There are three elements to a balance sheet, assets liabilities and equity.
Assets Liabilities and Equity Formula
As can be seen the three elements together must satisfy the accounting equation for the balance sheet to balance.
Assets = Liabilities + Equity
Assets
An asset is a resource the business has purchased in the past from which future economic benefits are expected to flow. They are items which a business owns and has control of such as inventory or motor vehicles. Additionally they can also include costs paid in advance such as rent, which will be treated as an expense in a future income statement.
Examples of Assets and Future Benefit
To illustrate suppose a business purchases a piece of machinery for use in its factory. The machinery will be in use over its useful life and therefore has a future economic benefit to the business.
In contrast to this, if a business purchases items which have no future economic benefit, then this cost will be recorded as an expense. To illustrate suppose the business has a wage cost for hours worked by factory employees. This cost has no future benefit (the hours paid for have already been worked) and the cost is treated as an expense.
Additionally costs which are immaterial may also be treated as expenses even though they might have a future benefit. For example, a box of pens has a future value, but the cost is immaterial. The time and effort needed to monitor the inventory of pens is such that it would be more efficient to record the cost as a stationery expense in the current accounting period.
Assets in Accounting
It should be noted that the term assets in accounting is much narrower than that used in the general sense. It is important to realize that not all assets have a cost. For example the inherent value of employees, customer lists or brands of a business are in the general sense assets. However they have no cost and are not regarded as assets in accounting. Consequently they are not included on the balance sheet of the business.
Assets are shown on the balance sheet of the business as either current assets or non-current assets. In the accounting records, asset accounts normally have a debit balance. Consequently they are increased by debit entries and decreased by credit entries.
Current Assets
Assets can classified as current assets if they are cash or cash equivalents, or when they are held primarily for the purpose of trade or they are realized or used as part of the normal operating cycle. Current assets includes assets such as inventory, accounts receivable, short-term investments, accrued revenue, prepaid expenses and cash.
Additionally there are other assets which are not part of the normal operating cycle. Such assets are classified as current assets if they expect to be realized within twelve months of the balance sheet date.
Current assets are shown on the balance sheet at the lower of cost or net realizable value in order of liquidity (most liquid first).
Non-Current Assets
Non-current assets are all other assets not classified as a current asset. They include long term investments in marketable securities, property, and plant and equipment.
It is important to realize that non-current assets are for use long term within the business and are not bought primarily to be sold. They are sometimes referred to as long term assets or fixed assets.
Non-current assets such as property, plant and equipment are included in the balance sheet at their original cost less accumulated depreciation.
Liabilities
A liability is an obligation to pay a third party incurred by a business as part of its trading operations. For example, when a business buys goods from a supplier on credit, the business has a liability to the supplier to pay for the goods. The settling of the liability will result in an outflow of resources. A liability can also arise from the receipt of revenue in advance. Liabilities are beyond the control of the business.
A liability is shown on the credit side of the balance sheet and is part of the fundamental accounting equation. Liabilities can be classified in the balance sheet as current liabilities or non-current liabilities.
Current Liabilities
Liabilities can classified as current liabilities when they are held primarily for the purpose of trade or they are settled as part of the normal operating cycle.
Examples of balance sheet current liabilities include the following:
- Short term notes payable
- Accounts payable
- Accrued expenses
- Deferred revenue
- Dividends payable
- Interest payable
- Short term loans
- Taxes payable
It is important to correctly identify operating current liabilities, as they form an important component of the calculation of working capital, and the current and quick liquidity ratios.
Additionally there are other liabilities which are not part of the normal operating cycle. These are classified as current liabilities if they have to be settled within twelve months of the balance sheet date. They will include liabilities such as bank overdrafts short-term loans and the current portion of long-term debt, dividends payable, and income taxes.
Non-Current Liabilities
Non-current liabilities are all other liabilities not classified as a current liabilities. They include long term debt, notes payable, and bonds payable.
Non-current liabilities are those which are payable in a period of time greater than the normal operating cycle of the business or twelve months, if longer.
For most businesses, the operating cycle is shorter than twelve months, and so non-current liabilities are usually those due in more than twelve months from the balance sheet date.
