Reading a financial statement: The balance sheet (assets, liabilities and equity)
|A set of financial statements is comprised of several key statements. This article explains the balance sheet. Related articles contain details on the income statement and the cash flow statement (and more).|
When you read a set of financial statements, you’ll see that the balance sheet has three sections:
These three sections of the balance sheet are explained below.
Balance sheet: Assets
An asset is an item that the company owns, with the expectation that it will yield future financial benefit. This benefit may be achieved through enhanced purchasing power (i.e., decreased expenses), revenue generation or cash receipts.
Different types of assets
Current assets are those assets that you expect to either convert to cash or use within one year, or one operating cycle―whichever is longer. Examples of current assets include cash, accounts receivable and inventory (e.g., raw materials, work in progress, finished goods).
Long-term assets are those that you use in the operation of your company and that will continue to offer benefit beyond a single year or operating cycle. Examples of long-term assets include buildings, machinery and equipment (also known as fixed or capital assets). Many long-term assets are amortized as they are used.
Assets can also be intangible, such as trade secrets, industry know-how, patents or copyrights. Intangible assets are expected to produce value simply through the rights and privileges conferred by owning them.
Generally Accepted Accounting Principles (GAAP) often requires that assets be recorded based on certain criteria. Assets are generally defined as items that:
- Are controlled by the corporation
- Are the result of a past transaction
- Will result in a future benefit to the corporation
This definition is fairly intuitive and usually agrees with a company’s internal analysis of their assets. However, a company’s analysis and GAAP may differ over the values. This is particularly true for intangible assets and assets that are developed internally.
GAAP requires assets to be valued using a specific method (which may be cost or fair market value). Additionally, accounting is traditionally conservative. As a result, items are often required to be expensed if certain criteria cannot be met that prove there will likely be a future benefit to the corporation.
The notes to the financial statements can be very helpful in understanding the values that have been given to an asset and why it might differ from your expected valuation.
Balance sheet: Liabilities
The opposite of assets are liabilities. Liabilities are amounts that the company owes and will have to settle in the future.
Different types of liabilities
Current liabilities are those that are expected to be settled within one year, or one operating cycle―whichever is longer. Examples of current liabilities include accounts payable, demand loans and current portions of long-term liabilities.
Current liabilities are often compared to current assets as a measure of liquidity.
Liabilities are generally defined as items that:
- Are a present obligation of the corporation
- Are the result of a past transaction
- Will result in a future cost to the corporation
Like assets, many liabilities are intuitive. However, there may be some instances where a liability needs to be recorded although the company may not have perceived it as one. An example of this would be a finance lease where there is no present obligation to pay the future lease payments. However, because you have essentially agreed to take on substantially all of the benefits of ownership of the asset, GAAP requires you to record a liability. Another example is where preferred shares may essentially have the qualities of debt financing and must be recorded, at least in part, as a long-term liability rather than as equity.
As with assets, there will be some instances where the valuation may also vary from what you expect.
Balance sheet: Equity
Equity is made up of two main components: equity instruments and retained earnings.
Contributed surplus is also recorded in the equity portion of the balance sheet for earnings that are not profits. Retained earnings (or deficit) are discussed as part statement of retained earnings.