Chima moves on to explain the balance sheet, a financial statement that reports the amount of a company's
(A) assets,
(B) liabilities, and
(C)
stockholders' (or owner's) equity at a specific point in time.
Because
the balance sheet reflects a specific point in time rather than a period
of time, Chima likes to refer to the balance sheet as a
"snapshot" of a company's financial position at a given moment. For
example, if a balance sheet is dated December 31, the amounts shown on the
balance sheet are the balances in the accounts after all transactions
pertaining to December 31 have been recorded.
(A)
Assets
Assets
are things that a company owns and are sometimes referred to as the resources
of the company. Femi readily understands this—off the top of his head he names
things such as the company's vehicle, its cash in the bank, all of the supplies
he has on hand, and the dolly he uses to help move the heavier parcels. Chima
nods and shows Femi how these are reported in accounts called Vehicles, Cash,
Supplies, and Equipment.
She mentions one asset Femi hadn't
considered—Accounts Receivable. If Femi delivers parcels, but
isn't paid immediately for the delivery, the amount owed to Fast Delivery is an
asset known as Accounts Receivable.
Prepaids
Chima
brings up another less obvious asset—the unexpired portion of prepaid expenses. Suppose Fast Delivery pays N180,000
on December 1 for a six-month insurance premium on its delivery vehicle. That
divides out to be N30,000 per month (N180,000 ÷ 6 months). Between December 1
and December 31, N30,000 worth of insurance premium is "used up" or
"expires".
The expired amount will be reported as Insurance Expense on December's income statement. Femi
asks Chima where the remaining N150,000 of unexpired insurance premium would be
reported. On the December 31 balance sheet, Chima tells him, in an asset
account called Prepaid Insurance.
Other
examples of things that might be paid for before they are used include supplies
and annual dues to a trade association. The portion that expires in the current
accounting period is listed as an expense on the income statement; the part
that has not yet expired is listed as an asset on the balance sheet.
Chima
assures Femi that he will soon see a significant link between the income
statement and balance sheet, but for now she continues with her explanation of
assets.
Cost
Principle and Conservatism
Femi
learns that each of his company's assets was recorded at its original cost,
and even if the fair market value of an item increases, an accountant will not
increase the recorded amount of that asset on the balance sheet. This is the
result of another basic accounting principle known as the cost principle.
Although
accountants generally do not increase the value of an asset, they might decrease
its value as a result of a concept known as conservatism. For example, after a few months in
business, Femi may decide that he can help out some customers—as well as earn
additional revenues—by carrying an inventory of packing boxes to sell.
Let's
say that Fast Delivery purchased 100 boxes wholesale for N150 each. Since the
time when Femi bought them, however, the wholesale price of boxes has been cut
by 40% and at today's price he could purchase them for N90 each. Because the
replacement cost of his inventory (N9000) is less than the original recorded
cost (N15000), the principle of conservatism directs the accountant to report
the lower amount (N9000) as the asset's value on the balance sheet.
In
short, the cost principle generally prevents assets from being reported at more
than cost, while conservatism might require assets to be reported at less than
their cost.
Depreciation
Femi
also needs to know that the reported amounts on his balance sheet for assets
such as equipment, vehicles, and buildings are routinely reduced by
depreciation. Depreciation is required by the basic accounting principle known
as the matching principle.
Depreciation is used for assets
whose life is not indefinite—equipment wears out, vehicles become too old and
costly to maintain, buildings age, and some assets (like computers) become
obsolete. Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income statement over its
useful life.
As
an example, assume that Fast Delivery's van has a useful life of five years and
was purchased at a cost of N3million. The accountant might match N600,000 (N3million
÷ 5 years) of Depreciation Expense with each year's revenues for five years.
Each year the carrying amount of the van will be reduced by N600,000.
(The carrying amount—or "book value"—is reported on the balance sheet
and it is the cost of the van minus the total depreciation since the van was
acquired.)
This means that after one year the balance sheet will report the
carrying amount of the delivery van as N2.4million, after two years the
carrying amount will be N1.8million, etc. After five years—the end of the van's
expected useful life—its carrying amount is zero.
Femi
wants to be certain that he understands what Chima is telling him regarding the
assets on the balance sheet, so he asks Chima if the balance sheet is, in
effect, showing what the company's assets are worth. He is surprised to hear Chima
say that the assets are not reported on the balance sheet at their worth
(fair market value). Long-term assets (such as buildings, equipment, and
furnishings) are reported at their cost minus the amounts already sent
to the income statement as Depreciation Expense.
The result is that a
building's market value may actually have increased since it was acquired, but
the amount on the balance sheet has been consistently reduced as the
accountant moved some of its cost to Depreciation Expense on the income
statement in order to achieve the matching principle.
Another
asset, Office Equipment, may have a fair market value that
is much smaller than the carrying amount reported on the balance sheet.
(Accountants view depreciation as an allocation process—allocating the
cost to expense in order to match the costs with the revenues generated by the
asset. Accountants do not consider depreciation to be a valuation
process.) The asset Land is not depreciated, so it will
appear at its original cost even if the land is now worth one hundred times
more than its cost.
Short-term
(current) asset amounts are likely to be close to their market values, since
they tend to "turn over" in relatively short periods of time.
Chima
cautions Femi that the balance sheet reports only the assets acquired and only
at the cost reported in the transaction. This means that a company's
reputation—as excellent as it might be—will not be listed as an asset. It also
means that Jeff Bezos will not appear as an asset on Amazon.com's balance
sheet; Nike's logo will not appear as an asset on its balance sheet; etc.
Femi
is surprised to hear this, since in his opinion these items are perhaps the
most valuable things those companies have. Chima tells Femi that he has just
learned an important lesson that he should remember when reading a balance
sheet.
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