Balance Sheet : This financial statement is a listing of the Assets (items owned), Liabilities (items owed), and Owner’s Equity (what belongs to the owner(s)). The relationships between all these items are represented by the accounting equation.
As was discussed above, Assets are items that are of value and are owned by the entity for which you are accounting. Let’s make this idea more specific. For an Asset to be listed on a Balance Sheet of a company, the item must pass three tests.
HOW DO WE KNOW WHEN AN ASSET GOES ON THE BALANCE SHEET ?
The following items give us some hints :
• The company must control the item. (This usually means ownership.)
• The item must have some value to the company.
• The item must have value that can be measured.
Let’s look at some examples. Because of the first test, a traditional Balance Sheet does not list the employees of a company, even though we may refer to them as “Assets” in a non-accounting sense, because the company does control, to a certain extent, but does not own these individuals. But what about basketball players or other professional athletes?
Doesn’t the team own them? The answer is no. What the team owns is not the players themselves, but the player’s contracts. Therefore, in this situation, the basketball team ownership would list the contracts of the players as an Asset.
With the second test almost anything that is used in the business to earn income and to generate cash does have some value. Certain items that do meet the first requirement might be eliminated from being listed as Assets by this test. Examples might include an old truck that does not work or Inventory that cannot be sold any longer because it is now outdated; for example, old versions of computer software.
An example of the third test would be when the company purchases a used machine. The company purchased it for a fixed amount of money and has a record of this transaction that clearly indicates the value of the machine. (Note: Neither the company nor the Balance Sheet deals with an over- or under-paid amount for the machine. The Balance Sheet reflects only historical cost, which is what is recorded as the amount paid for the machine, whether the company paid too much or got a bargain!)
Let’s assume that a company has built up a thriving business, and some of the reasons for this growth are the reputation of the owner and the location of the company. Neither the reputation of the owner nor the location of the company has been paid for. We also do not have any way of measuring a value to put onto these items. Therefore, they fail the third test, and cannot be listed as Assets of the business.
Another example of an Asset that would fail the test is any Asset that was given to the company. In this situation, there is no historical cost to the company and thus the Asset would not be reflected on the Balance Sheet, since it does not meet this third test. Now, you might say that we can determine a monetary value for this Asset. And you are right! In many countries, this Asset would then be reflected on the Balance Sheet at that value.
However, under generally accepted accounting principles in the United States, since there was no historical cost to this Asset, it would not be listed as one of the company’s Assets.
Below is a list of items that might be considered Assets by a company. Indicate whether they should be listed on the Balance Sheet as an Asset and why or why not.
1. A bicycle that belongs to the owner of the company
2. A building used to build and sell the bicycles of the company
3. A broken tool that is not used in the business any longer
5. Money owed to the company from sales of bicycles
6. Money owed by the company to the gas company
7. The land that the company’s building is on
8. A truck used to deliver the bicycles to customers
9. Money in the personal bank account of the owner
10. Money paid in advance for a three-year insurance policy on the business
1. No. This would not appear on the company’s Balance Sheet, since this is an Asset that belongs to the owner and not the business.
2. Yes, because this Asset is used by the business.
3. No. This was once an Asset, but is no longer one since it is not used in the operations of the business.
4. No. Although a company’s employees are often referred to as “Assets,” they are not listed as Assets on a company’s Balance Sheet since the company does not own them.
5. Yes. This is called Accounts Receivable.
6. No. This is a Liability, not an Asset (something owed rather than something owned).
7. This depends on whether the company owns the land. If it does, the land is considered an Asset because it has value.
9. No. This is an Asset of the owner, not of the company, and these Assets are kept separate.
10. Yes, this has future benefit to the company since the insurance company owes them insurance for three years into the future.
Assets are normally subdivided on the Balance Sheet into two categories. The first is called Short-Term Assets (or Current Assets). These items will be used or converted into cash within a period of one year or less.
Long-Term Assets (also called Non-Current Assets) are not expected to be converted to cash or totally “used up” in a year or less. Rather, they are expected to be of value to the company for more than a year. Long Term Assets would include equipment, land, and buildings.
Intangible Assets are Assets that cannot be physically touched. They must still meet the three tests mentioned earlier in order to be listed on the Balance Sheet as an Asset; however, they do not have any tangible characteristics.
Some examples of intangible Assets include trademarks, copyrights, and patents, as long as they have been purchased from the prior owner of the business. You might be inclined to call goodwill an intangible Asset; goodwill is based on location of the business, reputation of the owners, and name recognition by the public, and is of great value to a business.
Keep in mind, though, that because of the Generally Accepted Accounting Principles , this and any valuable item which was not paid for and thus does not have a historical cost, cannot be listed on the Balance Sheet as an Asset.
Refer to the Balance Sheet of Solana Beach Bicycle Company (figure bellow).
The Total Liabilities of the business are equal to $23,000. As with the Assets, the Liabilities list represents both short-term and long-term items. Again, similar to the list of Assets, the Short-Term Liabilities will be paid off in a period not to exceed one year. The Long-Term Liabilities will remain as debt to the company for longer than one year.
With this or any long-term debt, a portion of it becomes due and payable each year. Thus, most companies’ Balance Sheets show the current portion of all long-term debt separately in the Short-Term Liabilities section.
As we have discussed above, the equity of Solana Beach Bicycle Company comes from two sources. The Owner’s Investment of $60,000 represents the amount invested in the business by the owner through the purchase of various Assets or as money in the bank that is meant for the business. The Retained Earnings of $10,385 represent the amount of profit earned by the business since its inception minus any money that the owner may have taken out for his or her personal use.
Understanding Cash and Retained Earnings: Let’s take a moment to clarify a very important point about Retained Earnings that often causes confusion among owners of small and large businesses alike. The Retained Earnings in a business are not equal to cash, that is, “money in the bank.”
Just because a company has kept profits in the business over the years does not mean that all of these profits have been retained in the form of cash. For example, after the company earns a profit, it may take that cash and purchase Assets or pay off some of its Liabilities. Business owners often assume that they are doing well because they are making profits without taking into account the amount of cash they have at their disposal. If they do not have sufficient cash, however, they will find themselves in dire straits since they may not be able to make the payroll, pay their taxes, or pay for other Liabilities. It is absolutely essential that businesses have a good cash management plan.
A revised Balance Sheet for Solana Beach Bicycle Company using the most common subheadings would look like the one shown in Figure 2.