What is a balance sheet?

A balance sheet is a financial statement that shows the position of a company's assets and liabilities on a specific date. The balance sheet is prepared after preparing the statement of profit and loss statement (income statement). The balance sheet and other financial statements differ in the sense that the balance sheet shows the financial position at any given point in time. In contrast, the other financial statements show the financial performance over a particular duration.

Components of a balance sheet

A balance sheet comprises three components: assets, liabilities, and owner's equity. The following are descriptions of all three components:

  • Asset: An asset is a possession that assists a company in generating revenue. Assets are classified as either tangible assets such as plant and machinery or intangible assets such as goodwill. Assets are further classified as fixed assets or current assets based on their potential possession period. If the assets are intended to be used for a period longer than one year, they are referred to as fixed or long-term assets. Current or short-term assets are assets that are intended to be used for less than one fiscal year. Current assets include unearned income such as rent receivable, interest receivable, accounts receivable, and short-term investments.
  • Liability: A liability is a debt, an overdue payment, or an obligation. A liability, like any asset, can be classified as a current liability or a long-term liability based on how long it has been outstanding. Liabilities include home mortgages, long-term, and short-term borrowing, auto loans, loans from subsidiaries, and loans from financial institutions. Short-term liabilities should be paid with current assets or working capital, whereas long-term liabilities should be paid with fixed assets.
  • Owner's equity: Owners equity consists of the owner's capital contribution as well as the reserves and profits plowed back from the owner's equity or shareholders' equity capital.
This image shows the three components of a balance sheet- assets, liability and equity.
Components of a balance sheet

Formats of a balance sheet

The horizontal or account format and the vertical or report format are the two most common formats for presenting a balance sheet.

  • Horizontal format: Horizontal format is a two-column layout with assets and liabilities listed on either side. It is also known as a T-format or an account format. The data presented here is only for one year. As a result, comparing the financial position to the previous year is difficult using this format.
  • Vertical format: The assets and liabilities are displayed vertically on a single side from top to bottom. This presentation style is also known as the report format. This balance sheet presentation lists the valuable assets and liabilities for the current year and the previous year. As a result, it is appropriate for comparing asset and liability positions or calculating financial ratios for two years at the same time.

The balance sheet is intended for use by internal stakeholders, the company's management team, and external stakeholders such as investors and financial institutions that have extended a loan to the company and creditors.

  • The balance sheet is used by shareholders and company management to compare the company's current financial position to previous years. This comparison assists management in developing an effective monetary policy or making adjustments to existing policies in order to improve the company's liquidity and leverage positions. Working capital would be hampered by an unfavorable liquidity position. The various balance sheet ratios, such as leverage ratios, liquidity ratios, capital ratios, debt service ratios, and interest coverage ratios, demonstrate the firm's financial health. This assists management in making the best use of the available resources.
  • Potential investors use financial statements to decide whether or not to invest in the company. If a company is highly leveraged, that is, if its equity capital is less than its debt, it is considered risky. Investors are hesitant to invest in such a company.
  • Before extending any borrowing, financial institutions such as banks and non-banking finance companies use the balance sheet to determine the firm's capital requirement. To determine a company's creditworthiness, banking institutions look at its leverage and coverage ratios. When a business approaches a bank for a credit facility, the bank evaluates and thoroughly scrutinizes the company's financial statements before making any loans.
  • The balance sheet is used to calculate several important financial ratios. The balance sheet also shows the company's capital requirements. Depending on the purpose, the capital can be either short-term or long-term. For instance, working capital requirements are of short duration.
  • The balance sheets of banks assist the government in developing an appropriate monetary policy. If the regulatory body believes that banks have more liabilities than assets due to non-performing assets, the federal monetary policy is adjusted. Monetary policy influences the amount of money available in the economy. If there is enough cash available, firms will not approach banks for loans, reducing the banks' debt burden. The treasury department keeps a close eye on monetary policy.

Accounting equation

The accounting equation states that the total assets will equal the sum of liabilities and shareholders' capital. This equation forms the basis of the accounting system and can be used to check if there are any discrepancies while preparing the financial statements. The double-entry accounting system ensures that every transaction is recorded in two debit and credit entries. It means that each debit has a corresponding credit entry. Thus, every transaction will ultimately affect the assets and the liabilities. The double-entry accounting system is the reason why a balance sheet always balances.

