Imagine that you make a list of everything that is important to you. Along with this list you attach values to all of these items. Then you make a list of everything that you owe to others, and again you attach values to these items. Then you subtract the total value of the second list from the total value of the first. Voila! You have just created the basic components of a Balance Sheet.
In a business, the first list of items is called Assets. Assets are valuable resources owned by the business and can be either short- or long-term in nature. Your second list of items is called Liabilities. Liabilities are what you owe to others for resources that were furnished to the business.
The parties to whom the company owes money are normally called creditors. The creditors are said to “have a claim against the Assets.” Table 1 illustrates the origin of some Liabilities a company or individual might incur.
Table 1: WHERE DO LIABILITIES COME FROM?
|What They Are Called||Where Liabilities Originate|
|Accounts payable||Purchase of items|
|Wages payable||Services from employees, not yet paid|
|Utilities payable||Utilities used, not yet paid for|
|Rent payable||Unpaid rent|
Your third list can be labeled Owner’s Equity. Owner’s Equity reflects the amount the owner has invested in the firm. There are two sources of Owner’s Equity:
- The amount of money provided directly by the owner or other investors, called Owner’s Investment; and,
- The amount retained from profits, called Retained Earnings.
Profit takes many forms : Profits are not always cash; profit can be made up of promises to pay money as well. For example, when there is a sale for a receivable, there will be Revenue, but no cash coming into the company. The money will come in during a later time period but can be considered profit for the company.
Let’s look at an example. The Solana Beach Bicycle Company is a small business that makes, repairs, and sells bicycles. The company was started by Samantha Fernandez in January 2006. Sam (as all of her friends call her) has been an avid bike rider for many years and always felt she could build a “better mouse trap” or bicycle, that is. Sam invested some money she had saved and some that she had inherited into her business.
Take a look at the bicycle company’s Balance Sheet in Figure 2. This is a proprietorship, because Samantha is the sole owner of the company. The Balance Sheet would look a little different for a corporation.
By looking at the bicycle company’s Balance Sheet, you can see that there are several Assets belonging to the company that together are valued at $93,385. You can also see that the company has several Liabilities, valued at $23,000. Finally, when you subtract the Liabilities from the Assets, you can see that the company has equity (also referred to as net worth) of $70,385.
This represents a combination of the amount of money that the owner has invested into her business ($60,000), and the profit that was earned and retained in the business since its inception ($10,385). Since this is the first year of business, all of the profit must have been earned this year.
What Does the Date on the Balance Sheet Mean?
There is a great deal of disagreement as to how accountants arrive at the values that are shown above on the Balance Sheet. Of most concern are the values attached to the Assets, and consequently to the Owner’s Equity or net worth of the business. The Balance Sheet represents a “snapshot” of the financial position of the business on that specific date.
In the case of Solana Beach Bicycle Company, this point in time is December 31, 2006.
Alert! The Balance Sheet Is a Snapshot: The numbers that are represented in a Balance Sheet only represent the financial position of the business at the exact point in time for which the Balance Sheet was prepared and no other. In Figure 3, this means December 31, 2006, only, not December 30 or January 1. On any other date there might be more or less Assets and Liabilities, and thus the Balance Sheet would look different.
What Is Historical Cost?
As you saw above, all of the items on the Balance Sheet have values attached to them, but where did these numbers come from? In the United States, accountants and other users of financial statements have agreed that financial statements (including Balance Sheets) must be based on historical cost.
This means that the values on the Balance Sheet for Solana Beach Bicycle Company do not represent what the Assets or the Liabilities would be worth today if they were to be sold. Instead, the values represent what was paid for the Assets and what the business agreed to pay to the creditors on the date of the obligation.
Does this confuse the reader of the financial statements? No. Because everyone has agreed to follow this convention, everyone preparing and using these financial statements understands the language that is being spoken.