DEFINITION:
Balance sheet is a list of the accounts having debit balance or credit balance in the ledger. On one side it shows the accounts that have a debit balance and on the other side the accounts that have a credit balance. The purpose of a balance sheet is to show a true and fair financial position of a business at a particular date. Every business prepares a balance sheet at the end of the account year. A balance sheet may be defined as:
- "It is a statement of assets, liabilities and owner's equity (capital) on a particular date".
- "It is a statement of what a business concern owns and what it owes on a particular date". What is owns are called assets and what it owes are called liabilities.
- "It is a statement which discloses total assets, total liabilities and total capital (owner's equity) of a concern on a particular date".
- "It is a statement where all the ledger account balances which remain open after the preparation of trading and profit and loss account, find place".
Balance sheet is so called because it is prepared with the closing balance of ledger accounts at the end of the year. It has two sides - assets side or left hand side and liabilities side or right hand side. The accounts have a debit balance are shown on the asset side and those have a credit balance are shown on the liabilities side and the total of the two sides will agree.
Assets means all the things and properties under the ownership of the business i.e. building, plant, furniture, machinery, stock, cash etc. Assets also include anything against which money or service will be received i.e. creditors accrued income, prepaid expenses etc.
Liabilities means our dues to others or anything against which we are to pay money or render service, i.e. creditors, outstanding expenses, amount payable to the owner of the business (capital) etc.
Asset side of the balance sheet indicates the different types of assets owned by a concern, while liabilities side discloses the various sources through which funds have been obtained in order to acquire those assets. Balance sheet reveals the financial position of the firm on a particular date at a point of time, so it is also called "position statement". It is prepared on the last day of the accounting year and discloses concern for the whole year cannot be determined through the balance sheet because financial position is ever changing. The is why the heading of the balance sheet is given as under:
Balance Sheet as at 31st December, 2005(If accounting year ends on 31 Dec. 2005)
Features of Balance Sheet:
Balance sheet has the following features:- It is the last stage of final accounts
- It is prepared on the last day of an accounting year.
- It is not an account under the double entry system - it is a statement only.
- It has two sides - left hand side known as asset side and right hand side known as liabilities side.
- The total of both sides are always equal.
- The balances of all asset accounts and liability accounts are shown in it. No expense accounts and revenue accounts are shown here.
- It discloses the financial position and solvency of the business.
- It is prepared after the preparation of trading and profit and loss account because the net profit or net loss of a concern is included in it through capital account.
Method of Preparation of Balance Sheet:
All the information necessary for the preparation of balance sheet is available from trial balance and from some other ledger accounts. After transferring accounts relating to expenses and revenues to trading and profit and loss account, the trail balance contains only the accounts of assets, liabilities, and capital. All assets have debit balances and all liabilities and capital have credit balances. The asses are shown on the asset side of the balance sheet and liabilities and capital are shown on the liabilities side of the balance sheet after arranging them properly.As the balance sheet is prepared on the last day of an accounting year, so its heading and format will be:
Balance Sheet
as at 31st December, 2005
as at 31st December, 2005
| Asset | $ | Liabilities and Capital | $. |
Classification of Assets:
Assets may be classified as follows:
Real Assets:
Assets which have some market value are called real assets, e.g. building, machinery, stock, debtors, cash, goodwill, etc. Real assets are further divided into two types according to their permanence:
Fixed Assets: Assets which have long life and which are bought for use for a long period of time are called "fixed assets". These are not bought for selling purposes, e.g. land, building, plant, machinery, furniture etc. Fixed assets are again sub-divided into two:
- Tangible Assets: Assets which have physical existence and which can be seen, touched and felt are called "tangible assets", e.g. building, plant, machinery, furniture etc.
- Intangible Assets: Assets which have no physical existence and which cannot be seen, touched or felt are called "intangible assets", e.g. goodwill, patent right, trade mark etc.
Current Assets: Assets which are short-lived and which can be converted into cash quickly to meet short term liabilities are called "current assets", e.g. stock debtors, cash etc. Such assets change their form repeatedly and so, they are also known as circulating or floating assets. For example, on purchase of goods cash is converted into stock and on sale of goods, stock is converted into debtors, on collection from debtors, debtors take the form of cash etc.
