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 peridiod. The BlBalance 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 BlBalance 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 rihight 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 Accu mulated 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.