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Week 3The Balance Sheet

Reference: Chapter 5pp. 143-172,181-183

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Learning Objectives

• Explain the purpose of a Balance Sheet• Explain and apply the definition of assets and

liabilities• Explain and apply the definition of equity• Prepare and interpret a Balance Sheet using the T

format and narrative format• Explain and apply the measurement of assets and

liabilities to the balance sheet• Discuss the limitations of the balance sheet

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NATURE AND PURPOSE OF THE BALANCE SHEET

• Presents the financial position of an entity at the reporting date

• Lists an entity’s assets, liabilities and owner’s equity at reporting date (at a specific point in time)

• Reflects – the assets in which the entity has invested (its

investing decisions), and – how the entity has financed the assets (its

financing decisions)

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NATURE AND PURPOSE OF THE BALANCE SHEET continued

2010 2009 2010 2009

Cash at bank 12 000 30 000 Accounts payable 37 000 55 000Accounts receivable 12 000 14 000 Mortgage 10 000 10 000Inventory 30 000 28 000 Loans 45 000 45 000Motor vehicles 40 000 36 000 Total liabilities 92 000 110 000

Buildings 80 000 70 000 Owner’s equity 82 000 68 000Total assets 174 000 178 000 Total liabilities & equity 174 000 178 000

Mama Dudes CaféBalance sheet as at 30 June

Balance date

Reflects duality system & accounting equationAssets = Liabilities + Equity

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Definition of Assets

• Essential characteristics for an asset are:– the resource must be controlled by the entity– the resource must be as a result of a past event– future economic benefits are expected to flow to

the entity from the resource

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Definition of Liabilities

• Essential characteristics for a liability are:– A present obligation to another entity– The present obligation arises as a result of past

events– An outflow of resources embodying economic

benefits is expected to flow from the entity as a result of settling the present obligation

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THE DEFINITION AND NATURE OF EQUITY

• Equity is the residual interest in the assets after the liabilities are deducted

• Equity represents the claim of owner/s on the firm’s assets

• Equity comprises of various items including– Capital contribution by owners– Profits retained in the entity

EQUITY = ASSETS – LIABILITIES

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Activity 3.1

• An Italian restaurant called Appetito has established an outstanding reputation. Every lunch and dinner service the restaurant is booked to capacity, and there is a 2 month waiting list for a table for non-regular customers. The restaurant is famous for its excellent food. The owner knows that the chef is critical to the restaurant’s fame and success. The owner believes that the chef is his biggest asset, and wants to record the chef as an asset on the business balance sheet. The owner asks for your opinion on this.

• Can the chef be recorded as an asset on the balance sheet? Discuss

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FORMAT AND PRESENTATION OF THE BALANCE SHEET

• Two main formats– T-format

• Assets on left-hand side and liabilities on right-hand side• Often used for smaller entities

– Narrative format • Assets, liabilities and equity presented down the page, net

assets is also shown

• Comparative information allows users to see how firm’s financial position has changed between the previous and current periods (shown in example on slide 10)

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FORMAT AND PRESENTATION OF THE BALANCE SHEET (T-format)

2010 2009 2010 2009

Cash at bank 12 000 30 000 Accounts payable 37 000 55 000Accounts receivable 12 000 14 000 Mortgage 10 000 10 000Inventory 30 000 28 000 Loans 45 000 45 000Motor vehicles 40 000 36 000 Total liabilities 92 000 110 000

Buildings 80 000 70 000 Owner’s equity 82 000 68 000Total assets 174 000 178 000 Total liabilities & equity 174 000 178 000

Mama Dudes CaféBalance sheet as at 30 June

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FORMAT AND PRESENTATION OF THE BALANCE SHEET (Narrative format)

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CLASSIFICATION, PRESENTATION AND DISCLOSURE OF ELEMENTS ON THE BALANCE SHEET

• Accounting standards (rules) exist that prescribe the presentation, classification and disclosure requirements for assets, liabilities and equity on the balance sheet

• Assets and liabilities are generally classified, which means separated into Current and Non-Current

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Current and non-current assets and liabilities

• Distinction between current and non-current classification is based on timing

• If the economic benefits (of asset) or outflow of resources (for liability) are expected to be realised in the next reporting period (next 12 months), the asset or liability is categorised as current

• If economic benefits (of asset) or outflow of resources (of liability) are expected beyond next the reporting period, the classification is non-current

Classification in the Balance Sheet

Current Assets –assets that are cash, we will be used or converted to cash within 12 months e.g. cash accounts receivable, inventory, supplies, prepayments

Non-current Assets – assets that are not current assets (i.e. more than 12 months). e.g. building, land, equipment, motor vehicles

Classification in the Balance Sheet

Current Liabilities – the debt is expected to be settled within 12 months. e.g. Accounts payable (creditors), wages payable, bank overdraft, unearned revenue

