The Balance Sheet
To examine the financial status of a company at a fixed point in time, accountants prepare a statement of financial position, which is more commonly called a “balance sheet.” The balance sheet consists of three major components: assets, liabilities, and owner’s equity. In a corporation, owner’s equity is called shareholder equity, since it is the shareholders who own the business.
Assets are what a business owns and include cash, inventory, plant and equipment, and intellectual property, such as copyrights, trademarks, and patents. Assets also include monies owed to a business, which are called receivables.
For example, a business may have accounts that record credit it has extended to its customers. Another type of asset is the expected benefit from an already incurred expense. The expense is referred to as “prepaid,” such as the subscription fee for Industry Today that Mdumiseni Corporation paid in our earlier example. Assets are listed on a balance sheet in order of their liquidity, with the most liquid of assets, cash, appearing first.
A second component of the balance sheet is liabilities, which are what the business owes. These accounts include monies owed by the business that represent future obligations, called “payables,” such as payments owed to a business’s suppliers. Payables also include loans, which may be notes payable or mortgages. Liabilities also include deferred income, which is monies the business has received for a good or service that the business has not yet provided. When a business incurs an expense for which there is no present legal obligation, it records it as an “accrued liability.”
For example, a balance sheet that is compiled in the middle of a two-week payroll period would reflect an accrued liability of half of the pending payroll amount. The balance sheet reflects the liability, but the company has not yet disbursed the funds.
If assets represent what a business owns and liabilities represent what a business owes, then what has left over the difference between the two amounts- is called “owner’s equity,” which is, by one measure, the worth of the business. We can represent the relationship among the three components in a mathematical equation, which is called the “fundamental accounting equation.” It may be expressed as: Assets equals liabilities plus owner’s equity. Note that if a company’s liabilities exceed its assets, the company is insolvent. Another way of stating the fundamental accounting equation would be that liabilities equals assets minus owners’ equity, or owners’ equity equals assets minus liabilities.
For example, assume Mdumiseni Corporation has R10 million in assets and R7 million in liabilities. Mdumiseni Corporation would therefore be worth the difference between the assets and liabilities, that is, R3 million.
Structurally, the assets are listed on the left of a balance sheet while the liabilities are listed on the right side. Also, assets that are expected to be converted into cash or consumed within one year are called “current assets” and are listed first in order of liquidity. Assets not expected to be converted into cash or consumed within one year are called “long-term assets” and are listed after the current assets. It is the same with liabilities. Liabilities that are expected to be paid within one year are short-term liabilities and are listed first and long-term liabilities, which are those liabilities where payment is not expected to occur within one year, follow.
The Income Statement
While the balance sheet shows the financial health of a company at a given time, the statement of results of operations, commonly called the “income statement,” shows the income or loss of a company over a year. The income statement shows revenues and gains, along with expenses and losses. Revenues are the monies earned by a company for the sales of its goods and services, along with miscellaneous earnings which would include interest and dividends. Capital gains are those amounts that the company realizes, not as a result of its ordinary course of business, but, rather, from the sale of its assets, marketable securities, and other transactions, collectively referred to as other comprehensive income. Since assets are recorded at historical cost, the gain is the sale price less the amount originally paid for the asset.
For example, Mdumiseni Corporation purchases a plant for R1 000 000 in Mpumalanga, but three years later Mdumiseni determines it would be better to conduct its manufacturing operations in KwaZulu Natal. It sells its Mpumalanga plant for R1 300 000, thus realizing a gain of R300 000 on the sale.
The income statement also lists expenses and losses. Expenses are costs incurred in running the business and generating income. They include the cost of goods the company has sold, salaries and wages, rent, interest, and income taxes. Since some assets may lose value over time, a company will need to periodically deduct the lost value. This is called “depreciating” an asset, and it is accomplished by recording the reduction in value as a depreciation expense.
For example, Mdumiseni Corporation’s plant in Mpumalanga loses value through normal wear and tear. Mdumiseni, therefore, deducts R50 000 annually as a depreciation expense to reflect the loss in value of its Mpumalanga plant. For accounting purposes, the R1 000 000 plant will be worth R950 000 at the end of its first year, R900 000 at the end of its second year, and so on.
Note that, while the building itself can be depreciated, the land itself cannot, as land does not necessarily lose its value as it ages. The amounts that can be depreciated for tax purposes are set forth in tax regulations.
In addition to expenses, the income statement will show losses, which are costs that are not incurred in the ordinary course of business. Losses may include litigation, natural disasters or changes in employee pension fund liabilities.
The income statement typically lists revenues and gains first, followed by expenses and losses. Revenues and gains minus expenses and losses equals “net income,” which is how much the business earned in the time reflected by the income statement. Some companies use this “single step” approach, while others use a “multiple step” approach in the calculation of income or loss.
In the multiple step approach, “gross profit” is sales minus cost of goods sold. Subsequently, subtracting operating expenses from the company’s gross profit will give the company’s “operating margin” or “net operating margin.” Other amounts added or subtracted produce a final “net income” or “net loss” figure. This number, when used in calculations involving the number of outstanding shares held by shareholders, can provide an earnings per share amount, which is an important metric for investors and creditors.
One important relationship between the balance sheet and the income statement is that the increase in net income on the income statement equals the increase in owners’ equity on the balance sheet. For observers to evaluate the financial health of a business, financial statements will typically include income statements for three successive reporting periods.
In our next section, we will begin discussing the Accounting principles.