Non-current liabilities are sometimes referred to as long term liabilities, and are shown on the balance sheet between current liabilities and equity, forming part of the total liabilities of the business.
Examples of non-current liabilities include the following:
- Long term bonds payable
- Long term notes payable
- Deferred revenue
- Long term loans
- Deferred income taxes
- Long-term unearned revenue
- Long term mortgages payable
Non-Current Liabilities Example
It is important that liabilities are correctly classified into current and non current components. For example, suppose a business issued 5,000 bonds paying 6% interest at the start of the financial year, January 1 2021. The bonds are issued for 500,000, and the business has an obligation to redeem 500 bonds each year starting from 2016.
At the end of the first year, December 31 2021, the interest payable of 500,000 x 6% = 30,000, and bonds of 50,000 due to be redeemed in 2022, are shown as current liabilities as they are due within 12 months of the balance sheet date. The remaining bonds of 450,000 are shown as long term liabilities as they are due to be redeemed in more than 12 months from the balance sheet date.
Assets and Liabilities Comparison
The differences between assets and liabilities discussed above are summarized in the table below.
| Assets | Liabilities |
|---|---|
| Resource | Obligation |
| Future benefit | Future sacrifice |
| Under control of business | Beyond control of business |
| Arises from past event | Arises from past event |
Equity
Equity is the amount due to the owners of the business, this includes the paid-in capital invested by them and any retained earnings the business has. For a company the term owners equity is replaced by the term stockholders equity.
Equity can also be viewed as the net worth of business which is the difference between its assets and liabilities. This can be seen by rearranging the basic accounting equation.
Assets = Liabilities + Equity
This can be rearranged to give the following:
Equity = Assets - Liabilities
It is important to understand that the equity shown in the balance sheet does not reflect the market value of the equity but is simply the difference between the assets of the business at cost and the liabilities.
Assets Liabilities and Equity Summary
Together, assets, liabilities, and equity make up the balance sheet of a business. The balance sheet provides important information to stakeholders such as investors, suppliers, and regulators, about the financial health and stability of the business.
Last modified February 1st, 2023 by Michael Brown
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.
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Posted By: Michael Brown Balance Sheet, Tutorials
February 1, 2023
Balance Sheet Basics
I'm a seasoned financial expert with extensive knowledge in accounting principles, specifically focusing on balance sheets. I've been actively involved in the field for many years, working as a chartered accountant and consultant. My experience includes serving as a CFO or controller for various companies, building financial models across diverse industries, and managing small businesses.
Now, let's delve into the concepts mentioned in the article about balance sheets:
1. Assets:
- Assets are resources owned by a business that are expected to provide future economic benefits.
- Examples include inventory, motor vehicles, prepaid expenses, and long-term investments.
-
Not all assets have a cost; inherent values like employees or brands may not be considered assets in accounting.
Current Assets:
- Cash, cash equivalents, and assets held for trade or normal operating cycles.
-
Examples: inventory, accounts receivable, short-term investments, prepaid expenses.
Non-Current Assets:
- Long-term investments, property, plant, and equipment.
- Non-current assets are for long-term use within the business.
2. Liabilities:
- Liabilities are obligations to third parties incurred through business operations.
- Examples include short-term notes payable, accounts payable, and long-term debt.
-
Liabilities are classified as current or non-current based on the time to settle.
Current Liabilities:
- Settled within the normal operating cycle or 12 months.
-
Examples: short-term loans, taxes payable, accrued expenses.
Non-Current Liabilities:
- Liabilities payable beyond the normal operating cycle or 12 months.
- Examples: long-term bonds payable, deferred income taxes, mortgages payable.
3. Equity:
- Equity represents the amount due to the owners of the business.
- It is the difference between assets and liabilities: Equity = Assets - Liabilities.
-
Equity includes paid-in capital and retained earnings.
For a company, the term "owners equity" is often replaced by "stockholders equity."
These concepts together adhere to the fundamental accounting equation: Assets = Liabilities + Equity. The balance sheet, composed of assets, liabilities, and equity, provides vital information about a business's financial health to stakeholders such as investors, suppliers, and regulators. It's crucial to understand that the equity shown in the balance sheet reflects the difference between the assets' cost and the liabilities, not the market value of equity.
