Welcome and overview



Chapter 3

The Balance Sheet

There are three financial statements, indicated in the table below. This chapter will address the balance sheet, which tells us what the business owns (assets) and owes (liabilities), and therefore what is left over for the owners (owner’s equity).

|Preferred name |Also known as… |Tells us |

|Balance Sheet |Statement of Financial Position |What the business owns and owes |

|Revenue Statement |Statement of Financial Performance |How much money the business made or lost last year |

| |Profit & Loss Statement | |

| |Income Statement | |

|Cash Flow Statement |Statement of Cashflows |Where cash came from, and went, last year |

| |Funds Statement | |

What is a balance sheet?

A balance sheet is a structured way of listing what the business owns, what the business owes, and what is left over for the owners.

Consider Movie Moments Ptd Limited, a business selling DVDs, drinks and popcorn in a rented store, which started two years ago by issuing $1,000 worth of shares to the sole shareholder and owner, John Smith. On 30 June 2010, the business has the following items that it owns and owes:

Car 30,000

Loan from bank 25,000

Payable to suppliers 30,000

Owing from customers 12,000

Shop fittings 10,000

DVD stock 30,000

Loan from shareholder 10,000

Overdraft 5,000

Credit card debt 12,000

Soft drinks for sale 1,000

Whilst this list is accurate, it tells us nothing about the business. Can you easily tell what the business owns? Can you tell what the business owes? Can you see what is left over for the owners?

From this list of things the business owns (called assets) and the things the business owes (called liabilities) we simply cannot easily tell the financial position, or state of affairs, of the business as at 30 June 2010. A balance sheet helps us sort this out.

A balance sheet is no more than a structured way of rewriting this list of what the business owns (assets), and what the business owes (liabilities).

[picture]

Discuss total assets = total liabilities + owner’s equity

As indicated in figure x, the layout of a balance sheet has a section called current, and non current, for each of assets and liabilities. The word “Current” signifies whether the asset will be converted to cash in 12 months or less (for assets), or whether the liability has to be repaid in 12 months of less (for liabilities). This is an important concept to master – current relates to whether an item will have a cash impact within the next 12 months.

The first step in creating a balance sheet from the list above is to first determine which categories each of the items relate to – to sort identify what sort of asset and liability they are. The list below has classified each of the items as either current or non current asset, or current on non current liability, and indicates the reason why that classification was made.

Review each line in the table below.

|Item |Category |Reason |

|Car 30,000 |Non current asset |Will not be sold within 12 months |

|Loan from bank 45,000 |Non current liability |Does not have to be repaid within 12 months |

|Payable to suppliers 30,000 |Current liability |Has to be paid within 12 months |

|Owing from customers 12,000 |Current asset |Will be receivedin cash within 12 months |

|Shop fittings 10,000 |Non current asset |Will not be sold within 12 months |

|DVD stock 30,000 |Current asset |Will be sold within 12 months |

|Loan from shareholder 10,000 |Non current liability |Does not have to be repaid within 12 months |

|Overdraft 5,000 |Current liability |Has to be repaid within 12 months |

|Credit card debt 12,000 |Current liability |Has to be repaid within 12 months |

|Soft drinks for sale 1,000 |Current asset |Will be sold within 12 months |

Taking this list, and then allocating the various items into the correct structure from Figure 3.x is as follows:

