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    Balance Sheet Essay (2849 words)

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    Although the balance sheet was first implemented just a couple of centuries ago,it has quickly developed and sophisticated to become nowadays a widely used andpowerful tool in the hands of professional users, well known and popular evenamong the mass public. In spite of its prominence, or may be because of it, thebalance sheet can not be easily and fully described in a few words, but still,if we leave aside its various functions and forms and any other subjectivefactors, we can state that the balance sheet is a summary of an enterprises’assets, liabilities and equity at a specific moment of time. To simplify thisdescription even further we could say that the balance sheet shows an entity’spossessions, obligations and others’ debts to it. The “objective”point of view however is often too restrictive, and the most simple things manytimes prove to be rather complex.

    . . Among the thousand more complex definitionsappended to the balance sheet one of my favorites is the definition given by. . .

    . according to which the balance sheet is a statement meant to communicateinformation about the financial position of an enterprise at a particular pointin time, summarizing the information contained in accounting records in a clearand intelligible form, giving information about the financial state of anenterprise and indicating the relative liquidity of the assets, showing theliabilities of the enterprise (i. e. what the enterprise owes and when theseamounts will fall due), able to assist the user in evaluating the financialposition of the enterprise, being however only part of the data needed by users. Or to summarize this long description with which I completely agree, I could saythat although the balance sheet is one of the most outstanding instruments inthe hands of financial analysts, managers, investors and other users, itsimportance should not be over emphasized, it has to be viewed along with manyother documents, and it is far from being the perfect and the “super”financial document.

    In order to get a more clear, complete and fair picture ofthe balance sheet, apart from reviewing the definitions given by the experts inthis field, we would need to consider as many sides and issues of the subject aspossible. Being objective we should have a look at the etymology of the word”balance”, the history of this document, its theoretical essence andthe basic concepts of accounting implied in it, its forms in the accountingpractise. In our attempt however not to become “over-objective” orscholastic, we should also review the aims and purposes of the balance sheet andthe extent to which they are fulfilled, the users of this financial statementand their contradictory needs, the negative aspects and restrictions of thebalance sheet, and finally the trends of its further development. In short, wehave to go further into the matter.

    . . The history of the so called financialstatements, and the balance sheet among them, can be traced back to RenaissanceItaly, where along with the double – entry book – keeping they first evoked torespond to the growing more and more complex needs of the accounting connectedwith the economic development of the society at that period (expansion of tradeactivities, development of banking, etc. ) and with the transition from the owner- manager model towards limited companies or the breakdown of ownership fromcontrol. Obviously these historical events called for the development of newmethods and new documents, reflecting the changes. Naturally the word”balance” itself has also an Italian origin (“bilan”, “bilanz”)though it is formed up of two latin words: “bi” – double and “lanx”- scales.

    Even from here it becomes obvious that the balance sheet is a sheet orsummary of two different aspects of one and the same thing: an entity’sfinancial position. Further to this aspect, we can take a look at the definitionof the balance sheet given by John Arnold, Tony Hope and Alan Southworth:”The balance sheet is the most inituitive and easily understood document ofaccounting. Most of us at some stage in our lives will be required to compute alisting of our possessions. Such a listing of possessions is a major element inthe construction of a balance sheet.

    “. Far from being a precise statementon what the balance sheet is, it can easily be perceived from a phylosofical andpsychological view point, and then, though defined at present times, it can berelated with the historical side of the balance sheet. The link is as simple asthat: one would generally describe his possessions by listing the things he hasand those that should be returned to him, as well as his debts to other people,further more, he would intuitively put those “lists” on the scales tofind out what his financial state is, or “to get the balance”. Toextend this etimological analogy a bit more, by putting on the different sidesof the scales the lists of his possessions and his debts, one would, probablyintuitively, measure his financial position with the height difference thatwould occur between the sides of the scales.

    Then, in the prossess of separationof the owner from the manager, this way of measurement of a person’s financialstate, was naturally transferred into what we now call an enterprise’s balancesheet. Furthermore, the fundamental method of “scaling” possessionsand debts continues be the basis of this document. As we all know a fundamentalcharacteristic of every balance sheet is that the total figure for assets alwaysequals the total of liabilities plus owners’ equity. As we have already seen,actually the above simple equation, representing the theoritical essense of thisdocument, and a basis of its practical side, is the reason for it to be calledbalance.

