4 Balance Sheet 23.10.08

The main objective of accounting is to convey information. This objective is achieved by different accounting reports prepared by a company. One of the most important reports is the Balance Sheet. Balance Sheet is concerned with reporting the financial position of a company at a particular point in time. The balance sheet shows the assets and liabilities classified and arranged in a specific manner. Q. What is a Balance Sheet? What are the objectives of preparing Balance Sheet? Explain its characteristics. After ascertaining the profit or loss of the business, the businessman wants to know the financial position of his business. For this purpose he prepares a statement of Assets and Liabilities, which is called Balance Sheet. It is prepared on a specified date because the figure shown in the Balance Sheet is true on that date only. The totals of the Assets and Liabilities should be equal. If it is not so, it means that there is some error. The Committee on Terminology of American Institute of Certified Public Accountants has defined the balance sheet as, "a list of balances in the assets and liability accounts. This list depicts the position of assets and liabilities of a specific business at a specific point of time." Objectives of Balance Sheet: The following are the objectives of preparing a balance sheet: 1.

Principal Objective: The main purpose of preparing balance sheet is to know the financial position of the business at a particular date.

2.

Subsidiary Objectives: Though the main aim is to know the exact financial position of the firm at a particular date, yet it serves other purpose as well. i. It gives information about the actual and real owner’s equity. Though the capital of the owner indicates

owner’s equity, yet some other liabilities are to be accounted for against it also. ii. It helps the firm to make provisions against possible future losses. A provision is made in the form of the Reserves. Characteristics of Balance Sheet: The Balance Sheet as distinct from other statements has the following characteristics:

financial

1. It is a statement and not an account. Although balance sheet is a part of the final accounts and prepared with the help of accounts, yet it is not an account but a statement. 2. It is always prepared on a particular date, and thus shows the position at that date and not for a period. 3.

It has no debit side and credit side. Nor the words ‘To’ and ‘By’ are used before the names of the accounts shown therein. The headings are Liabilities and Assets.

4. It shows the financial position of the business concern. 5. It shows what the firm owes to others and also what others owe to the firm. The totals of Liabilities and Assets always are equal. Q. Short note on uses of Balance Sheet. The balance sheet reflects the financial position of the enterprise. It provides useful information to various users. The balance sheet is described as a snapshot of the financial position of a business entity. The various groups interested in the company can draw useful inferences from an analysis of the information contained in the balance sheet. The balance sheet is also called the position statement. 1. It shows the financial position of the business concern. 2. It shows what the firm owes to others and also what others owe to the firm. 3. It shows the nature and value of the assets.

It also reflects the liquidity of a firm. What information does it convey to an outsider? Balance sheet is prepared with a view to measure the true financial position of a business concern at a particular point in time. It shows the financial position of a business in a systematic form. It is a screenshot of the financial position of the business. At one glance, the position of the business, at a particular point of time, can be understood. The various groups interested in the company can draw useful inferences from an analysis of the information contained in the balance sheet. Shareholders usually have twin interests, an interest in receiving a regular income and an interest in the appreciation of their investment in shares. Investment decisions of the prospective investors and dis-investment decisions of the existing investors are influenced by the composition of assets and liabilities shown in the balance sheet. Similarly, other interested parties like regulatory and developmental agencies of the government, consumer, and welfare organizations can derive useful conclusions from a study of the balance sheet about the working of the corporate sector and its contribution to the national economy. Classification of Items: Q. Explain the meaning of: Owner’s Equity Assets Fixed Assets Accrued Liabilities Contingent Liability Accounts Receivables Owner’s Equity

Owner’s Equity is the residual interest in the assets of the enterprise. Therefore the owner’s equity section of the balance sheet shows the amount the owner have invested in the entity. However, the terminology ‘owner’s equity’ varies with different forms of organization depending upon whether the enterprise is a joint stock company or sole proprietorship/partnership concern. Sole proprietorship/partnership concern: The ownership equity in a sole proprietorship or partnership is usually reported in the balance sheet as a single amount for each owner rather than distinction between the owner’s initial investment and the accumulated earnings retained in the business. Joint Stock Company: In the case of joint stock companies, according to the legal requirements, owners’ equity is divided into two main categories. The first category called share capital or contributed capital. It is the amount that owners have invested directly in the business. The second category of owners’ equity is called retained earnings. In the other words Owners’ equity is the claim against the assets of a business entity. It could be expressed total assets of a company less claims of outsiders or liabilities. Assets "The entire property of all kinds possessed by or owing to a person or organisation is called assets". "Assets are valuable resources owned by a business and acquired at a measurable money cost". They may be: a.

Fixed Assets: These are those assets, which are acquired for relatively long periods for carrying on the business of the enterprise. Such assets are not meant for resale. For example, Land and Building, Plant and Machinery etc.

b.

