The Balance Sheet



From PLI’s Course Handbook

Basics of Accounting for Lawyers 2009: What Every Practicing Lawyer Needs to Know

#18409

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The Balance sheet

Lawrence M. Cirelli

Hanson Bridgett LLP

I. The Balance Sheet - An Overview

A. It is one of the four basic financial statements, the others being the Income Statement, the Statement of Cash Flows and the Statement of Stockholder’s Equity.

B. Unlike the other basic financial statements, it is a snapshot as of a particular date.

C. Assets = Liability + Stockholders’ Equity

1. This just makes sense. How do you get assets? You either borrow the money or someone invests (capital) in the business.

II. How a Balance Sheet is Developed

A. Source Documents

1. Invoices

2. Contracts

3. Checks

4. Bank Statements

B. Journals

1. Cash Disbursements

2. Cash Receipts

3. Payroll

C. General Ledger

D. Trial Balance

E. Balance Sheet

III. Accounting Concepts

A. Materiality

B. Reasonable Estimates

C. Historical Cost v. Fair Market Value

IV. Assets

A. Definition - the economic resources used to carry out an entity’s operations. They can be tangible or intangible, natural or man-made.

B. Current v. Long-Term

1. Current assets are cash and other assets expected to be converted into cash, or sold, or consumed, within one normal operating cycle or one year, whichever is longer. An operating cycle is the time it takes to begin with cash, buy necessary items to produce revenues, for example, by selling goods or services, and receiving cash. Different types of businesses have different lengths of operating cycles.

a. Cash

b. Marketable securities - readily marketable stocks and bonds held as short-term investments.

c. Receivables - accounts receivable and notes receivable with maturity dates of a year or less. These assets are valued at their net realizable value.

d. Inventory - tangible personal property (i) held for sale, in the normal course of business, (ii) in the process of production for such sale, or (iii) held for use in the process of manufacturing products for sale.

1) Valuation methods include FIFO (“first-in, first-out”), LIFO (“last-in, first-out”) and weighted average.

2) Observations

a) In times of rising costs, the FIFO method results in higher inventory value, lower costs of goods sold and, thus, higher profit.

b) Also, FIFO more closely approximates replacement value.

c) In times of rising costs, the LIFO method results in lower inventory value, higher cost of goods sold and, thus, lower profit.

d) If LIFO is used during times of rising costs, since profits will be lower, taxes will be lower, and there will be more cash flow.

e) If LIFO is used, inventory probably will be valued below market value.

e. Prepaid Assets - for example, insurance, rent and taxes, which are paid in advance and consumed over some future period.

C. Non-Current Assets

1. Long-Term Investments - investments expected to be held in excess of a single operating cycle, regardless of the investment’s marketability. These include holdings of equity, other securities like bonds, property investments, and the cash surrender value of life insurance policies.

2. Property, Plant and Equipment - tangible assets used in the operation of the business, for example, buildings, equipment, machinery, land and furniture. With the exception of land, such assets are normally depreciated over their useful lives.

3. Intangible Assets - these are assets used in an entity’s business. Their value is derived from the rights held by the entity for their use. Examples include patents, copyrights, trademarks and goodwill.

4. Other Assets - for example, organization costs.

V. Liabilities

A. Definition - claims against an entity that must be satisfied with cash, other assets, new obligations or services.

B. Types of Liabilities

1. Clearly determinable liabilities - existence and amounts certain.

a. For example, accounts payable, notes payable, interest payable, unearned fees, wages payable, sales and excise taxes payable, current portions of long-term debt and payroll liabilities

2. Estimated liabilities - existence certain, but amount can only be estimated.

a. For example, product warranties payable.

3. Contingent liabilities - existence and usually amount uncertain.

a. For example, lawsuits and income tax disputes.

C. Current vs. Long-Term

1. Current liabilities are (1) payable within one year or one operating cycle, whichever is longer or (2) will be paid out of current assets or will create current liabilities.

a. Short term notes payable.

b. Current portion of long-term debt and capital leases.

c. Trade accounts payable.

d. Accrued expenses.

e. Cash dividends payable.

f. Unearned revenues.

g. Income taxes payable.

D. Long-Term Liabilities

1. Notes payable.

2. Bonds payable.

3. Mortgages.

4. Non-current obligations under capital leases.

5. Pension obligations.

6. Minority interests.

7. Contingent liabilities.

E. Contingent Liabilities

1. FASB (Financial Accounting Standards Board) Statement No. 5 defines a contingency as “an existing condition, situation or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”

2. Classifications

a. Probable - future event resolving the uncertainty is likely to occur.

b. Remote - there is only a slight chance that the event will occur.

c. Reasonably possible - the chance of the event occurring is more than remote, but less than probable.

3. Accounting for contingent liabilities.

a. They are charged against earnings if:

1) It is probable an asset will be impaired or a liability incurred as of the date of the financial statements, and

2) The amount can be reasonably estimated.

b. If the liability is reasonably possible, the nature of the contingency and the estimate of possible loss or range if an estimate cannot be made is to be disclosed in the notes to the financial statements.

VI. Stockholders’ Equity

A. Contributed capital.

1. Capital stock - the legal capital retained by the company (i.e., the minimum amount the company cannot pay out in dividends).

2. Additional paid-in capital - the additional capital contributed in excess of the legal minimum.

B. Unrealized capital.

1. Unrealized capital - this account is used to classify the receipt or usage of assets without a corresponding entry in the liability section (i.e., donations).

C. Retained earnings.

1. Retained earnings - the total amount of an entity’s earnings not distributed to the stockholders. That is, the retained amount of profit not distributed in the form of dividends.

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