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The balance sheet, also known as the statement of financial position, shows the financial situation of the company on a particular date, generally the last day of its financial year. This statement lists the company’s assets, liabilities, and shareholders’ funds (owners’ equity).
An asset is something owned by a company that will be used to generate income. Assets can consist of cash, things you can convert into cash like investments, and equipment you need to make products or provide services. Most often, the asset section of the balance sheet is divided into current assets and fixed assets. Current assets include cash and other items (marketable securities, accounts receivable and inventory) that will or can become cash within the course of a calendar year. Accounts receivable refers to money owed the company by its clients or customers who have promised to pay for the products at a later date. Marketable securities are short-term investments in securities that can be converted into cash quickly. Inventory includes finished goods ready for sale, or goods in the process of being finished. Fixed assets, also called long-term assets are long-term investments in land, buildings, machinery, equipment, furniture, and other property used in running the business. Items classified as fixed also include intangible assets, such as corporate “goodwill’, or reputation, as well as patents, trademarks, and copyrights, these assets often being the most important factor for obtaining future incomes. Fixed assets have a useful life of more than one year.
Assets are listed in descending order by liquidity, or the ease with which they can be converted into cash. Thus, current assets are listed before fixed assets.
Liabilities come after assets because they represent claims against the company’s assets or what the business owes to its creditors such as banks and suppliers. The liabilities section of the balance sheet is often divided into current liabilities and long-term liabilities. Current liabilities are obligations which must de repaid within one year. These include accounts payable, notes payable, and accrued expenses. Accounts payable represent amounts owed to suppliers for goods and services purchased with credit. Accrued expenses represent all unpaid financial obligations (such as wages earned by employees but not yet paid and taxes owed to the government). Long-term liabilitieshave longer repayment terms.
If liabilities are subtracted from assets (assets – liabilities) the remaining amount is the owners’ share of a business. This is known as owners’ equity, in other words the investment of the owners in the business. The owners’ equity includes share capital (money received from the issue of shares) and the company’s reserves, including the year’s retained earnings (the portion of shareholders’ equity that is not distributed to its owners in the form of dividends).
The interdependence of these three components (assets, liabilities, and owners’ equity) constitutes the fundamental accounting equation as follows: assets equal liabilities plus owners’ equity.
ASSETS = LIABILITIES + OWNERS’ EQUITY
The accounting equation applies to all economic entities regardless of size, nature of business, or form of business ownership. The accounting equation must always remain in balance; in other words, one side must equal the other. To keep the accounting equation in balance, companies use a double-entry bookkeeping system that records every transaction affecting assets, liabilities, or owners’ equity. For example, if a company borrowed $10,000 from a bank, $10,000 would be added to assets (cash) on the left side of the accounting equation and $10,000 would also be added to liabilities (bank loans) on the right side. Thus two entries are required for every transaction and in this way the accounting equation is always kept in balance.
Thus, the balance sheet is a snapshot of a company’s financial position on a particular date, like December 31, 2014. In effect, it freezes all business actions and provides a baseline from which companies may measure change. This statement is called a balance sheet because it includes all elements in the accounting equation and shows the balance between assets on one side of the equation and liabilities and owners’ equity on the other side. Some companies prepare a balance sheet more often than once a year, perhaps at the end of each month or quarter. By reading a company’s balance sheet you should be able to determine the size of the company, the major assets owned, any asset changes that occurred in recent periods, how the company’s assets are financed, and major changes that have occurred in the company’s debt and equity in recent periods.