The objectives of this chapter are to:
•
•
•
•
•
•
•
•
•
explain the nature and purpose of the ‘entity’ concept; define the major components of a balance sheet; identify and explain the ‘accounting equation’; outline the relationship between ‘assets’ and ‘sources of finance’ as disclosed in the balance sheet; explain the impact of individual transactions on ‘net assets’ and ‘owner’s capital’ contained in the balance sheet; demonstrate the impact of profit on assets and on the owner’s capital; show how assets and sources of finance are presented in the balance sheet, distinguishing between ‘fixed assets’ and ‘current assets’ on the one hand and
‘capital’, ‘current liabilities’ and ‘non-current liabilities’ on the other; outline different possible ways of valuing assets; and explain why historical cost is widely used for reporting purposes.
THE ENTITY CONCEPT
n Chapter 1 we saw that there are three main forms of trading organization
(clubs and societies do not usually trade) within the private sector of the economy – the sole trader, the partnership and the limited company. There are two important differences between sole traders and partnerships (sometimes referred to as ‘firms’) on the one hand and limited companies on the other:
I
1 The relationship between ownership and management. In the case of firms, the owner or owners run the business, whereas in the case of the limited company there may well be a significant separation between the ownership and managerial functions. This is particularly likely in the case of the public limited company, where the bulk of the finance is provided by the general public.
2 The owner’s liability for business debts. Sole traders and partners normally have unlimited liability for the debts of their firm, whereas the shareholders of limited companies are not required to contribute beyond the amount originally paid for shares issued by the company.
The latter distinction is significant when a business runs into financial difficulties.
In the case of firms, the creditors claim first against the business assets; if these are insufficient to satisfy the amounts due, the creditors can then claim against the owner’s personal wealth. In an extreme situation, the owner of a bankrupt firm could be forced to sell his or her home and all other personal belongings to meet
THE BALANCE SHEET
11
demands from the firm’s creditors. (It is to avoid this outcome that a person in business sometimes transfers the ownership of personal assets to his or her partner.)
This contrasts with the relative position of investors and creditors of a limited company, where any deficiency of business assets compared with liabilities at the date of liquidation is borne by the creditors.
Company law, therefore, regards a limited company as a separate legal entity.
The creditor contracts with the company and can claim only against its assets. No such legal distinction is recognized where the business is carried on by a sole trader or by partners. The position in accountancy, however, is quite different. It is always assumed, for accounting purposes, that the business entity has an existence separate and distinct from its owners, managers or any other individuals with whom it comes into contact during the course of its trading activities. The assumption of a separate existence, usually referred to as the entity concept, requires a careful distinction to be drawn between business affairs and personal transactions. One of the reasons for requiring this distinction to be made is that it facilitates performance assessment. A sole trader forms a business in the hope that it will earn him or her a satisfactory profit and, to discover whether this objective has been achieved, profit must be calculated only on the basis of business transactions.
Illustration 2.1
On 1 January 20X1 Mr Old was made redundant and received £30,000 in
statements Chapter Chapter A BALANCE SHEET: i - changes constantly (every time an activity occurs) ii - shows assets, liabilities and equities as of a specific date. Prepared at least once per year. iii - uses original cost (historical cost principle) for most items. Current Fair Market Value (FMV) used for some assets like marketable securities since daily price is readily available. iv - Only shows items that can be expressed in monetary units ($) Which assets or liabilities can’t be expressed…
Chapter 2 Balance Sheet and the Flow of Costs: * When costs create an immediate benefit, company records it to be an expense on the income statement. * Example: Gasoline for delivery vehicles * When cost creates future economic benefit, the company records the cost on the balance sheet as an asset * Ex: Inventory to be resold * Ex: Equipment to be later used for manufacturing * Asset = future economic benefit * Remains on balance sheet until it is used…
whiteboard. 2. Vocabulary: -inventory -asset -liability -market value -book value -solvency -debts -book value -market value -FFSC -interest-expense ratio -net farm income from operations ration -liquidity ratio 3. Another name for net worth and net worth statement. 4. What does a balance sheet show you? 5. Examples of the different assets and liabilities and their life span. (financial assets, personal assets, capital assets, current, intermediate, fixed) 6. Equation…
Abstract This paper explores the uses of financial statements, specifically the balance sheet and income statement. It explores them from a personal point of view and how the balance sheet is used in an everyday life of an individual using his own assets and liabilities and determining his net worth. As it also discusses how a manager can benefit his company by understanding the concept of a balance sheet and using it to determine how well the company is doing and its ability to pay its debts…
Current and Noncurrent Assets December 24, 2013 ACC/400 A balance sheet is a statement that summarizes the assets, liabilities, and shareholders’ equity at a specific point in time of a company (“Investopedia,” 2013). Balance sheets reflect financial health of a company at the end of a fiscal period. Assets are items of value to an organization and can be tangible, physical items or intangible items with no physical form. Assets are divided into two categories, current and noncurrent…
BALANCE SHEET JIMMY DAVIS MAY 4, 2014 ACCT 302 I am writing this paper today so that we can get to know more about balance sheets. First of all I would like to discuss my pleasure in how one day I would like to be a entrepreneur and open a store that sell sneakers are a business that is in that type of field. So in order to open a store you would need to keep a record of my financial sheets which has my balance statement in my folders as well. Most people say that…
this paper I will be discussing the balance sheet and how the use of it can be applied to my everyday life. I will also explain how I can apply my new skills to my current position at my place of employment. Select either the balance sheet or income statement and explain how the use of it may be applied to your everyday life. For this topic I have decided to select the balance sheet and how the use of it could be applied to my everyday life. The balance sheet is defined as “A financial statement…
identifying, measuring and communicating economic (financial) information about a company, primarily to investors and creditors (existing or potential). Content of Financial Reports The Management Letter The Financial Statements: Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows The Footnotes The Auditor’s Report 3 The Management Letter The management letter is the statement of management to the investors. It indicates: management…
point of time the assets of any entity must be equal to the total of equities” (Accounting for Management, 2014). This paper will discuss how the accounting equation relates to the components of the balance sheet and examples of how transactions affect the accounting equation. How the Accounting Equation Relates to the Components of the Balance Sheet The balance sheet is a financial statement which reflects the accounting equation and the company’s financial position. Assets, liabilities, and…
Ch 4, Ques 4.1 The difference between the income statement and balance sheet in regards to timing is the following: * An income statement is a report that contains information in regards to an organizations’ assets and financing in order to obtain those assets that is collected over a certain period of time * A balance sheet is snapshot of the financials for that organization (with assets on the left and liabilities on the right side) for that particular date that was requested Ch 4, Ques…