Generally Accepted Accounting Principles (GAAP)

GAAP is a set of rules that govern the preparation of financial statements and disclosure requirements for all companies in the United States. GAAP is a regulatory requirement. GAAP is important because it contributes to investor trust. In the absence of GAAP rules, investors would not rely on their financial disclosures or the financial statements presented to them. As a result, GAAP is critical in ensuring consistency of preparation and investor confidence.

GAAP vs International Financial Reporting Standards (IFRS)

GAAP requires all companies in the United States to adhere to the GAAP guidelines, whereas IFRS is a global regulator. If a company follows the IFRS rules, it is exempt from GAAP requirements. This exemption benefits non-United States companies operating in the United States because it saves them time and effort in complying with dual regulations. The main difference here is that GAAP establishes standards or guidelines and is regulatory, whereas IFRS focuses on applicability.

GAAP hierarchy

Accountants should follow the hierarchy outlined below when preparing financial statements or making financial disclosures.

  • Statements by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants.
  • Technical bulletins by the FASB.
  • Industry audit requirement by the AICPA.
  • Accounting guides, disclosure requirements, and statements of positions of AICPA.
  • FASB implementation guide.
  • Accounting interpretation by the AICPA.

Why is balance sheet regulation required, and who is responsible for adhering to it?

In light of various scandals resulting from window dressing and various manipulations in balance sheet data resulting in meltdowns in business entities causing economic loss to various stakeholders, the state accounting boards, in collaboration with the Public Company Accounting Oversight Board (PCAOB), delegate a regulatory framework through GAAP and IFRS. To ensure true acquittal, GAAP and IFRS must be followed by incorporated public entities and co-signed by management.

Regulation for banking, NBFC’s and insurance companies

The Federal Reserve Board is one of the apex bodies in the United States that regulates the operation and maintenance of commercial banking companies' financial statements. It establishes the reporting framework that must be followed to prepare and present balance sheet data. It establishes the reporting framework that must be followed when preparing and presenting balance sheet data. NBFCs, on the other hand, are not subject to the Federal Reserve Board's jurisdiction and must instead follow the regulatory framework established by the Dodd-Frank Wall Street Reform and Consumer Protection Act for the preparation of balance sheets. The National Association of Insurance Commissioners creates the reporting and regulatory framework that all insurance companies in the United States must follow. The Internal Revenue Service establishes and regulates the taxation aspects that all companies listed above must present.

Regulation in case of liquidation and consolidation

The rules governing liquidation and consolidation are outlined in Generally Accepted Accounting Principles (GAAP) and the applicable International Financial Reporting Standards (IFRS) governing the situations mentioned earlier. Codification Accounting Standards Committee (ASC)-205 governs the regulatory framework for ceasing operations, while IFRS 10 governs consolidated balance sheets' accounting treatment and presentation.

GAAP establishes specific guidelines for financial statement preparation. These principles are discussed further below:

  • Principle of regularity: The principle of regularity states that the balance sheet must be prepared on a regular basis. There should be no gaps in the preparation of the balance sheet in any fiscal year.
  • Principle of consistency: The principle of consistency states that the accounting policies and methods used should be the same each year. There should be no changes to the policies and procedures used to prepare the balance sheet for subsequent years. This ensures that the balance sheets of different periods are comparable.
  • Principle of sincerity: The principle of sincerity requires that the balance sheet be prepared in an unbiased and sincere manner.
  • Principle of continuity: As a general rule, the balance sheet should be prepared with the assumption that the business will continue in the near future.
  • Principle of periodicity: The periodicity rule requires that all assets and liabilities be recorded and reported during the relevant accounting period.
  • Principle of materiality: According to the principle of materiality, all financial information should be fully disclosed in a transparent manner. Footnotes should be used, and off-balance-sheet items should be disclosed.
The adjoining image shows that the GAAP principles relate to regularity, consistency, sincerity, continuity, periodicty and materiality.
GAAP principles