Out of current assets those which can be converted into cash very quickly or which are already in the form of cash are called liquid or quick assets e.g. debtors, cash in hand, cash at bank etc.
Fictitious Assets: Assets which have no market value are called fictitious assets. examples of fictitious assets include preliminary expenses, loss on issue of shares etc. They are also known as nominal assets.
Besides these, there is another type of assets whose value gradually reduce on account of use and finally exhaust completely. This type of assets is called wasting assets e.g. mine, forest etc.
Classification of Liabilities:
Internal Liabilities:
The total amount of debts payable by a business to its owner is called internal liability e.g. Owner's equity (capital), reserve etc. From practical view point internal liabilities should not be regarded as liabilities, since there is no question of meeting such liabilities al long as the business continues.
External Liabilities:
All debts payable by a business to the outsiders (other than the owner) are called external liabilities e.g. creditors, debentures, bills payable, bank overdraft, etc. External liabilities are further divided into two.
Fixed or Long Tern Liabilities: The liabilities which are payable after a long period of time are called fixed or long term liabilities e.g. debentures, loan on mortgage etc.
Current or Short Term Liabilities: The debts which are repayable within a short period of time are called current or short-term liabilities e.g. creditors, bills payable, bank overdraft etc. Current liabilities may again be divided into two:
- Deferred Liabilities: Debts which are repayable in the course of less than one year but more than one month are called deferred liabilities e.g. Short term loan etc.
- Liquid or Quick Liabilities: Debts are repayable in the course of a month are called liquid or quick liabilities e.g. bank overdraft, outstanding expenses, creditors etc.
Besides the above, there is another type of liability which is known as contingent liability. It is one which is not a liability at present, but which may or may not become a liability in in future. It depends upon certain future event. For example, suppose, the buyer of goods filed a suit in the court against the seller claiming damage of $10,000 for breach of contract. This will be regarded as a contingent liability to the seller until the receipt of the court's order. To the buyer, this is a contingent asset. Both contingent liability and contingent asset are not recorded in the balance sheet. They are generally mentioned in the balance sheet as a note.
Grouping and Marshaling of Assets and Liabilities in Balance Sheet:
As we have discussed that the main purpose of balance sheet is to disclose a true and fair financial position of a business on a particular date. So, the assets and liabilities must be shown in such a manner that the financial position of the business can be assessed through it easily and quickly. Thus an arrangement is made in which assets and liabilities are shown in the balance sheet. Such an arrangement is called marshaling of assets and liabilities. There are three methods of marshaling:
- Permanency Preference Method
- Liquidity Preference Method
- Mixed Method
These methods of preparing a balance sheet are briefly explained below:
Permanency Preference Method:
Under this method, the assets and liabilities are shown in balance sheet in the order of their permanence. In other words, the more permanent the assets and liabilities, the earlier are they shown. This method is adopted by joint stock companies and under this method the balance sheet will take the following form:
Balance Sheet as at.....
| Assets | $ | Liabilities | $ |
| Fixed Assets: Good will Patent Land Building Plant & Machinery Furniture & Fixtures Current Assets: Investment Stock Sundry debtors Bills receivable Prepaid expenses Liquid Assets: Cash at bank Cash in hand | Fixed Liabilities: Capital Reserves Long term loans Current Liabilities: Sundry creditors Bills payable Bank overdraft Outstanding expenses |
Liquidity Preference Method:
Under this method, assets and liabilities are shown in order of their liquidity. The more liquid the assets, the earlier are they shown. The sooner the liabilities are to be paid off, the earlier are they shown. This method is adopted by sole proprietorship and partner ship business. Under this method the form of balance sheet is:
Balance Sheet as at.....
| Assets | $ | Liabilities | $ |
| Liquid Assets: Cash at bank Cash in hand Current Assets: Investment Stock Sundry debtors Bills receivable Prepaid expenses Fixed Assets: Good will Patent Land Building Plant & Machinery Furniture & Fixtures | Current Liabilities: Sundry creditors Bills payable Bank overdraft Outstanding expenses Fixed Liabilities: Capital Reserves Long term loans |
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