Movie Moments Pty Limited

Balance Sheet as at 30 June 2010

|Asset | | |Liabilities | |

|Current assets | | |Current liabilities | |

|Owing from customers (Receivables) |12,000 | |Payable to suppliers (Accounts payable) |30,000 |

|DVD stock |30,000 | |Overdraft |5,000 |

|Soft drinks for sale |1,000 | |Credit card debt |12,000 |

| Total current assets |43,000 | | Total current liabilities |47,000 |

| | | | | |

|Non current assets | | |Non current liabilities | |

|Car |30,000 | |Loan from bank |15,000 |

|Shop fittings |10,000 | |Loan from shareholder |10,000 |

| Total non current assets |40,000 | | Total non current liabilities |25,000 |

| | | | | |

|Total assets |83,000 | |Total liabilities |72,000 |

| | | | | |

| | | |Owner’s equity | |

| | | |Issued shares |1,000 |

| | | |Retained profits |10,000 |

| | | | Total Owner’s equity |11,000 |

| | | | | |

|Total assets |83,000 | |Total liabilities + owner’s equity |83,000 |

By using the structure of the balance sheet, and sorting the list into current assets, non current assets, current liabilities and non current liabilities, we can see that:

• in addition to the $1,000 in shares, the owner’s have retained profits from the business of 10,000. We can see this because the total assets ($83,000) are $11,000 more than the total liabilities ($72,000), and this difference is owner’s equity. This means owner’s equity must total $11,000. As we know that owner’s equity will contain the $1,000 of issued shares, this means there must be $10,000 of retained profits. This is the profit that business has made over the last two years.

• From the total current liabilities, we can see that the business owes $47,000 due in the next 12 months. However, the business only has current assets (ie items that will be turned to cash in the next 12 months) of $43,000. It is $4,000 short. The business may need to increase its overdraft, or borrow some money during the next 12 months. The difference between current assets and current liabilities is called working capital. Movie Moments has -$4,000 in working capital, which may be a problem.

Please note and highlight the following things:

• The heading of the balance sheet contains the name of the business, and the date at which the balance sheet is being drawn up. Balance Sheets are always expressed as at a specific date.

• There are separate headings for Assets, Liabilities and Owner’s equity

• There are separate headings for Current Assets, Non current assets, Current Liabilities and Non Current Liabilities

• There are separate totals for current assets, non current assets, current liabilities, non current liabilities

• There are separate total for Assets, Liabilities, and Owner’s Equity

• The last line has been inserted as a check for us. It is not a formal part of the balance sheet, but confirms to us that the maths is correct. The reason a balance sheet is called a balance sheet is because the assets balance (or equal) the total of liabilities and owners equity.

This is sometimes expressed as the accounting equation:

Total Assets = Total Liabilities + Owner’s equity.

So, the balance sheet is merely a structured way of sorting and writing down the things that a business owns, and owes, as at a given date. Once we know what the business owns (assets) and what the business owes (liabilities) the difference between the two is what the owner’s own. If total liabilities are greater than total assets, the owner’s shares are not worth anything, as the company will have made losses!

The balance sheet above has been set out with assets on the left, liabilities and owner’s equity on the right. It is also permissible to stack the elements of a balance sheet vertically (called a narrative form of the balance sheet). In this form, assets are first, followed by liabilities and then owner’s equity. Below is the same balance sheet for Movie Moments, except drawn in the narrative form where assets are above liabilities, which are above owner’s equity.

