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This is an article for those who want to understand as to what is Balance Sheet. This article deals more with understanding B/S, and less with its interpretation. Interpretation of B/S would require a separate article. While understanding B/S is related more with Accountancy, interpreting it is related more with Finance.
For finance and accountancy, the objective and rationale for their existence are Balance Sheet (B/S) and Profit & Loss A/c (P/L). Though different specialisations of Finance and Accountancy might use these two statements for different purposes and in different ways – it goes without saying that these two together form the core of the profession. Here we shall deal with B/S only, but also keep refering to certain other Accounts and related statements wherever required.
Table of Contents
- What is a Balance?
- What is a point of time in Context of Balance Sheet
- Financial Year and Balance Sheet Date
- What is Balance Sheet?
- Modern Classification of Accounts: Looking at different balances
- The Balance Sheet
- What to look in a Balance Sheet
- Few other things
- Format of the Balance Sheet as prescribed by the VIth schedule of India’s Companies Act 1956
What is a Balance?
Do you carry a wallet / purse with you? If you are carrying a wallet / purse at this moment, count the currency in it now! The currency in your purse at this moment is the cash balance with you. There may be a few other things in your purse – perhaps a grocery bill that has not been paid by you – and you have arrangement with the grocery store to pay such bills at the end of the month. There may be other such papers in your purse eg. you have paid an advance to your electrician for some works at your home. In this situation, the grocery bill payable would be a current liability in the form of outstanding expense / Bills Payable; while the advance given by you would be a prepaid expense and would get classified under current assets. Now, what do these amounts signify? These are the balances that you carry with yourself at this moment.
What is a point of time in Context of Balance Sheet
The term this moment is very important in the context of B/S. A B/S might as well be called a snapshot / photograph of the financial position of an entity at a particular moment or a particular point of time.
Just as the cash balance in your purse keeps changing from day to day and many times within a particular day, similarly the balances of various accounts of an entity keeps changing everyday. Therefore, if a balance sheet is made at the end of day 1 and at the end of day 2 – the balance sheet would be different. This is simply because the balances being carried by the entity is different at different point of time.
Financial Year and Balance Sheet Date
It is for this reason that for statutory purposes, the B/S is made on specified dates of the year – at least four B/S are made representing the position of the entity at the end of each quarter for a particular financial year. The B/S date follows the statutory requirement of the country in which the entity is situated. In India the financial year (FY) is from 1st April of a year to 31st March of next year. Therefore the date of the annual B/S is 31st March of the year. In some other countries including USA, the FY is the calendar year (1st Jan to 31st Dec), and therefore the annual B/S date of entities in those countries are 31st December of the year. The date on which the B/S is prepared for the FY is called the Balance Sheet Date.
What is Balance Sheet?
Joining the concepts detailed above, we can say that –
» B/S is a sheet (ie it is not an account – it is just a sheet)
» that shows the balance of an entity
» at a point of time (more particularly on a specified day at the end of financial year).
Technically, there is no specific format for preparation of B/S. However, different countries prescribe certain Accounting Standards, on the basis of which the B/S needs to be presented. Certain statutory documents like the Companies Act even prescribes the format in which the B/S needs to be presented, audited and filed with the Registrar of Companies. B/S are usually prepared in the following formats:
1) Liabilities | Asset
2) Sources of Funds (ie. Liabilities)
Application of Funds (ie. Assets)
While the horizontal format (first format) is usually used for scholastic purposes, the Companies Act of India and ICAI prescribes the Vertical format (second format) that is given in Schedule VI of Companies Act of India 1956.
Modern Classification of Accounts: Looking at different balances
» Asset A/c
» Liabilities A/c
» Capital A/c
» Withdrawl A/c
» Revenue A/c
» Expenditure A/c
I have used the term balance of an entity above. That is exactly what B/S is. However for the purpose of making B/S, we have to deal with Accounts. Accounts are of different types as can be seen from classification in the box. Accounts in the nature of Revenue A/c and Expenditure A/c are those accounts that deal with operational aspect of the business entity. These accounts that are in the nature of Revenue A/c and Expenditure A/c are closed for the year by transfering their balances to the P&L A/c, except for the outstanding and prepaid expenses that are added / deducted from their respective accounts in the P&L A/c, and the amounts in the outstanding / prepaid accounts get reflected in the B/S as Liability / Asset.
