231,182). This process is repeated for each subsequent year. If additional loans are made, the additiona l interest and principal payments are adde d to the existing loan payment amount for that year.
The terms of a loan can certainly vary from the figures we used above; however, the process is the same. You can change the amount of the loan, interest rate, and payment frequency, based on the loan agreement.
Slide # 27 Balance Sheet
Assets + Liabilities = Owners’ Equity
Slide # 28 Balance Sheet
Owners’ Equity Owners’ Equity is basically the part of the company, through investments and rolled over profit, that belongs to the owners. (Corporations, which are owned by stockholders, call this Stockholders’ Equity.)
Owners’ Equity is composed of capital rolled over from the previous period, additional contributions, net income from the previous year, and the amount withdrawn from the business, if applicable.
Slide # 29 Balance Sheet
Owners’ Equity Beginning Owner Capital is the value of the Owners’ Equity from the previous accounting period. You can find it on the previous year’s Balance Sheet.
Owner Capital Paid In for the current year is the value of capital contributed during the current accounting period. If the owner contributes equipment or inventory from personal use, it is treated as conversion to business use and the value is recorded here at its fair market value. Owners may contribute cash, equipment, inventory, or some combination of these.
Slide # 30 Balance Sheet
Owners’ Equity Net Income After Taxes for the current year is the value of the income generated by the business for the accounting period after deducting income taxes. It comes directly from the Income Statement you prepared earlier. (Corporations refer to this figure as Retained Earnings.)
Less Owner Withdrawals is the amount of funds/capital that the owner withdraws from the business for the year.
Sum these entries for Total Owners’ Equity.
Slide # 31 Balance Sheet
Owners’ Equity
Sum the entries to calculate Total Owners’ Equity.
Slide # 32 Balance Sheet
Now it is time to check your work using the balance sheet equation.
Assets = Liabilities + Owners’ Equity
Although the equation is simple, it is no simple feat to balance the equation. If the equation does not balance, you will have to check all of your financial statements for errors or omissions.
Try the activities provided to see if you can balance the equation.
Slide # 33 Balance Sheet
This concludes the Balance Sheet portion of the tutorial.
Close this browser window to go back to the launch page and try the activities. Feel free to revisit the information provided here at any time.