Overview of Financial Statements

Read each section in this chapter, which explains the purpose of the balance sheet, income statement, and the cash flow statement. It also is a guide to where you will find financials on publicly traded companies. You should get as much practice working on these statements as you can, since they are the fundamental information on any organization. Make the connections between each financial statement. The more you understand the connectivity of these statements, the better understanding you will have of how the entire accounting system works, which is important if you want to understand the overall operations of any company.

The Balance Sheet

Assets

Assets on a balance sheet are classified into current assets and non-current assets. Assets are on the left side of a balance sheet.


Learning Objective

  • Sketch the asset section of a balance sheet


Key Points

  • The main categories of assets are usually listed first, and normally, in order of liquidity. On a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.
  • Current assets are those assets which can either be converted to cash or used to pay current liabilities within 12 months. Current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities paid within a year
  • A non-current asset cannot easily be converted into cash. Non-current assets include property, plant and equipment (PPE), investment property, intangible assets, long-term financial assets, investments accounted for using the equity method, and biological assets.


Term

  • liquidity
    Availability of cash over short term: ability to service short-term debt.


The Balance Sheet

A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and normally, in order of liquidity. On the left side of a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.


Balance Sheet

Sample Domestic Balance Sheet (DBS) to be referenced by Domestic Well-Being Accounting (DWBA)

Current Assets

A current asset on the balance sheet is an asset which can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities which will be paid within a year.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or treasury bills, marketable securities and commercial papers. Cash equivalents are distinguished from other investments through their short-term existence; they mature within 3 months whereas short-term investments are 12 months or less, and long-term investments are any investments that mature in excess of 12 months.

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms.

Most manufacturing organizations usually divide their inventory into:

  • raw materials - materials and components scheduled for use in making a product,
  • work in process (WIP) - materials and components that have began their transformation to finished goods,
  • finished goods - goods ready for sale to customers, and
  • goods for resale - returned goods that are salable.

A deferred expense or prepayment, prepaid expense (plural often prepaids), is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period. For example, if a service contract is paid quarterly in advance, at the end of the first month of the period two months remain as a deferred expense. In the deferred expense, the early payment is accompanied by a related, recognized expense in the subsequent accounting period, and the same amount is deducted from the prepayment.


Non-current Assets

A non-current asset is a term used in accounting for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets. Non-current assets include property, plant and equipment (PPE), investment property (such as real estate held for investment purposes), intangible assets, long-term financial assets, investments accounted for by using the equity method, and biological assets, which are living plants or animals.

Property, plant, and equipment normally include items such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment (depreciation allowance) over short-term assets.

Intangible assets are defined as identifiable, non-monetary assets that cannot be seen, touched or physically measured. They are created through time and effort, and are identifiable as a separate asset. There are two primary forms of intangibles - legal intangibles (such as trade secrets (e. g., customer lists), copyrights, patents, and trademarks) and competitive intangibles (such as knowledge activities (know-how, knowledge), collaboration activities, leverage activities, and structural activities). The intangible asset "goodwill" reflects the difference between the firm's net assets and its market value; the amount is first recorded at time of acquisition. The additional value of the firm in excess of its net assets usually reflects the company's reputation, talent pool, and other attributes that separate it from the competition. Goodwill must be tested for impairment on an annual basis and adjusted if the firm's market value has changed.

Investments accounted for by using the equity method are 20-50% stake investments in other companies. The investor keeps such equities as an asset on the balance sheet. The investor's proportional share of the associate company's net income increases the investment (and a net loss decreases the investment), and proportional payment of dividends decreases it. In the investor's income statement, the proportional share of the investee's net income or net loss is reported as a single-line item.