In a way, whether it be revenue expenditure or a capital expenditure, money has been spent – however the treatment of the two is different, because revenue expenditure is consumed within the year, while only a part of the capital expenditure is consumed in a year. Consequently the balances of expenditure a/c (a revenue expense) are transfered to Dr. side of P&L A/c and are considered expensed, while the balances relating to asset a/c (a capital expense) are carried on the B/S. These balances in the Balance Sheet are the balances, that continues to be in possession of the entity.
There are also some other items like deferred reveneue expenditure that are though revenue expenditure are carried forward and written off over a period of time. Till that time such balances relating to deferred revenue expenditure are shown as Asset in the B/S. For the other accounts that come in the remaining classifications, their balances are carried forward and find place in the Balance Sheet.
Examples of these accounts:
» Asset A/c eg. Land A/c, Building A/c, Machinery A/c
» Liabilities A/c eg. Creditors A/c, Bills Payable A/c, Loan A/c
» Capital A/c eg. Owners Capital A/c, Owners Equity A/c, Share Capital A/c
» Withdrawl A/c eg. Drawings A/c
» Revenue A/c eg. Sales A/c, Interest Received A/c
» Expenditure A/c eg. Rent A/c, Stationary A/c
The Balance Sheet
Finally we would try to understand the Balance Sheet. The Balance Sheet can be divided into four parts:
1. Long Term (LT) Liabilities
2. Short Term (ST) Liabilities (Current Liabilities)
3. LT Assets
4. ST Assets (Current Assets)
The LT Liabilities consist of: Owners Equity (Share Capital), LT Debt (Debentures, Secured or unsecured debt or loan), and Reserves and Surplus that is held by the entity. It is not necessary that all business entities would have the same kind of entries in Balance Sheet. All this depends on the nature of the enterprise. If it is a firm, it need not have a share capital, instead it would have Capital A/c of partners. Similarly if the entity is a non-profit organisation like an NGOs, clubs etc then instead of owners capital, we would be having capital fund, and instead of share capital, we would be having donations being added to capital fund. The basic difference between a normal business and a non-profit business is that the surplus (profit) of the non-profit organisation is not available for distribution. In this article, we would be analysing the Balance Sheet as it is of a normal Company form of entity.
» Owners Equity »
This consists of Share Capital, more appropriately equity share capital. The equity shareholders are the real owners of a Co. as it is they who take the risk of the entrepreneur in providing the original capital for the formation of the company. Equity share is shown in the Balance Sheet is at nominal price ie. at par. For example, if the par value of the share of a company is Rs. 10, it is of no concern for Balance Sheet whether it was issued at a discount or in premium or what the current market price of the share quoted in the stock exchange.
» Reserve and Surplus »
This is also part of the Shareholders fund. Whatever, the surplus retained by the entity goes here. But these Reserves and Surplus are also of different types. Usually, General Reserve is used for the monies retained by the entity. However there may sometimes be reserves created due to unrealised gains eg. if a company is having operations in foreign country, and due to foreign exchange fluctuations, the profit might get inflated – as this profit is unrealised gain, capital reserve is created for accounting for such adjustments. While the monies from General Reserve would be available for distribution among shareholders; however, the amount shown in capital reserve from unrealised gains are not available for distribution. Also, a very basic concept – that Asset is owned by the business and Liabilities are owed by the business to outside parties. Consequently, profits would comes under Liabilities as it is owed by the business to be distributed to the owner / shareholders; while losses would be classified as Asset as it remains with the business. If profits remain undistributed, they are recorded under Reserves and Surplus. Also, profits can be capitalised by giving out bonus shares (then it gets recorded under Owners Equity), or profits can simply be distributed as dividends to shareholders.
» Loans »
There are secured loans and unsecured loans. The secured loans are debts, that have been taken by issuing charge on specific / rolling asset of the company. Debentures and Bank loans come under this classification. The loans can as well be unsecured ie. the loan has been given without any charge or mortgage. This means that if the company goes into liquidation, the unsecured loans would stand in the same category as the equity shareholders and wont get any priority in distribution of proceeds from the liquidated assets.
» Current Liabilities and Provisions »
These are the liabilities that are usually rolling liabilities and get settled within a year. These include Creditors / Suppliers / Bills payable, Bank Overdraft / Cash Credit Facility, Outstanding Expenses etc. These are the balances in these accounts at the end of the year. The Dividends Payable and Tax Payable constitute the provisions, because these amounts have been provided for in the P&L A/c. A difference must be kept in mind eg. wage payable would be an outstanding expense, and not a provision. Suppose the wage for the year is Rs. 90,000, and actual payment has been 80,000. But in calculation of the P&L A/c on accrual basis, wage would be taken as 90,000, because that amount has been incurred for the purpose of business operation. In contrast, Dividend payable and tax payable are estimates that have been provided for in P&L A/c. Suppose the amount appropriated for Tax Payable is Rs 27,000 for 20X1, and the actual tax paid in 20X2 is 20,000, then this amount of 20,000 is debited to Tax Payable A/c and Credited to Bank A/c. Provisions can also be seen as amount that continues to lie with the business ie. actual cash outflow has not occured on such amount as is reflected in the provision.
