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What is Balance Sheet, Truly?

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Balance SheetBalance sheets (also known as statements of financial position) present information about assets, liabilities, and owner’s equity (depending on the type of reporting enterprise, this is referred to as shareholder’s equity, net assets, members’ equity, or partners’ capital) and their relationships to each other. They reflect an enterprise’s resources (assets) and its financing structure (liabilities and equity) in conformity with generally accepted accounting principles. The balance sheet reports the aggregate effect of transactions at a point in time, whereas the statements of income, retained earnings, comprehensive income, and cash flows all report the effect of transactions occurring during a specified period of time such as a month, quarter, or year.

For years, users of financial statements put more emphasis on the income statement than on the balance sheet. Investor’s main concern was the short-run maximization of earnings per share. During the late 1960s and early 1970s, the future prospects of business enterprises were largely judged based on measures of earnings growth. But the combination of inflation and recession during the 1970s and the emphasis in FASB’s Conceptual Framework Project on the asset-liability approach to accounting theory brought about a rediscovery of the balance sheet.

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This shift toward emphasis on the balance sheet has marked a departure from the traditional transaction-based concept of income toward a capital maintenance concept espoused by economists. Under this approach to income measurement, the amount of beginning net assets would be compared to the amount of ending net assets, and the difference would be adjusted for dividends and capital transactions. Only to the extent that an enterprise maintained its net assets (after adjusting for capital transactions) would income be earned. By using a capital maintenance concept, it was asserted that investors would theoretically be better able to predict the overall profit potential of the reporting enterprise.

The balance sheet is studied in order to assess the enterprise’s liquidity, financial flexibility, ability to pay its debts when due, and to distribute cash to its investors to provide an acceptable rate of return. An enterprise’s liquidity refers to the extent to which it holds cash or cash equivalents in the normal course of operating its business. The concept of financial flexibility is broader than the concept of liquidity. Financial flexibility is a company’s ability to take effective actions to alter the amounts and timing of its cash flows so it can respond to unexpected needs and opportunities. Financial flexibility includes the ability to raise new equity capital or to borrow additional amounts by, for example, utilizing unused lines of credit.

The rights of the shareholders and other suppliers of capital (bondholders and other creditors) of an enterprise are many and varied. The disclosure of these rights is an important objective in the presentation of financial statements. The rights of shareholders and creditors are mutually exclusive claims against the assets of the enterprise, and the rights of creditors (liabilities) take precedence over the rights of shareholders (equity). Both sources of capital are concerned with two basic rights: the right to share in the cash or property disbursements (interest and dividends) and the right to share in the assets in the event of liquidation.

Although a balance sheet presents an enterprise’s financial position, it does not purport to report its value. It cannot for reasons that include:

  • The values of certain assets, such as human resources, secret processes, and competitive advantages are not included in a balance sheet despite the fact that they have value and will generate future cash flows.
  • The values of other assets are measured at historical cost, rather than market value, replacement cost, or specific value to the enterprise. For example, property and equipment are measured at original cost reduced by depreciation, but the underlying asset’s value can significantly exceed that adjusted cost and the assets may continue to be productive even though fully depreciated in the accounting records.
  • The values of most liabilities are measured at the present value of cash flows at the date the liability was incurred rather than at the current market rate. When market rates increase, the increase in value of a liability payable at a fixed interest rate that is below market is not recognized in the balance sheet. Conversely, when interest rates decrease, the loss in value of a liability payable at a fixed rate in excess of the market rate is not recognized.

 

 
In recent years, FASB standards have increasingly employed fair value as the relevant measure for items presented in the balance sheet. For example:

  • ASC 320, Investments—Debt and Equity Securities, changed the relevant measure for most investments in securities to fair value from the lower of cost or market.
  • ASC 815, Derivatives and Hedging, requires derivative financial instruments, whether asset or liabilities, to be reported at fair value which, prior to that pronouncement, were not reported on the balance sheet at all.
  • ASC 820, Fair Value Measurements and Disclosures, improves the consistency and comparability of the fair value measurements appearing in the balance sheet. Measuring more assets and liabilities at fair value enhances the ability of a balance sheet to report a measure that more closely approximates the enterprise’s value.

 

In many industries, it is common for the balance sheet to be divided into classifications based on the length of the enterprise’s operating cycle:

  • Assets are classified as “current” if they are reasonably expected to be converted into cash, sold, or consumed either within one year or within one operating cycle, whichever is longer.
  • Liabilities are classified as “current” if they are expected to be liquidated through the use of current assets or incurring other current liabilities.

 

The excess or deficiency of current assets over or under current liabilities, which is referred to as net working capital, identifies, if positive, the relatively liquid portion of the enterprise’s capital that is potentially available to serve as a buffer for meeting unexpected obligations arising within the ordinary operating cycle of the business. In some industries, the concept of working capital has little importance and the balance sheet is not classified. Such industries include broker-dealers, investment companies, real estate companies, and utilities. Personal financial statements are unclassified for the same reason.

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