Current Assets: These assets are also termed as ‘Floating or Circulating Assets’. Such assets are acquired with the intention of converting them into their values constantly. The essential difference between ‘Current Assets’ and ‘Fixed Assets’ is that the current assets are held essentially for a short period and they are meant for converting into cash. Unsold stock, debtors bills receivables, bank balance, cash in

hand, etc are some of the examples of current assets. According to the Institute of Chartered Public Accountants, U.S.A., "Current Assets include cash and other assets or resources commonly identified as those which are reasonably expected to be realised in cash or sold or consumed during the normal operating cycle of the business. c.

Fictitious Assets: Assets of no real value but included in the balance sheet for legal or technical reasons, e.g., preliminary expenses.

d.

Tangible and Intangible Assets: Tangible assets are those assets, which can be seen and touched i.e. assets having their physical existence e.g. land and building, plant and machinery, furniture and fixtures, stock-in-trade, cash, etc. Intangible assets cannot be normally sold in the open market since they are not having any physical existence e.g. goodwill, patents, trade marks, prepaid expenses etc.

e.

Liquid Assets: Assets that can be easily converted into cash like Bank account, Bills receivables, etc. As a matter of fact, all current assets excluding stock-in-hand and prepaid expenses are called liquid assets.

f.

Wasting Assets: These are the assets which are exhausted with, or which lose themselves in, the goods they produce. Mines and quarries are common examples of such assets. Copyright, patents, trademarks, etc. are also classified as wasting assets since they get exhausted with the lapse of time.

Fixed Assets These are those assets, which are acquired for relatively long periods for carrying on the business of the enterprise. Such assets are not meant for resale. For example, Land and Building, Plant and Machinery, etc. Current assets provide benefits to the organization by their exchange into cash. In the case of fixed assets, value addition arises by facilitating the process of production or trade.

All man made things have limited life. In accounting, we are concerned with the useful life of the assets. Useful life is the period for which a fixed asset could be economically used. Benefits from the fixed assets will flow to the organization throughout its useful life. Valuation of the fixed assets is usually made on the basis of original cost. However, since the assets have the limited life the cost will be expiring with the expiration of the life. Thus, valuation of the asset is reduced proportionate to the expired life of the asset. Such expired cost is known as depreciation. Example: Suppose a trader buys a delivery van at a cost of Rs. 50,000. Assume that the van will have to be discarded as junk at the end of five years. In this case we take a depreciation of Rs. 10,000 per year and the process of providing depreciation for each year will continue. At the end of the fifth year the valuation of the asset will be zero. The value of the assets at cost is usually referred to as gross fixed assets and the amount of depreciation to date as accumulated depreciation. Net value of the asset is usually referred to as net fixed assets. Fixed assets normally include assets such as land, building, plant, machinery, etc. All these items, with exception of land, are depreciated. Land is not subject to depreciate and hence shown separately from other fixed assets. Accrued Liabilities Accrued liabilities represents expenses or obligations incurred in the previous accounting period but the payment for the same will be made in the next period. In many cases where payments are made periodically, such as wages, rent and similar items, the last month’s payment many appear as accrued liabilities (especially if the practice is to pay the same on the first working day of a month). This obligation shown on the balance sheet indicates that the firm owed the said amount on the balance sheet date. Contingent Liability

These are liabilities which will exist or not, will depend on any future incident. For the sake of shareholders’, it is shown in the footnote in the Balance Sheet. The items, which may come under this sub-heading, are: i.

Claims against company, which are still not accepted by the company.

ii. Liability for amount uncalled on partly paid shares. iii. Arrears of fixed cumulative dividends. iv.Estimated amount of incomplete contracts expenditures), arrangement of which is not made.

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Other contingent liability. For example, liability for bill discounted, disputed liabilities or claim, etc. Accounts Receivables Accounts receivables are amounts owed to the company by debtors. This is the reason why we also use the term sundry debtors to denote the amounts owed to the firm. This represents amounts usually arising out of normal commercial transactions. In other words, ‘accounts receivable’ or sundry debtors represents unpaid customer accounts. These are also known as trade receivables, since they arise out of normal trading transactions. Trade receivables arise directly from credit sales and as such provide an important information for management and outsiders. In most situations these accounts are unsecured and have only the personal security of the customer. It is normal that some of these accounts default and become uncollectible. These collection losses are called bad debts. It is not possible for the management to know exactly which accounts and what amount will not collected. However, based on past experience, it is possible for the management to estimate the loss on the receivables or sundry debtors as a whole. Such estimates reduce the gross value of account receivable to their estimated realizable value. For example: Rs.

Accounts Receivable

6,00,000

Less: Estimated collection loss at30,000 5% Net realizable value of accounts5,70,000 receivable The estimated collection loss is variously referred to reserve for doubtful debts, reserve for bad debts or reserve for collection losses. It is also not an uncommon practice to refer to this as a provision instead of reserve. It is a usual practice for debts to be evidenced by formal written promises to pay or acceptance of an order to pay. These formal documentary debts represent Promissory Notes Receivable or Bills Receivable. These instruments used in trade are negotiable instruments and hence enable the trader to assign any of his receivables to another party or a bank for realizing immediate liquidity. It is also usual for account receivables to be pledged or assigned mostly to banks against short-term credits in the form of cash credits or overdrafts.