Movie Moments Pty Limited

Balance Sheet as at 30 June 2010

|Asset | | |

|Current assets | | |

|Owing from customers (Receivables) |12,000 | |

|DVD stock |30,000 | |

|Soft drinks for sale |1,000 | |

| Total current assets |43,000 | |

| | | |

|Non current assets | | |

|Car |30,000 | |

|Shop fittings |10,000 | |

| Total non current assets |40,000 | |

| | | |

|Total assets |83,000 | |

| | | |

|Liabilities | |

|Current liabilities | |

|Payable to suppliers (Accounts payable) |30,000 |

|Overdraft |5,000 |

|Credit card debt |12,000 |

| Total current liabilities |47,000 |

| | |

|Non current liabilities | |

|Loan from bank |15,000 |

|Loan from shareholder |10,000 |

| Total non current liabilities |25,000 |

| | |

|Total liabilities |72,000 |

| | |

|Owner’s equity | |

|Issued shares |1,000 |

|Retained profits |10,000 |

| Total Owner’s equity |11,000 |

| | |

|Total liabilities + owner’s equity |83,000 |

Exercises

3.1 Why is a balance sheet called a balance sheet?

3.2 What is the accounting equation?

3.3 Describe the major structural features of a balance sheet.

3.4 Provide the heading for a Balance Sheet for JB Hifi Limited for the year that started 1 January 2010.

3.5 Describe what is different with a narrative balance sheet form.

3.6 From the Balance Sheet for Movie Moments at 30 June 2010, find and complete the following information:

Total assets

Total current liabilities

Total current assets

Total liabilities

Owner’s equity

Issued shares

Retained earnings

3.7 Describe and give an example of a current asset.

3.8 Describe and give an example of a current asset.

3.9 Describe and give an example of a non current liability.

3.10 Describe and give an example of a non current asset.

Classifying financial items

In the next section we will explore the items typically found in each of the rectangles on a balance sheet. That is, what is typically found in current assets, non current assets, current liabilities, non current liabilities, and owner’s equity.

Typical current assets

Current assets are items of value to the business, which are either already cash, or will be turned to cash during the course of the next 12 months.

Typical current assets and their descriptions are outlined in the table below. Note that the same item can sometimes be called other things (synonyms). For example, cash could be called cash, cash at bank, cash on hand, or deposits. All of these things are the same.

In the table, where an items is called by other words they are also displayed as also known as

|Cash |Cash is a current asset because it is already cash. |

|Also known as | |

|Cash at bank | |

|Cash on hand | |

|Deposits | |

|Accounts receivable |This is amounts that the business is owed by others, often the payment for goods that have already |

|Also known as |been provided to your customers. It is a current asset because the payment is expected to be received |

|Trade debtors |within the next 12 months. The language of receivable is because it is an amount to be received by the|

|Debtors |business. The language of debtors refers to a debt that is owed to the business by someone else.. |

|Trade receivables | |

|Inventory |Inventory is the value of items that you have on hand for sale. For Movie Moments, stock is the DVDs |

|Also known as |on the shelves, and also the soft drink in the fridge for purchase. Inventory (or stock) is expected |

|Stock |to be sold and turned to cash within the next 12 months, and hence is classified as a current asset. |

|Stock on hand |The language of “closing” refers to the amount of stock at the end of the year, which is contrasted to|

|Closing Stock |“opening” stock which is the level you had 12 months ago, at the beginning of the financial period. |

|Closing inventory |Businesses which sell stock will conduct a physical stocktake at the end of their financial year to |

| |determine how much stock they have – this is a manual counting process of all of the items that they |

| |have on hand for sale. |

|Short term investments |These are short term, liquid investments, that can be turned to cash, or loans the business has |

|Also known as |extended to another party which are repayable within the next 12 months. |

|Short term loans | |

|Listed shares | |

|Prepayments |Prepayments relate to where a business pays an amount in advance (for example an insurance premium) |

|Also known as |and the period of cover extends beyond the end of the financial period. For example, if Movie Moments |

|Prepaid insurance |paid contents insurance on 1 June 2010 for one year for $120, then only $10 would relate to the year |

| |ended 30 June 2010, and $110 will relate to next year. The prepayment, of $110, is displayed on the |

| |balance sheet because it is of value to the company and has not been used. Any prepayment for a |

| |service to the business which will be performed or delivered after the end of the financial period is |

| |recorded here as a current asset. |

Typical non current assets

Non current assets are items of value to the business, which will not be sold or turned to cash during the course of the next 12 months.

Typical non current assets and their descriptions are outlined in the table below. Note that the same item can sometimes be referred to by other synonyms. For example, property could be called land and buildings, real estate, buildings or land holdings. All of these things are the same.

