Balance Sheet

Balance sheet is one of the most significant financial statements. It indicates the financial condition or the state of affairs of a business at a particular moment of time. More specifically, balance sheet contains information about resources and obligations of a business entity and about its owners’ interests in the business at a particular point of time. Thus, the balance sheet of a firm prepared on 31st December 2011 reveals the firm’s financial position on this specific date. In accounting’s terminology, balance sheet communicates information about assets, liabilities and owner’s equity for a business firm as on a specific date. It provides a snapshot of the financial position of the firm at the close of the firm’s accounting period.

Balance Sheet

Assets — Assets, representing economic resources, are the valuable possessions owned by the firm. These possessions should be capable of being measured in monetary terms. Assets are the future benefits. They represent: (a) stored purchasing power (cash), (b) money claims (receivables, a stock) and (c) tangible and intangible items that can be sold or used in business to generate earnings. Tangible items include land, building, plant, equipment or stocks of materials and finished goods and all such other items which have physical substance. Intangible items do not have physical existence, but they have value to the firms. They include patents, copyrights, trade name or goodwill. Assets may be classified as current assets, and long term assets. Current Assets — current assets, sometimes also called liquid assets, are those resources of the firm which are either held in the form of cash or are expected to be converted into cash within the accounting period or the operating cycle of the business. The accounting period is of one-year duration. The operating cycle is the time period which is taken to convert raw material into finished goods, sell finished goods, and convert receivables (goods sold on credit) into cash. In majority of the cases, the operating cycle is equal to or less than the accounting period. Current assets generally include cash, marketable securities, book debts (accounts receivables) and stock of raw material, work-in-process and finished goods.

  • Cash is the most liquid current asset. It is the current purchasing power in the hands of the firm and can be used for the purposes of acquiring some resources or paying some obligations. Cash includes actual money in had and cash deposits in bank account.
  • Marketable securities are the temporary or short-term investments in shares, debentures, bonds and other securities. These securities are readily marketable and can be converted into cash within the accounting period. A firm usually invests in marketable securities when it has temporary surplus cash. A number of Indian companies invest their surplus cash in the Unit Trust of India’s units, or other securities. The inter-corporate lending is another popular short-term investment in India. It is a common accounting practice to show marketable securities at original cost or current market price, whichever is lower.
  • Book debts (or account receivables) — Are the amounts due from debtors (customers) to whom goods or services have been sold on credit. These amounts are generally realizable into cash within the accounting period. All book debts may not be realized by the firm. Some may remain uncollected. The debts which will never be collected are called bad debts. Accountant generally makes an estimate or provision for bad debts and show good debts separately from bad debts in the balance sheet.
  • Bills receivables — represent the promises made in writing by debtors to pay definite sums of money after some specified period of time. Bills are written by the firm and become effective when accepted by debtors.
  • Stock (or inventory) — includes raw materials, work-in-process and finished goods in the case of manufacturing firms. Raw materials and work-in-process inventories are needed for smooth production. The stock of finished goods is kept for serving customers on a continuing basis. A merchandize business may not have raw materials and work-in-process inventories as it has no manufacturing activity. Inventories are carried in the balance sheet at the original cost or the market price, whichever is less. Inventories are the least liquid current assets. First they have to be sold and then receivables have to be collected.
  • Prepaid expenses and accrued incomes — are also included in current assets. Prepaid expenses are the expenses of future period paid in advance. Examples of prepaid expenses are prepaid insurance, prepaid rent, or taxes paid in advance. They are current assets because their benefits will be received within the accounting period. Accrued incomes are the benefits which the firm has earned, but they have not been received in cash yet. They include items such as accrued dividend, accrued commission, or accrued interest.
  • Loan and advances — are also included in current assets in India. They include dues from employees or associates, advances for current supplies and advances against acquisition of capital assets. Except for the advance payment for current supplies, it is not proper to include loans and advances in current assets.
  • Long-term Assets: – Long-term assets are held for periods longer than the accounting period. They are held for use in business, and not for the purpose of sale. Long-term assets would normally include fixed assets, long-term investment and other non-current assets.
  • Fixed assets — They would generally form a major group in the manufacturing firms. Tangible fixed assets include land, building, machinery, equipment, furniture etc. These are normally recorded at cost. Costs of tangible fixed assets are allocated over their useful lives. The amount so allocated each year is called depreciation. Costs of tangible fixed assets are reduced every year by the amount of depreciation. Depreciating an asset is a process of allocating cost and does not involve any cash outlay.
  • Intangible fixed assets — represent the firm’s rights and include patents, copyrights, franchises, trade marks, trade names and goodwill. Patents are the exclusive rights granted by the government enabling the holder to control the use of an invention. Copyrights are the exclusive rights to reproduce and sell literary, musical and artistic works. Franchises are the contracts giving exclusive rights to perform certain functions or to sell certain services or products. Trade marks and trade names are the exclusive rights granted by the government to use certain names, symbols, labels, designs etc. Goodwill represents the excessive earning power of a firm due to special advantages that it possesses. Costs of intangible fixed assets are amortized over their useful lives.
  • Gross and net block — The term gross block is used to represent the original cost of total fixed assets. When accumulated depreciation is subtracted from the gross block, the difference is called the net block.
  • Investments — Long-term investments represent the firm’s investment in shares, debentures and bonds of other firms or government bodies for profits and control. These investments are held for a period of time greater than the accounting period. Usually, the long-term investments are shown at the original costs, but the current market prices may be given in parentheses.
  • Other assets — All other assets which cannot be included in any of the above categories are grouped as other assets. Usually, they represent deferred charges. Prepayments for services or benefits for period longer than the accounting period are referred to as deferred charges and include advertising expenditure, preliminary expenses etc.

