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The Law of Accounting: The Balance Sheet
 
 
The Law of Accounting: The Balance Sheet

The Balance Sheet: An Overview

In both formal bookkeeping and accounting, a balance sheet is a summarized statement detailing a company's or individual's financial transactions, including the assets, liabilities, and equity for a specified time frame.

Commonly referred to as a balance sheet, the name is highly apropos because it reflects the essential law of accounting wherein the components of the balance sheet must by definition be equal, or balance. Adhering to the most basic accounting principle, the balance sheet must comply with the following formula: assets equal liabilities plus owners' equity.

Often described as a snapshot of the company's financial condition at a specific point in time, the balance sheet is the only one of the four basic financial statements that focuses upon a single point in time, as opposed to a period of time.

Balance Sheet: Components

Contemporary balance sheets tend to have three parts: assets, liabilities, and shareholders' or owners' equity. Typically, the primary categories of assets are listed first, followed by the categories of liabilities.

The third part of the balance sheet includes the "net assets" or "net worth." Both terms are used for the amount you get when you calculate the difference between the assets and the liabilities.

Shareholders' Equity/Owners' Equity

The "net assets" or "net worth" component is also referred to as the shareholders' equity or owners' equity.

Formally, shareholders' equity is considered to be part of the company's liabilities. Essentially, shareholders' equity consists of funds owed to shareholders, although these payments are not made until all other liabilities have been remunerated.

Generally speaking, because items listed under liabilities have more definitive amounts and payment particulars, shareholders' equity figures are not included within this component of the balance sheet.

Although shareholders' equity may be listed in a separate section, it is still included with the listed assets and liabilities when arriving at a balanced figure. To arrive at such a state of balance, records of the values of each of the balance sheet's accounts are maintained via the double-entry bookkeeping system, and shareholders' equity must equal assets minus liabilities.

Shareholder's equity is commonly used to determine "return on equity (ROE)." Reflected as a percentage figure, it is a measure of the amount of earnings a company generates in four quarters, as compared to its shareholder's equity.


Book Value

As we know, Assets = Liabilities + Shareholder's/Owner's Equity, and as such, Shareholder's/Owners' Equity would include liquid assets such as cash, hard assets (e.g., real estate), and retained earnings. In this sense, shareholders' equity, as a whole, is able to show the liquidation value a company has in the event all of its assets should be sold.

Akin to the Kelley Blue Book used in automobile shopping, "book value" uses shareholder equity to determine the value of a company. Quite literally, book value determines a company's worth based upon figures found within its accounting ledger.

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To calculate a company's "book value per share," you take the shareholders' equity and divide it by the current number of outstanding shares.

To determine the company's price-to-book ratio (P/B ratio), you take the stock's current price and divide it by the current book value (total assets minus intangible assets and liabilities).

Traditionally, the closer to book value you can buy shares, the better a deal you are getting on your purchase. However, it should be mentioned that in today's world, book value is somewhat skeptically viewed.

This is because most companies have greater flexibility with how they value their inventory and also because inflation or deflation may be a mitigating factor. However, as far as financial companies such as banks, brokerage firms, and credit card companies are concerned, the book value remains extremely relevant.

Balance Sheet: Sample

The following list is intended to provide examples of the types of categorical line items that may be included on a balance sheet:

Assets

  • Current assets
  • Cash and cash equivalents
  • Securities
  • Accounts receivable
  • Inventories
  • Prepaid expenses
  • Investments reserved for trading
  • Additional current assets
  • Fixed assets (non-current assets)
  • Property, facilities, and equipment
  • Accumulated depreciation
  • Donations
  • Additional intangible fixed assets
  • Investments and employee benefits
  • Deferred tax assets

Liabilities and Equity

Current liabilities

  • Accounts payable
  • Current income tax liabilities
  • Current portion of bank loans payable
  • Short-term provisions
  • Other current liabilities

Long-term liabilities (fixed liabilities)

  • Bank loans
  • Security-issued debt
  • Deferred tax liabilities
  • Provisions
  • Minority holding interest

Equity

  • Share capital
  • Capital reserves
  • Revaluation reserves
  • Translation reserves
  • Retained earnings

Equity Valuation

While the term "equity valuation" might be considered an enhanced term for what is already on the balance sheet, it is still useful because it provides shareholders and potential buyers, as well as existing management, with a realistic value of what the business is worth, as compared to a potentially distorted perspective of the net assets as indicated by the balance sheet.