In the table, where an items is called by other words they are also displayed as also known as

|Land and buildings |These items are not expected to be sold within the next 12 months, as they are part of the ongoing |

|Also known as |things the business needs to function. For Business Studies purposes, these are recorded at their |

|Real Estate |cost, that is, what the business paid for the assets. |

|Property | |

|Factories | |

|Furniture and fittings |These items are not expected to be sold within the next 12 months, as they are part of the ongoing |

|Also known as |things the business needs to function. For Business Studies purposes, these are recorded at their |

|Furniture |cost, that is, what the business paid for the assets. |

|Fixtures | |

|Equipment | |

|Shop fittings | |

|Machinery | |

|Plant and equipment | |

|Depreciation |For Business Studies purposes, depreciation means the reduction in value of a non current asset which |

| |has occurred through use, wear and tear, or simply time by growing old. For example, a new car |

| |purchased ten years ago by the business is not today worth what the business paid for it. The |

| |difference between the original purchase price, and the value of the item if sold today, is called |

| |depreciation. Depreciation is recorded in the balance sheet as a negative non current asset – placed |

| |near the non current asset to which it relates. For example, any depreciation on the car owned by |

| |movie moments would be shown in the balance sheet as: |

| | |

| |Depreciation on motor vehicle (2,000) |

| | |

| |In the non current assets section of the balance sheet. |

|Intangibles |These items are intangible, that is, they are not physical objects like machinery or land or |

|Includes |buildings. Intangibles can, however, be very valuable. Examples include copyright rights, trademarks |

|Trademarks |and mastheads of newspapers. Valuation of intangibles can be difficult and involve third party |

|Copyright |specialist valuers. |

|Goodwill | |

|Patents | |

|Mastheads | |

|Intellectual property | |

|Designs | |

Current liabilities

Current liabilities are debts or obligations that the business must repay within the next 12 months. In other words, cash will be used to pay these items within the next 12 months.

Typical current liabilities and their descriptions are outlined in the table below. Note that the same item can sometimes be referred to by other synonyms. For example, accounts payable could be called creditors, trde credtiros, or payables. All of these things are the same.

In the table, where an items is called by other words they are also displayed as also known as

|Trade creditors |These are unpaid bills from your suppliers, for goods or services you have bought from them but have |

|also known as |not yet paid for. In the business you will have received invoices for these services, however you have|

|Creditors |not yet paid them on the date of your balance sheet. These amounts are payable within the next 12 |

|Accounts Payable |months. Every business will have trade creditors on their balance sheet, as every invoice is never |

|Payables |paid on a given balance sheet date. |

|Overdraft |An overdraft is a loan from the bank which you progressively withdraw as you need it. You can |

| |withdraw up to the limit of the overdraft. Banks can require immediate repayment of overdrafts, hence |

| |they are classified as a current liability. |

|Short term loan |Loans from others to the business which are required to be repaid within the next 12 months are |

| |current liabilities. An example would include a short term loan from a shareholder to help a business |

| |over a cyclical cash flow problem (like a toy store with low sales in the early months of the year). |

|Accruals |These are expenses that the business has incurred, but has not yet received an invoice for and has not|

|Also known as |paid. On the basis of experience, the business knows that an expense has been incurred during the |

|Accrued insurance |year, for which it will be invoiced, and so a current liability is recorded in the balance sheet for |

|Accrued wages |that amount. |

|Wages owing | |

|Income tax payable | |

Non current liabilities

Non current liabilities are financial obligations or debts of the business which are not required to be paid in the next 12 months. That is, cash will not be required to pay these amounts within the next 12 months.

Typical non current liabilities and their descriptions are outlined in the table below. Note that the same item can sometimes be referred to by other synonyms. For example, Long Term Debt could be called Long Term Borrowings, or Bonds. All of these things are the same.