    Actually, the two sides of the balance sheet are merely two views ofthe same business property. Having defined the essence of the balance sheet, intheoretical aspect we have to review the concepts in accordance with which it isbuilt up. Since it is an accounting document, obviously, we would have to findout the application of the basic accounting principles in it. Further to this wecan deffinitely state that the balance sheets is in complince with all of thebasic accounting principles and concepts. Let us review some of the most obviousprinciples that can be referred to the balance sheet: The entity principle: asin all accounting documents in the balance sheet an enterprise is presumed toexist in its own right.

    It is therefore treated as a separate entity from theperson or persons who own or operate it and in no way reflects their assets orliabilities. The same applies equally to organizations that are not commonlyreferred to as businesses (charities, clubs, etc. ). The money-measurementconcept: obviously everything shown on the balance sheet is measured in money,all pointers that cannot be expressed in monetary terms, being left aside; Thecost principle: I would classify this one as may be the most contradictoryprinciples not only in the financial statements but in the accouning itself. Ican even add that it is the reason for some of the negative aspects of thebalance sheet.

    In spite of the different ways in which assets can be valued theaccountants have traditionally used the historic cost as the basis of valuationof assets in the balance sheet, assuming that the enterprise is a”going-concern”, and taking into consideration the need forobjectivity. Periodicity principle: being a document, showing the financialposition of a firm on a given date, by its very nature the balance sheet has tobe drawn at a some periods of time, so there is no way for it not to comply withthis principle. As already mentioned the balance sheet can be easily referred toand found in complience with any other concepts like the accrual concept, theduality concept, the prudence principle, etc. To finish with the aspects herereferred to as “objective”, we have summarize in short the practicalside of the balance sheet.

    No matter how often it is drawn, and what of the twopopular forms it is presented in, the balance sheet, as known, consists of threemajor parts: assets – or what the firm possesses and has the right receive infuture; liabilities – or what the firm’s obligations are; shows also how many ofthese should be returned in the short-run, and how many the enterprise canemploy in the long-run; owner’s equity – the firm’s capital, it can be alsofigured as the differense between assets and liabilities. To summarize thetheoretical and practical essense of the balance sheet, we can use anothercontemporary definition of it given by A. Belkaouli in “Accountingtheory”: “The balance sheet measures the financial positions at apoint in time”. I think the arguments of the author are clear: if we assumethat the current financial position can be described with the figures of thefirms’ possessions and obligations, listed by types and amounts than we wouldhave to agree that the balance sheet gives us this information. Obviously, beingan indicator of the enterprises’ financial position, the balance sheet is auseful and powerful tool in the hands of managers, financial analysts andexternal users. Combined with the data on other financial statements it formsdifferent ratios (like short-term liquidity ratios, short- and long- termsolvency ratios, asset utilisation ratios and many others), which are the basisof each financial analysis.

    It is these data that can tell you if a company hasenough money to continue to fund its own growth or whether it is going to haveto take on debt, issue debt, or issue more stock in order to keep on keeping on. Does a company have too much inventory? Is a company collecting money from itscustomers in a reasonable amount of time? Once again, it is the balance sheet -the listing of all of the assets and liabilities of a company – that can tellyou all of this. And once again, its understanding is crucial for the managementof the company, potential investors, and many other users. Now, having in mindall afore said, let us view another definition of the balance sheet: “Youcan not have a more meaningless and confused statement holding a position ofsuch a great importance” (Keron Bhattacharaya, “The accountancy’sfaulty sums”). Interesting opinion.

    . . In order to find out this authorspoints of view we will have to consider the balance sheet restrictions andlimitations and the needs of its users, or at least some of them. The balancesheet is in essence a list of the assets and liabilities of the enterprise ororganization at a point of time.

    The fact that it represents the position at onepoint in time is itself a limitation as it is only relevant in that point oftime. At any other time a new sheet has to be drawn up. This means that in orderfor the balance sheet to be useful it should be as up to date as possible, andthat its utility diminishes the more out of date it becomes. Similarly, in orderthat it is an accurate measure of the assets and liabilities should be as up todate as possible, and here lies another limitation. Another very stronglimitation of the balance sheet is the fact that the costs are given in theirhistorical expression.

    Although, as prevoiusly stated, this has its reasons,still in some cases it blurs the information on the sheet. This is especiallytrue applied to the accounting in high – inflation environment, and is probablyone of the reasons for the opinion of the South Asian author – Keron Bhattaraya. But even in normal economics sometimes the assets being stated as a figure whichbears little if any relation to the current value (the most obvious example ofthis in recent years has been the changes in prices and values of land andbuildings). This is a serious contradiction and recently there has been a trendshowing assets in public accounts at a valuation rather than at a historicalcost.