Liabilities – Liabilities are debts payable in future by the firm to its creditors. They represent economic obligations to pay cash or provide goods or services in some future period. Generally, liabilities are created by borrowing money or purchasing goods or services on credit. Examples of liabilities are creditors, bills payable, wages and salaries payable, interest payable, taxes payable, bonds, debentures, borrowing from banks and financial institutions, public deposits etc. Liabilities may be of two — current liabilities and long —term liabilities.

  • Current liabilities are debts payable within an accounting period. Current assets are converted into cash to pay current liabilities. Sometimes new current liabilities may be incurred to liquidate the existing current liabilities. The typical examples of current liabilities are creditors, bills payable, bank overdraft, tax payable, outstanding expenses and incomes received in advance.
  • Sundry creditors represent current liability towards suppliers from whom the firm has purchased raw materials on credit. This liability is also known as accounts payable, and it is shown in the balance sheet till the payment has been made to the creditors.
  • Bills payable are the promises made in writing by the firm to make payment of a specified sum to creditors at some specific date. Bills are written by creditors over the firm and become bills payable once they are accepted by the firm. Bills payable have a life of less than a year; therefore, they are shown as current liabilities in the balance sheet.
  • Bank borrowing forms a substantial art of current liabilities of a large number of companies in India. Commercial banks advance short-term credit to firms for financing their current assets. Banks may also provide funds (term loans) for financing the firm’s fixed assets. Such loans will be grouped under long-term liabilities.
  • Provisions are other types of current liabilities. They include provision for taxes, or provision for dividends. Every business has to pay taxes on its income. Usually, it takes some time to finalize the amount of tax with the tax authorities. Therefore, the amount of tax is estimated and shown as provision for taxes or tax liability in the balance sheet. Similarly, provision for paying dividends to shareholders may be created and shown as current liability.
  • Expenses payable (or outstanding expenses) and income received in advance are other examples of current liabilities. The firm may owe payments to its employees and others at the end of accounting period for the services received in the current year. These payments are payable within a very short period. Examples of outstanding expenses are wages payable, rent payable, or commission payable. A firm can sometimes receive income for goods or services to be supplied in future. As goods or services have to be provided within the accounting period, such receipts are shown as current liabilities in the balance sheet. Long-term loans are payable periodically. That portion of the long-term loan which is payable in the current year will form part of current liabilities. A firm may also raise deposits from public for financing its current assets. These may be therefore classified under current liabilities. It may be noted that public deposits may be raised for duration of one year through three years.
  • Long-term Liabilities – sometimes also called fixed liabilities, are the obligations or debts payable in a period of time greater than the accounting period. Long-term liabilities usually represent borrowing for a long period of time. They include debentures, bonds, and secured long-term loans (mortgages) from financial institutions.
  • Debenture or bonds — When the firm has to raise large sum of money as debt from the public, it issues debentures or bonds. A debenture or a bond is a general obligation of the firm to pay interest and return principal sum as per the agreement. Loan raised through issue of debentures or bonds may be secured or unsecured.
  • Secured loans or mortgages are the long-term borrowing with fixed assets pledged as security. Mortgages are shown as secured long-term liabilities in the balance sheet. Term loans from financial institutions and commercial banks are secured against the assets of the firm.

Owners’ Equity – The financial interests of owners are caller owners’ equity. The owners’ interest is residual in nature, reflecting the excess of the firm’s assets over its liabilities. As liabilities are the claims of outside parties, owners’ equity represents owners’ claim against the business entity as of the balance sheet date. But the nature of the owners’ claim is not same as the claims of creditors. Creditors’ claim is defined and has to be met within a specified period. The claim of owners’ changes and the amount payable to them can be determined only when the firm is liquidated. Since assets are recorded at cost, there can be considerable difference between the owners’ book claim and the real claim. Initially, owners’ equity arises on account of the funds invested by them. Bit it changes due to the earnings of the firm and their distribution. The firm’s earnings (or losses) do not affect creditors’ claims. Owners equity will increase when the firm makes earnings and retains whole or a part of it. If the losses are incurred by the firm, owners’ claim will be reduces. In case of a company, owners of firm are called shareholders or stockholders. Therefore, owners’ equity in case of companies is referred to as shareholders’ equity or shareholders’ funds or capital or simply as share capital. Shareholders’ equity has two parts: (i) paid-up share capital and (ii) reserves and surplus (retained earnings) — representing undistributed profits. Paid-up share capital is the amount of funds directly contributed by shareholders. If shareholders are actually required to pay more than the stated or par value per share, the amount is separately shown as share premium. The second part of the share capital is referred to as retained earnings or reserves and surplus. The difference between the total earnings to date and the total amount of dividends to date is reserves and surplus. It represents total undistributed earnings. The term deficit is used to represent excess of total dividends over total earnings or losses incurred by the firm. Undistributed profits (reserve) may be earmarked for some specific purpose, such as replacement or debenture redemption. Reserves which are not earmarked are called free reserves. It should be realized that the amount of retained earnings shown in the balance sheet does not indicate anything about the ways in which it has been appropriated in the business. It can be invested in any type of resources. Thus, if the firm has retained earnings, it does not mean that it, at least, has that much cash.

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