In the table, where an items is called by other words they are also displayed as also known as

|Long term debt |These are money that others have loaned to the organisation where repayment is not due in the next 12 |

|Also known as |months. The sources of the borrowings can be different. Banks may extend loans that are not repayable|

|Bonds |for several years. A shareholder, or an investor, may loan the business money that is not repayable |

|Long term borrowings |for several years. Larger businesses can issue bonds in the capital markets, on which interest is |

| |payable during the life of the bond, and the bond amount is repaid at the end. For example, Walt |

| |Disney company has several billion dollars in bonds issued as a way of financing its business. |

|Mortgage |When a business needs long term debt to finance the purchase of specific assets, such as land and |

| |building, or new large machinery, the bank may extend a long term loan which is secured by the asset |

| |being purchased. The security taken by the bank is called a mortgage. The terms of the mortgage will |

| |provide that if the business does not repay the loan with interest as agreed then the lender can sell |

| |the asset on which they have the mortgage. Until the loan is repaid, the business cannot sell the |

| |property that is subject to the mortgage, which protects the interests of the bank. Technically |

| |speaking the item on the balance sheet should say “Long term loan” rather than mortgage, as the |

| |mortgage is an additional contract between the lender and the borrower that protects the interests of |

| |the lender under the loan agreement. |

|Debentures |These are long term borrowings from the public, usually by larger companies, and require the issue of |

| |a prospectus to potential investors. Typically an annual rate of interest is paid on the debenture, |

| |and the full amount of the debenture repaid at the end of the term. |

Owner’s equity

|Issued shares |This is the amount that the owners of the business have paid to the company for the issue of shares, |

|Also known as |and is one of the sources of finance for the business when it started originally. When the business |

|Issued capital |started, once the shares had been issued and the money received, the balance sheet would have shown |

|Shares |the same number in issued shares, and cash at bank – at that time there would only have been two items|

|Capital contributions |on the balance sheet. |

|Owner’s capital | |

|Retained earnings |This is the total of the profits and losses that have been earned by the business since it started, |

|Also known as |less any amounts that have been paid to the shareholders as dividends. The language of retained |

|Net profits |earnings comes from the fact that the business has not distributed all of the earnings to the owners |

|Reinvested earnings |of the business – it has retained some of the earnings to fund the operations and growth of the |

|Reinvested profits |business. |

|Drawings |Drawings is an amount taken from the business by the owners, and in simple examples may be shown as a |

| |negative in the owner’s equity section of the balance sheet. |

Exercises

3.11 Complete the following table to classify the following items by ticking the correct column.

| |Current |Non-Current |Current |Non-Current |Owner’s |

| |Asset |Asset |Liability |Liability |Equity |

|Issued capital | | | | | |

|Accounts payable | | | | | |

|Debenture | | | | | |

|Trade creditors | | | | | |

|Inventory | | | | | |

|Prepaid insurance | | | | | |

|Motor Vehicle | | | | | |

|Depreciation | | | | | |

|Accrued wages | | | | | |

|Prepaid insurance | | | | | |

|Land & Buildings | | | | | |

|Debtors | | | | | |

|Furniture and fittings | | | | | |

|Overdraft | | | | | |

|Long term loan | | | | | |

|Mortgage | | | | | |

|Retained profits | | | | | |

|Payables | | | | | |

|Trademarks | | | | | |

|Receivables | | | | | |

|Creditors | | | | | |

|Cash at bank | | | | | |

|Credit card | | | | | |

|Drawings | | | | | |

|Intangibles | | | | | |

3.12 Why is retained earnings called retained earnings?

3.13 Describe prepaid expenses and accrued expenses and identify where they are classified in the balance sheet.

3.14 List four items often found in current assets on a balance sheet.

3.15 List four items often found in non current assets on a balance sheet.

3.16 List four items often found in current liabilities on a balance sheet.

3.17 List four items often found in non current liabilities on a balance sheet.

3.18 List two items often found in owner’s equity on a balance sheet.

Internet resources

Flashcards for classification of balance sheet items

Video review of the balance sheet

Websites

Mootley fool

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