    Another short-coming of the balance sheet is its monetary expression. Little information can be drawn out of it on the enterprises’ activities, theprofit of certain investments or managers’ decision, the success of newproducts, the company employees. It would be impossible however to show all ofthese in one-sheet summary. As I have early pointed the balance sheet itself isa contradictory document also because of the various needs of its numberoususers and environments in which it is used. The activity in which theorganization is involved can have dramatic effects on the classification of anasset. What might not be an asset for one business would be an asset of anotherbusiness, undertaking a different activity.

    Apart from these cases, which are tosome extent reasonably clear cut, the activity can have dramatic effects on thedifficulty or otherwise of drawing up a balance sheet. Consider for example theproblems of a football club, trying to account for star players; or of a hightechnology business, trying to decide whether the cost of the patent on a newproduct is going to yield any future benefit when the state of the art ischanging so rapidly. There are also issues related to the ways in which abusiness is perceived and the ways in which the management would wish thebusiness to be perceived. For example a research has shown that the management,especially the management of smaller organizations, perceive that the bankersare interested in the amount of assets available as security for a loan oroverdraft. There is therefore a temptation to try to enhance the value of assetsperhaps by revaluing the land and building prior to applying for a loan.

    Similarly in a number of cases where a business is in trouble the assets havebeen revalued in order to bolster the image of the business and to promote theimpression of it having a “sound asset base”. In one word, what seemsgood and right to me, may not be enough for you. Still, there are many users towhich the balance sheet does not seem confused and is necessary, although theyhave conflicting needs: IRS and other government and state institutions. It isprobably fair to say that income statements are constructed with the IRS in mindmore than any other user. After all, it is the bottom line of the statementsthat determines what taxes will be due.

    Lenders are more interested in balancesheets, although the income statement is not taken lightly. The first question alender must ask is “What if this loan is not repaid?” The lender willwant something to sell to get paid back. A company’s balance sheet tells thelender what there is to sell. So a lender wants a balance sheet that indicateswhat the company owes (its liabilities) and what it owns (its assets).

    Assetsinclude such obvious things as property and cash, but also accounts receivables(what the company is owed) and prepaid expenses (like advances on rent). Thingsthe company owes (“accounts payable”) include debt and bills yet to bepaid, as well as what stockholders put into the business (“stockholderequity”) and retained earnings (profit not paid out to stockholders in theform of dividends or other payments). Lenders also want to look at the incomestatement, but they may be more interested in a cash statement. The IRS wants toknow how much profit you make, but wants profits to be adjusted to account fordepreciation (wear and tear) on assets the company owns. The lender finds thatinteresting, but the lender will not be comforted by the fact that the $1million you spend on a new building will be depreciated over 10 years when theloan is for three.

    Finally, of course, shareholders want to look at incomestatements and balance sheets. They give snapshots of the current health of thebusiness. They may be less interested in any one period’s report than the trend. Are profits getting better? Is the balance sheet fatter? That’s because theshare value does not have a simple relationship to either the balance sheet orthe income statement. The value of a business is based on what someone would payfor it to gain control of the money it will make in the future. The balancesheet gives this potential buyer an idea of how easily the company can financefuture growth and weather financial crises; the income statement gives the buyeran idea how much future profits might be.

    But an investor would need to know alot of other things before coming to a decision about how much to pay. Forpeople running the company, the financial statements are just a starting point. The really interesting numbers may not show up on a statement, such as theprofit margins on various products, projected sales, or order backlogs. Thefinancial statements pull all these things together, but any analysis of how acompany is doing needs a different kind of operational data. The best employeeownership companies share these numbers too. Now, having reviewed almost all theissues related with the balance sheet, we can say in my opinion that sine itsappearance a few centuries ago it has been an important and outstandingfinancial statement summarizing the financial position of an enterprise at aparticular point in time.

    In the quickly developing technological environemt itmight change its form, it might even change some of its principles, it will beviewed along with more and more information in the era of information, but itwill keep for some more time its “position of such a greatimportance”. BibliographyArnold J. , and S. Turley, Accounting for Management Decisions, 3rd ed. , 1996,Prentice Hall Europe (UK) Limited, London Berry A.

    and R. Jarvis, Accounting ina Business Context, 2edshnvd. ed. , 1994, Chapman & Hall, London Watts J. ,Accounting in the Business Environment, 2nd ed.

    , 1996, Pitman Publishing, LondonAdam, J. H. , Longman Dictionary of Business English, 2nd ed. , 1989, Longman GroupUK Ltd.

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