Many times, this imbalance stems from factors affecting the value of a business that have yet to be recorded. Another compelling development with regard to equity valuations has to do with the potential sale of a business. Because the business's present net worth, or total equity, tends to be based on its present status, if sold, the breakup value may negatively impact its overall value.

Off-Balance Sheet Entries

Currently within the accounting world, numerous meetings have been held to discuss the acceptable usage of off-balance sheet entries. The reason for such debates is that off-sheet entries, which were originally permitted so that investors did not have to align with a company's minor interest holdings, have proven to create distortions in terms of a company's actual holdings, as well as unperceived risks for investors.

By definition
, an off-balance sheet entry refers to individual legal entities (separate companies of which the parent holds less than 100 percent ownership) or contingent liabilities (e.g., letters of credit in which the parent company has guaranteed loans to separate legal entities). Though General Acceptable Accounting Procedures (GAAP) allow such items to be excluded from the parent's financial statements, they do stipulate that they be listed in footnotes.

Off-balance Sheet: Benefits

While off-balance sheet items may sound somewhat deceptive, they are not inherently bad or reflective of a company trying to get away with something.

In fact, just the opposite is sometimes true, wherein companies use off-balance sheet entries as a way of diverting the risk for investors. For instance, to reduce both the company's and its investors' exposure to risk, corporations dealing with foreign currency may opt to use exchange rate contracts and therefore do not have to list associated liabilities on their regular balance sheets.

Additionally, off-balance-sheet companies have found this tactic to be a successful way of helping finance new business ventures. In theory, the separate entities were created as a way of taking the risk of the new venture away from the parent and putting it onto an entirely separate company, either formed as a privately held partnership or a publicly traded spin-off. This way, the parent company was able to finance the new venture without draining existing shareholders' equity or further contributing to the parent's existing debt.

Often, the newly formed entities are in line with the company's principal pursuits, such as airlines seeking new alternative sources of fuels. Referred to as "subsidiaries," these newly formed entities may have been jointly funded by the parent in conjunction with outside investors specifically interested in the associated risk.

While the parent company was legally permitted to sell shares or directly borrow money, accounting and tax laws made it possible for the funding of projects to come from investors with a keen eye on investing in more risky, explorative ventures as opposed to the more stable parent company.

Off-balance Sheet: Hindrances

Although both GAAP and respective tax laws permit off-balance-sheet entries, there still appear to be gray areas wherein economic realities and other issues tend to cause unforeseen conditions.

Specifically, on account of the fact that off-balance sheets allow for the establishment of subsidiary companies, this then opens the door for the manipulation of data, such as inflating earnings and overestimating avenues for future growth.

As is true of many issues wherein creative accounting techniques, also known as financial engineering, are used, companies are under pressure to produce certain numbers and attain certain goals. Thus, they may be tempted to present data that is more in line with expectations than is true of reality.

For this reason, the concept of "full disclosure" has become a hot topic. Companies now are more closely monitored in terms of revealing all data and providing a complete accounting of their business activities.

Off-balance sheet entries may still be permissible, but because of their small-text, footnoted nature, some people still regard them as efforts to get something past the public.

With respect to off-balance sheet entries, in order to provide additional safeguarding to investors, some of the changes being discussed include:

  • prevention of officers of the parent company from also being officers of the off-balance-sheet subsidiary;
  • increasing the percentage of ownership in off-balance-sheet subsidiaries by outside and non-affiliated companies;
  • enforcing disclosure rules to ensure investors clearly understand any potential risks posed by off-balance-sheet companies.

 

 
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