Define and explain balance sheet.
How is a balance sheet prepared?
What are the objectives of preparing a balance sheet?
Definition and Explanation:
A balance sheet is a statement drawn up at the end of each trading period stating therein all the assets and liabilities of a business arranged in the customary order to exhibit the true and correct state of affairs of the concern as on a given date.
A balance sheet is prepared from a trial balance after the balances of nominal accounts are transferred to the trading account or to the profit and loss account. The remaining balances of personal or real accounts represent either assets or liabilities at the closing date. These assets ant liabilities are shown in the balance sheet in a classified form – the assets being shown on the right side and the liabilities on the left hand side.
Grouping and Marshalling:
In a balance sheet assets and liabilities should be properly grouped and classified under appropriate headings. The individual balance of each debtor’s and creditor’s account need not be shown. Debtors and creditors should be shown in total. The grouping together of dissimilar assets will make the balance sheet misleading.
The term marshalling means the order in which assets and liabilities are stated on the balance sheet as the balance sheet exhibits the financial position of a concern even to a non technical observer. It is of great importance that the different assets and liabilities should be arranged in the balance sheet on certain principles. The balance sheet is generally marshaled in three ways:
1. The Order of Liquidity or Realizability:
According to this method assets are entered up in the balance sheet following the order in which they can be converted into cash and the liabilities in the order in which they can be paid off. The following is a format of a balance sheet based on this order:
Balance Sheet as at ……….
|Bills Payable Loans Trade Creditors Capital||Cash in hand Cash at Bank Investments Bills Receivables Debtors Stock (Closing) Stores Furniture & Fixtures Plant & Machinery Land & Buildings|
2. The Order of Permanence:
This method is the reverse of the first method. Under this method the assets are stated according to their permanency i.e., permanent assets are shown first and less permanent are shown one after another. Similarly the fixed liabilities are stated first and the floating liabilities follow. The following is a specimen of a balance sheet based on this order:
Balance Sheet as at ……….
|Capital Trade Creditors Loans Bills Payable||Land & Buildings Plant & Machinery Furniture & Fixtures Stores Stock (Closing) Debtors Bills Receivables Investments Cash at Bank Cash in hand|
3. Mixed Order of Arrangement:
This method is the combination of the first two methods. Under this method the assets are arranged in order of realisability and liabilities are arranged in order of permanence.
The first method is adopted by sol proprietors, firms and partnership concerns. The second method is adopted by companies and the third method is adopted by banking concerns.
Objectives of the Balance Sheet:
The function of the correctly prepared balance sheet is to exhibit the true and correct view of the state of affairs of any concern. In a balance sheet as the assets and liabilities are shown in details after being properly valued, a trader can judge the position of his business from it.
Classification of Assets:
The properties and possessions of a business are called assets and they are classified into the following classes:
Fixed assets are assets which are acquired not for sale but for permanent use in the business e.g., land and buildings, plant and machinery, furniture etc. These assets help the business to be carried on.
Current Assets Or Circulating Assets or Floating Assets:
Current assets denote those assets which are held for sale or to be converted into cash after some time e.g., sundry debtors. bills receivables, stock of goods etc.
Liquid assets are those assets which are with us in cash or easily converted into cash e.g., cash in hand, cash at bank, investments etc.
The assets that depreciate through “wear and tear”, whose values expire with lapse of time or that become exhausted through working are known as wasting assets. This is a sub-class of fixed assets e.g., plant machinery, mines etc.
Intangible or Fictitious Assets:
There are assets which have no physical existence. Which can neither be seen with eyes not touched with hands. These are called intangible assets or fictitious assets. They do not represent any thing valuable. They include debit balance of profit and loss account, goodwill etc.
A contingent asset is one which comes into existence upon the happening of a certain event. If that event happens the asset becomes available, otherwise not. For example uncalled capital of a limited company.
Expenses paid in advance i.e., prepaid expenses, and income earned but not received are known as outstanding assets.
Classification of Liabilities:
The liabilities of a business are classified as follows:
These are the liabilities which are payable immediately or in the near future. These liabilities are payable after a long period. Long term loans, capital of the proprietor are the examples of such kind of liabilities.
These are the liabilities which are payable immediately or in the near future, such as creditors, bank loans etc.
Contingent liabilities are those liabilities which arise only on the happening of some event. The event may or may not happen. Thus a contingent liability may or may not involve the payment of money. Examples of contingent liabilities are:
Liabilities on bills discounted: In case the bill is dishonored by the acceptor, the holder may be called upon to pay the amount to the discounter.
Liability under guarantee: In case the debtor fails to fulfill his obligation, the man who has given a guarantee or surety have to make good the loss to the creditor.
Liability in respect of a pending suit: A suit pending against a person in a court is a contingent liability because if the decision of the court goes against him, he may thereby become liable to pay compensation.
Contingent liabilities are not recorded in the books not they are included in the balance sheet. They are simply referred to by way of foot notes on the balance sheet.
Outstanding expenses and unearned income are examples of outstanding liabilities.
Classification of Capital:
The surplus or excess of assets over liabilities is called the capital or the proprietor. Capital may be classified as follows on the basis of the capital fund invested:
The portion of the funds of a concern which is represented by the fixed and floating assets is called the trading capital
The portion of the funds of a concern which is represented by the fixed assets is called fixed capital.
The portion of the funds of a concern which is represented by the floating or circulating assets is called the circulating or floating capital.
It is the amount which remains for the working of the business after the liabilities for acquiring the fixed assets have been discharged. The excess of the floating assets over the floating liabilities is also called the working capital.
The debentures and other fixed loans are sometimes called loan capital.
It is represented by fictitious assets.
Valuation of Assets:
In order to exhibit a true financial position of a business , assets are to be valued carefully. The basis upon which the various assets are valued depends to some extent on the nature of the business and the objects for which the assets are held. The following principles, however, will serve as a valuable guide in this respect:
Fixed assets are valued on the method “going concern.” Valuation of the fixed assets must be ascertained from their capacity to earn revenue and that is shy they should be valued for the purpose of the balance sheet at cost price less depreciation which is an estimated loss arising out of the use of the fixed assets in course of the business.
Floating assets are valued on the principle of the “cost or market price whichever is less.” They are valued at a figure which they are likely to realize when converted into cash and as such they are valued at cost price or market price if the same is below the cost price at the date of valuation. It is never valued at a price exceeding the cost even if the market price is in excess of the cost price at the date of such valuation.
Vertical or Report Form of Balance Sheet
|Cash at bank||———|
|Debtors (Accounts receivable)||———|
|Bills receivable (Notes receivable)||———|
|Stock in trade (Inventory)||———|
|Total Current Assets||———|
|Furniture and fittings||———|
|Plant and machinery||———|
|Total Fixed Assets||———|
|Creditors (Accounts payable)||———|
|Bills payable (Notes payable)||———|
|Total Current Liabilities||———|
|Long terms loans||———|
|Add net income for the year||———|
|Total Liabilities and Capital||———|
You may also be interested in other articles from “final accounts” chapter:
- Trading Account
- Profit and Loss Account
- Difference Between Trading Account and Profit and Loss Account
- Balance Sheet
- Difference Between Trial Balance and Balance Sheet
- Examples of Trading and Profit and Loss Account and Balance Sheet
Other Related Accounting Articles:
- Trial Balance Sheet
- What is a Balance Sheet
- Examples of Trading and Profit and Loss Account and Balance Sheet
- Budgeted Balance Sheet
- Final Accounts
Download E accounting book in MS-word format for just 20 $ - Click here to Download