by Mark J. O'Donnell
This month we will review the financial map called the Balance Sheet. The rules for the map are Generally Accepted Accounting Principles (GAAP). The maps purpose is to report the company’s financial position on a particular day.
For example, here is an elementary balance sheet
Current assets
Cash $10,000
Accounts receivable 34,000
Inventory 5,000
Prepaid Insurance 3,000
Total current assets 52,000
Machinery 25,000
Accumulated depreciation (7,000)
Total assets $70,000
Current liabilities
Accounts payable $15,000
Credit cards payable 5,000
Line of credit 5,000
Total current liabilities 25,000
Long-term Note 15,000
Total liabilities 40,000
Equity 30,000
Total assets and liabilities $70,000
Here are a few basic rules:
1. The balance sheet is as of a particular date, e.g., December 31, 2021. It changes every day. Think of it as a snapshot. It is relevant for that moment; it does not reflect changes over time (that would be a movie or income statement).
2. GAAP requires that assets be stated at the lower cost or market. If the fair value of an asset is less than the cost, it is reduced to fair value.
3. Assets and liabilities are classified as current and noncurrent. Current assets will become cash in one year or less. Current liabilities will require cash in one year or less.
Most lines on a balance sheet represent property, a right to property, or a legal liability. Many are easy-to-understand items like Cash, Accounts Receivable, and Credit Card Debt. They represent things we recognize and are both tangible and accurately measured. Some items are not as tangible and represent accounting estimates. For example, see the ‘accumulated depreciation’ item associated with your machinery. Unlike other assets on our balance sheet, this line item attempts to measure the wasting of machinery over time by gradually reducing the asset value. Accounts like that are not tangible and are likely a measurement item. Another good example is prepaid insurance. You paid for 12 months of coverage but have only used seven by year-end, so you still ‘own’ 5 months of coverage. This account’s value represents the remaining premium.
Finally, there is ‘Equity.’ It is your total assets, less total liabilities. Here is an example. Say your home is worth $450,000. That is real. Your mortgage is $200,000. That is also real. The difference is not ‘real.’ It is a mathematical result. When we talk about the equity in our home, it is simply the difference between the value and the mortgage. Similarly, the Equity on a balance sheet is a numerical representation of the owner’s interest in the assets, net of liabilities.
It is all confusing at first. Here is some homework. Get out one of your company’s current balance sheets. Highlight the assets and liabilities that are “real.” For assets, start with the ones the bank considers collateral. For liabilities, the ‘real’ will be the ones that will let you know if you do not pay them timely. Likely, several items will not be highlighted. Most of those will be related to ‘measuring’ items, like prepaid insurance.
Next month in part two, we will discuss more of the items on a balance sheet and begin discussing what makes a balance sheet strong.
Questions? Please drop me a note at markodonnell@stcpa.com.
Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.
Submitted 2 years 30 days ago