Other rules to consider when preparing the balance sheet

Companies can prepare their balance sheets following GAAP principles, but additional regulatory requirements must be met. These measures are listed below:

  • Structure of the balance sheet: The format of the presentation is unrestricted. The financial position statement can be presented in either a vertical or horizontal format by the company. When deciding on a format, the company should consider the ease of presentation as well as the ease of comparing financial data from two periods.
  • Account presentation: The assets are listed in descending order of liquidity. This means that assets that can be easily converted into cash are prioritized over fixed assets. As a result, current assets like cash, bank balances, inventory, and debtors are mentioned first because they are more liquid than fixed assets like land and buildings, plant and machinery, equipment, and so on. Liabilities, like assets, are classified based on how quickly they must be paid. Short-term or current liabilities are listed first, followed by long-term liabilities. Finally, the shareholders' investment or equity capital, as well as the retained earnings, are presented.
  • Footnotes: Footnotes are included in all financial statements to provide additional information about the accounting policies used by the company to determine the value of assets and liabilities. Footnotes to a balance sheet typically include the inventory valuation method used, the breakdown of debtors into current and non-current debtors, and the types and nature of investments made by the company during the year.
  • Off-balance sheet items: Off-balance sheet items have no bearing on financial transactions and are not recorded in financial statements. Such items include contingent liabilities, letters of credit, revolving loans, and derivative contracts.
The image shows that the balance sheet regulations relate to structure, account presentation, date of presentation, footnotes and off-balance sheet items.
Balance sheet regulations

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:

  • Bachelor of Business Administration (Finance)
  • Masters of Business Administration (Finance)
  • Chartered Financial Analyst

Practice Problems

Question 1: Identify the term used for what the company owns and uses for revenue generation.

  1. Liability
  2. Asset
  3. Equity
  4. Machinery

Answer: (b)

Explanation: Liability refers to the outstanding expenses or the obligations of a company. Equity refers to the sum of the owner's capital and shareholders' capital. Machinery refers to the equipment that a company uses for production. Asset refers to the short-term and long-term resources owned by the company and used for revenue generation.

Question 2: Identify the term used for the information provided at the end of the balance sheet pertaining to off-balance sheet items.

  1. Disclosure
  2. Notes to balance sheet
  3. Footnotes
  4. Contingent liability

Answer: (c)

Explanation: Footnotes are provided at the end of financial statements. They are used to give details about the accounting policies, any changes in the accounting methods, and disclosure of off-balance sheet items.

Question 3: Identify the type of obligations or outstanding payments of the company which it needs to pay either in the current financial period or later.

  1. Liability
  2. Debt
  3. Asset
  4. Expense

Answer: (a)

Explanation: Liabilities are the obligations of the firm. They can be short-term or long-term. Debt, outstanding expenses, creditors, etc., are examples of liabilities.

Question 4: What does GAAP stand for?

  1. Generally Avoided Accounting Principles
  2. Globally Acceptable Accounting Principles
  3. Generally Accepted Accounting Principles
  4. Generally Acceptable Accounting Principles

Answer: (c)

Explanation: GAAP stands for Generally Accepted Accounting Principles. These are the common set of accounting principles, standards, and procedures that are issued by the Financial Accounting Standards Board.

Question 5: Identify the type of balance sheet format that displays the assets and liabilities side by side.

  1. Horizontal format
  2. Vertical format
  3. Page format
  4. Financial positions format

Answer: (b)

Explanation: In the vertical form of the balance sheet, the assets and liabilities are displayed in a T-format, i.e., side by side.

Common Mistakes

Students make a mistake in identifying certain assets and liabilities like investment, rent, non-current debtors, to name a few. The investment made by the company is an asset, whereas if investors invest in the company, it is a liability. The terminology for both categories of investment is the same. So, students tend to make a mistake. Information about off-balance sheet items and certain disclosures are mentioned in the footnotes. If the student does not go through the footnotes, ambiguity may arise.

While studying this topic, it is important to read the following topics to get a better knowledge:

  • Income statement
  • Cash flow statement
  • Funds flow statement
  • Analysis of financial statements
  • Ratio analysis

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