» Long Term Assets »
These are the fixed assets like Land, Building, Machinery, Furniture etc. The LT Assets also includes in it the intangible assets like Copyright, Patent, Goodwill (purchased), etc. These assets are shown after deducting depreciation from them. The Companies Act specifies the rate of depreciation that has to be deducted from these. The important thing is that the Balance Sheet usually shows these assets at Historical Cost less depreciation charged value. There are Accounting Standards that prescribe conservative standards for valuation of such assets. These assets are shown at their net realisable value only if such value is less than historical cost less depreciation.
» Current Assets »
These are assets that roll over within the year. These primarily constitutes of Investments, Debtors / Bills Receivable / Customers, Inventory (inclusive of Raw Material, Work in Progress and Finished Goods), Cash and Bank balance, and loans and advances given by the entity to others. Usually investments, which are basically marketable securities are shown separately. Here one must remember that inventory is also an asset, but its a current asset. Unlike capital assets like building, machinery etc, inventory does not depreciate. (Land, though a long term capital asset also does not depreciate). Inventory is recorded in lesser of book value or the net realisable value (NRV). The valuation of inventory is governed by Accounting Standard 2 issued by ICAI.
» Miscellaneous Expenditure »
These represents deferred revenue expenditure. This means for exmple, when a business starts operation, there are certain expenses like advertisement etc, that have to be done. Though these are in the nature of revenue expenditure, it is argued that these expenses should be seen as expenditure whose effect spans over more than one year. Consequently, the full amount is not abosorbed in the year of expenditure, but is written off over a number of years. Till that time, the yearly balance continues to disclosed under this head.
» P&L A/c »
The balance of P&L Appropriation A/c is carried in the B/S. If the balance is positive, that balance is shown in the Liabilities side under Reserves & Surplus. However, if the balance is negative, it is shown in the Asset side as a separate line item after Miscellaneous expenditure.
What to look in a Balance Sheet
One can find many things from the financial information contained in the B/S. Primarily, one should look at the Capital Structure (eg. Debt/Equity Ratio), Current Ratio (Current Asset/Current Liability), Cash Ratio, ROI (Return on Investment), EPS (Earning Per Share), P/E Ratio (Profit / Earning Ratio) etc. These ratios broadly indicate the liquidity, profitability and leverage of the business entity.
Few other things
One should keep in mind that these documents like P&L A/c and B/S of all the business entities are not public documents. These documents of Public Companies are public documents, but if its a Pvt Ltd Co, then these documents are not public document at least in India. This is despite the fact that all the companies have to get these documents audited at the end of the year and file the same with the Registrar of Companies.
The companies act provides for various prescriptions and restrictions relating to each of these entries. These relate to procedure for issue of shares and debentures, maintaining of reserves, rules relating to dividend payout, procedure for depreciation etc.
Apart from these, documents like P&L and B/S are the most significant documents used for evaluation of the company, particularly for provision of loans by banks.
Apart from P&L and B/S, there is also the CFS (Cash Flow Statement) that is now mandatory for the companies to disclose in their Annual Report. In India, the CFS is prepared in accordance to the Accounting Standard 3, as prescribed by the ICAI (Institute of Chartered Accountants of India).
Format of the Balance Sheet as prescribed by the VIth schedule of India’s Companies Act 1956
Name of Co…. B/S as on…
I Sources of Funds
1. Shareholders Funds:
b. Reserves and Surplus
2. Loan Funds:
a. Secured Loans
b. Unsecured Loans
II Application of Funds
1. Fixed Asset:
a. Gross : Block
b. Less : Depreciation
c. Net Block
d. Capital Work in Progress
3. Current Assets, Loans and Advances:
b. Sundry Debtors
c. Cash and Bank Balances
d. Other Current Assets
e. Loans and Advances
Less Current Liabilities:
Net Current Assets
4.a. Miscellaneous Expenditure to the extent not written off or adjusted
b. Profit and Loss A/c
You may like to read: Concept of Depreciation: The Backbone of Assets