Balance Sheet – Assets
Marilyn moves on to explain the balance sheet, a financial statement that reports the amount of a company's (A) assets, (B) liabilities, and (C) stockholders' (or owner's) equity at a specific point in time. Because the balance sheet reflects a specific point in time rather than a period of time, Marilyn likes to refer to the balance sheet as a "snapshot" of a company's financial position at a given moment. For example, if a balance sheet is dated December 31, the amounts shown on the balance sheet are the balances in the accounts after all transactions pertaining to December 31 have been recorded.
(A) Assets
Assets are things that a company owns and are sometimes referred to as the resources of the company. Joe readily understands this—off the top of his head he names things such as the company's vehicle, its cash in the bank, all of the supplies he has on hand, and the dolly he uses to help move the heavier parcels. Marilyn nods and shows Joe how these are reported in accounts called Vehicles, Cash, Supplies, and Equipment. She mentions one asset Joe hadn't considered—Accounts Receivable. If Joe delivers parcels, but isn't paid immediately for the delivery, the amount owed to Direct Delivery is an asset known as Accounts Receivable.
Prepaids
Marilyn brings up another less obvious asset—the unexpired portion of prepaid expenses. Suppose Direct Delivery pays RM1,200 on December 1 for a six-month insurance premium on its delivery vehicle. That divides out to be RM200 per month (RM1,200 ÷ 6 months). Between December 1 and December 31, RM200 worth of insurance premium is "used up" or "expires". The expired amount will be reported as Insurance Expense on December's income statement. Joe asks Marilyn where the remaining RM1,000 of unexpired insurance premium would be reported. On the December 31 balance sheet, Marilyn tells him, in an asset account called Prepaid Insurance.
Other examples of things that might be paid for before they are used include supplies and annual dues to a trade association. The portion that expires in the current accounting period is listed as an expense on the income statement; the part that has not yet expired is listed as an asset on the balance sheet.
Marilyn assures Joe that he will soon see a significant link between the income statement and balance sheet, but for now she continues with her explanation of assets.
Cost Principle and Conservatism
Joe learns that each of his company's assets was recorded at its original cost, and even if the fair market value of an item increases, an accountant will not increase the recorded amount of that asset on the balance sheet. This is the result of another basic accounting principle known as the cost principle.
Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism. For example, after a few months in business, Joe may decide that he can help out some customers—as well as earn additional revenues—by carrying an inventory of packing boxes to sell. Let's say that Direct Delivery purchased 100 boxes wholesale for RM1.00 each. Since the time when Joe bought them, however, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for RM0.60 each. Because the replacement cost of his inventory (RM60) is less than the original recorded cost (RM100), the principle of conservatism directs the accountant to report the lower amount (RM60) as the asset's value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less then their cost.
Depreciation
Joe also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic accounting principle known as the matching principle. Depreciation is used for assets whose life is not indefinite—equipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income statement over its useful life.
As an example, assume that Direct Delivery's van has a useful life of five years and was purchased at a cost of RM20,000. The accountant might match RM4,000 (RM20,000 ÷ 5 years) of Depreciation Expense with each year's revenues for five years. Each year the carrying amount of the van will be reduced by RM4,000. (The carrying amount—or "book value"—is reported on the balance sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the balance sheet will report the carrying amount of the delivery van as RM16,000, after two years the carrying amount will be RM12,000, etc. After five years—the end of the van's expected useful life—its carrying amount is zero.
Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on the balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense. The result is that a building's market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.
Another asset, Office Equipment, may have a fair market value that is much smaller than the carrying amount reported on the balance sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants do not consider depreciation to be a valuation process.) The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.
Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time.
Marilyn cautions Joe that the balance sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company's reputation—as excellent as it might be—will not be listed as an asset. It also means that Bill Gates will not appear as an asset on Microsoft's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. Joe is surprised to hear this, since in his opinion these items are perhaps the most valuable things those companies have. Marilyn tells Joe that he has just learned an important lesson that he should remember when reading a balance sheet.
Balance Sheet – Liabilities and Stockholders' Equity
(B) Liabilities
The balance sheet reports Direct Delivery's liabilities as of the date noted in the heading of the balance sheet. Liabilities are obligations of the company; they are amounts owed to others as of the balance sheet date. Marilyn gives Joe some examples of liabilities: the loan he received from his aunt (Notes Payable or Loan Payable), the interest on the loan he owes to his aunt (Interest Payable), the amount he owes to the supply store for items purchased on credit (Accounts Payable), the wages he owes an employee but hasn't yet paid to him (Wages Payable).
Another liability is money received in advance of actually earning the money. For example, suppose that Direct Delivery enters into an agreement with one of its customers stipulating that the customer prepays RM600 in return for the delivery of 30 parcels every month for 6 months. Assume Direct Delivery receives that RM600 payment on December 1 for deliveries to be made between December 1 and May 31. Direct Delivery has a cash receipt of RM600 on December 1, but it does not have revenues of RM600 at this point. It will have revenues only when it earns them by delivering the parcels. On December 1, Direct Delivery will show that its asset Cash increased by RM600, but it will also have to show that it has a liability of RM600. (It has the liability to deliver RM600 of parcels within 6 months, or return the money.)
The liability account involved in the RM600 received on December 1 is Unearned Revenue. Each month, as the 30 parcels are delivered, Direct Delivery will be earning RM100, and as a result, each month RM100 moves from the account Unearned Revenue to Service Revenues. Each month Direct Delivery's liability decreases by RM100 as it fulfills the agreement by delivering parcels and each month its revenues on the income statement increase by RM100.
(C) Stockholders' Equity
If the company is a corporation, the third section of a corporation's balance sheet is Stockholders' Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of Stockholders' Equity is exactly the difference between the asset amounts and the liability amounts. As a result accountants often refer to Stockholders' Equity as the difference (or residual) of assets minus liabilities. Stockholders' Equity is also the "book value" of the corporation.
Since the corporation's assets are shown at cost or lower (and not at their market values) it is important that you do not associate the reported amount of Stockholders' Equity with the market value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the corporation's "net worth".) To find the market value of a corporation, you should obtain the services of a professional familiar with valuing businesses.
Within the Stockholders' Equity section you may see accounts such as Common Stock, Paid-in Capital in Excess of Par Value-Common Stock, Preferred Stock, Retained Earnings, and Current Year's Net Income.
The account Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset). Another account Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders' Equity and expenses will automatically cause a decrease in Stockholders' Equity. This illustrates a link between a company's balance sheet and income statement.
Statement of Cash Flows
The third financial statement that Joe needs to understand is the Statement of Cash Flows. This statement shows how Direct Delivery's cash amount has changed during the time interval shown in the heading of the statement. Joe will be able to see at a glance the cash generated and used by his company's operating activities, its investing activities, and its financing activities. Much of the information on this financial statement will come from Direct Delivery's balance sheets and income statements.
Note:
To learn more about the statement of cash flows, visit: Explanation of Cash Flow Statement Drills for Cash Flow Statement
The three financial reports that Marilyn introduced to Joe—the income statement, the balance sheet, and the statement of cash flows—represent one segment of the valuable output that good accounting software can generate for business owners.
Marilyn now explains to Joe the basics of getting started with recording his transactions.
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