Non-current Liability – any liability that is not a current liability. e.g. 3 year bank loan payable, mortgage payable

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Current and non-current assets and liabilities continued

• On the balance sheet, an entity will usually show total amounts for– Current asset– Non-current assets– Current liabilities– Non-current liabilities

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Classification, presentation and disclosure of assets, liabilities and equity

• Assets are classified according to their nature or function

• Classifications can reflect– Liquidity– Marketability– Physical characteristics– Expected timing of future economic benefits– Purpose

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Classification, presentation and disclosure of assets, liabilities and equity continued

• Cash and cash equivalents• Trade receivables• Inventories• Non-current assets held for

sale• Investments accounted for

using equity method

• Financial assets• Property, plant and

equipment• Deferred tax assets• Agricultural assets• Intangible assets• Goodwill

Assets – Classes include:

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JB Hi-Fi Ltd

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Classification, presentation and disclosure of assets, liabilities and equity continued

• Liabilities and equity are classified according to their nature

• Classifications may be based on:– Liquidity– Level of security of guarantee– Expected timing of the future sacrifice– Source– Conditions attached to the liabilities

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Classification, presentation and disclosure of assets, liabilities and equity continued

• Trade and other payables• Borrowings• Tax liabilities• Provisions• Financial liabilities• Secured debts

Liabilities – Classes include:

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JB Hi-Fi Ltd

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Classification, presentation and disclosure of assets, liabilities and equity continued

• Share capital– Paid-up share capital, contributed capital

• Retained earnings• Reserves (e.g. Asset Revaluation Reserve)

Equity – Classes include (for a company):

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JB Hi-Fi Ltd

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Activity 3.2

• Classify the following items as current or non-current assets, current or non-current liabilities or equity– Cash at Bank, Loan Payable (due in 5 years), Share Capital,

Accounts Receivable, Tax Payable, Inventory, Retained Earnings, Land, Equipment

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MEASUREMENT OF ASSETS AND LIABILITIES

Different methods of valuation are used for different assets and liabilities on the balance sheet.Following are some examples of different values that are shown for items on the balance sheet.

The dollar value assigned to assets and liabilities is called their “carrying amounts” or “book values”.

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MEASUREMENT OF ASSETS AND LIABILITIES continued

• Assets and liabilities initially recorded at their historical cost (original cost).

• Non-current assets can continue to be recorded at historical cost, or can be revalued to fair value (market value).

• Inventory must be valued at the lower of its cost price and estimated selling price.

• Accounts receivable must be shown at the amount that is estimated to be collectable.

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Measuring non-current assets continued

• All non-current assets with limited useful lives must be depreciated

• Land is not depreciated• Depreciation is the allocation of the cost of the

asset to expense over its useful life• On balance sheet, depreciable assets are carried

at their cost (or fair value) less accumulated depreciation (accumulated depreciation is the sum of all depreciation expense for the asset)

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Activity 3.3

• The following is an extract from the balance sheet:

• As a user of the balance sheet, what does the $12,330 total property, plant and equipment asset value mean to you?

Balance Sheet (extract) $000 $000Land at independent valuation 5,860

Buildings at fair valuation 3,790

Less Accumulated Depreciation 1,270 2,520

Plant and Equipment at cost 9,460

Less Accumulated Depreciation 5,510 3,950

Total Property, Plant and Equipment 12,330

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Activity 3.4• From the following account balances of Daisy Pty Ltd as at

30 September 2011, prepare a balance sheet in both the T-format and the narrative format:

Accounts receivable (net) 25,000

Cash at Bank $50,000

Equipment 6,000

Inventory 20,000

Land 25,000

Loan Payable (due in 2020) 5,000

Retained Earnings 96,000

Share Capital 20,000

Tax Payable 5,000

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POTENTIAL LIMITATIONS OF THE BALANCE SHEET

1. Shows asset, liability and equity values at a particular point in time and may not be representative of other points in time

2. The entity’s value is not reflected due to:– Items that generate future benefits or involve

future sacrifices and cannot be measured reliably in dollars are not shown

– The historical nature (or combinations of cost and fair values) of the balance sheet

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POTENTIAL LIMITATIONS OF THE BALANCE SHEET continued

3. Preparing a balance sheet involves: – management choices – judgements – estimations

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Summary

• The balance sheet reports an entity’s financial position at a point in time

• A balance sheet may be presented in a narrative or T-format

• Asset and liabilities are classified into current and non-current to provide for useful information for decision-making

• Different ways are used to measure different assets and liabilities on the balance sheet

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Homework Questions

• The following homework questions should be completed from the textbook before class in week 4:

Chapter 5Comprehension Questions 5.2, 5.3, 5.7 page 187Exercises 5.17, 5.18, 5.24 parts a to d, 5.11 pages 192-193Problem 5.34 page 195