Balance Sheet or Statement of Financial Position (SoFP) is one of the core financial statements in a complete set that helps users understand and assess the financial position of the entity by analysing the assets, liabilities and residual interest of owners in the entity at a particular day.
Balance Sheet or Statement of Financial Position in simplest description possible is a report form of accounting equation. Mathematically accounting equation is represented as:
Capital + Liabilities = Assets
So it helps us understand the nature and value of asset owned by the entity and the level of liabilities that are involved in the operations of the business. By comparing the level of liabilities with assets users determine if it is fruitful to invest in the entity or not.
Format of Balance Sheet or Statement of Financial Position
Format relates to the way information is presented. The value of information is greatly reinforced if it is presented or formatted in a proper way. Similarly poor presentation technique can render information useless. A sample balance sheet is as follows:
Statement of Financial Position
as at December 31, 2013
|Less: Accumulated Depreciation Building||(40,000)||200,000|
|Less: Accumulated Depreciation Machinery||(30,000)||300,000||600,000|
|Cash at bank||10,000|
|Cash in hand||5,000||125,000|
|Shareholders’ Equity and Liabilities|
As this financial statement serves important information it needs to be easily understandable. To enhance understandability, assets and liabilities are classified following certain formatting concepts according to which similar items are grouped together and a total value of that group is reported. For example, instead of reporting each vehicle separately, a single total sum value of all the vehicles will be presented on the face of balance sheet.
Assets are then further divided into different classes and sub-classes as follows:
- Non-current assets/Fixed assets/Property, Plant and Equipment
- Tangible non-current assets
- Intangible non-current assets
- Current assets
Non-current assets are assets with expected useful life longer than next financial year e.g. machinery, building, land etc. Whereas current assets are assets with expected useful life up to next financial year i.e. they will be consumed or replaced within one year e.g. inventory, cash etc.
Non-current assets also known as fixed assets are further classified into tangible non-current assets i.e. assets that have physical existence whereas intangible assets are assets that do not have physical substance e.g. formula, copyrights.
Similarly liabilities are classified as follows:
- Non-current liabilities
- Current liabilities
Just like assets, non-current liabilities are liabilities that are to repaid after next one year whereas current liabilities are obligations to be met within next one year.
By classifying the assets and liabilities in this manner it is easy for users to understand if the entity has enough current assets to support its operations and how good the non-current assets are to generate revenue when combined with current assets. For example entity is able to produce something by utilizing raw material and machinery. Using both assets entity is able to make finished goods that they can sell and earn revenue.
But assets are not analysed in isolation. Users also want to know about the liabilities as they eat up entity’s resources. Assessing liabilities in terms of time help them assess how much cash will be needed and by what time and whether entity has sufficient plan and resources to meet liabilities on time.
Purpose of Statement of Financial Position – Advanced
It is already understandable that sum of amount invested by owner (capital) and the liabilities is equal to assets of entity owns by understand accounting equation which is:
Capital + Liabilities = Assets
Technically it means that whatever asset entity owns is either funded by the owner in the form of capital or it is funded by the lenders/creditors in the form of liabilities. It is important to understand where capital invested by owner is a direct source of funds whereas liabilities (e.g. loans) are indirect source of funds in the hands of management to buy more assets. However, unlike capital, liabilities have to be repaid and that affects entity’s financial position. Higher the liabilities higher the risk or weaker the financial position.
However, mere amount of liabilities is not a scale to judge entity’s financial position. Its better if we consider assets vs liabilities as a proportion. Therefore, instead of saying higher the liabilities higher risk it will be better if we say higher the proportion of liabilities higher the risk.
The user who is interested in knowing the financial position of the entity wants to know how many assets will be applied to payback the liabilities. It is just another way of saying whether entity has enough assets to its liabilities or whether assets and liabilities are “balanced” or not.
Users compare assets and liabilities with each other in order to assess the associated risk. To attract more investors, management of the entity tries to balance risks by maintaining appropriate level of liabilities considering the asset. Here we are not only talking only about payment risk (i.e. not able to pay liabilities on time) but many other risks associated with the entity e.g.
- sales targets not achieved
- growth targets are missed or growth is halted
- obsolescence of assets e.g. inventory is outdated or machinery based on old technology
All such information help user understand entity’s ability to meet business objectives and to pay its debts on time. More the entity is able better the financial position is. Less the entity is able poorer the financial position is.
The interpretation of risk is amplified if majority of the assets are funded by liabilities i.e. entity will have to pay back the funds it borrowed to buy the assets. This risk is minimized by maintaining appropriate amount of cash so that as and when payments are due obligations are met. However, if the entity is not holding enough cash or it is unable to generate enough cash then entity will have to sell its assets to pay in cash. Investors are interested in knowing if entity is able to pay the liabilities in cash on time as otherwise their investment will probably be applied in paying off the debt instead of buying new assets. Statement of Financial Position helps users with relevant information to answer these questions.
The question whether entity is holding assets of certain quality and quantity to back up its liability is more of a subjective matter. For some having just enough assets to cover liabilities is enough. Some argue that assets must be atleast twice the liabilities to be out of warm waters. So, it depends on user and the nature of decision in which the financial position of the entity is assessed.
From above discussion we understood that purpose of Balance Sheet is much more than just listing the values of assets and liabilities. It helps understand how the assets of the entity are funded. Another important thing we understood is that definition of risk is circumstantial based and it whether financial position of the entity is good or bad varies from user to user from decision to decision.
Format of Balance Sheet or Statement of Financial Position – Advanced
Although we know that SoFP contains information about assets and liabilities but it does not mean that you can list the assets and liabilities the way you like. To make financial information easy to understand assets, liabilities and equity is presented following certain rules that are called grouping and marshalling.
Grouping means presenting similar items together as one figure i.e. by combining them at one place and presenting as a single item on the face of financial statement. For example, entity may have many debtors which needs to be reported in the financial statement but not all of the debtors will be reported individually. Instead all of the debtors will be added (grouped) together and will be presented as a single total. Another example can of inventories which can be raw materials, work in process and finished goods and all three of them will be reported under inventories as one figure on the face of statement of financial position and income statement by grouping the three categories together.
Marshalling means presenting items in a logical order i.e. assets and liabilities in the statement of financial position are listed in particular order. While preparing statement of financial position assets and liabilities are presented by following a particular format or type of marshalling so that it is more understandable and thus adds more value to the financial information embedded in the financial statements.
There are two methods of marshalling:
- Marshalling by liquidity
- Marshalling by permanence
Marshalling by liquidity
According to this method the assets and liabilities are listed in descending order on the basis of liquidity i.e the asset which is the most liquid will be listed first and the asset which is least liquid will be listed last. Similarly the liabilities which are falling due earliest will be listed first and the ones payable latest will be listed last.
Marshalling by permanence
This method is completely opposite to the liquidity method. According to this order of listing, assets and liabilities are listed in descending order on the basis of their permanence i.e. the asset with the longest useful life (least liquid) will be listed first and the asset with the least or shortest (most liquid) useful life will be listed last.
Author: Hasaan Fazal
Accountant by heart and took it not just as a profession but as a passion. Founded ACCALIVE and PakAccountants. At ACCALIVE he is a full time teacher and writing regularly for PakAccountants on multiple business related topics including Excel, interview tips and more.
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