The Balance Sheet
| Author | Vern Krishna |
| Pages | 88-142 |
88 Understanding Financial Statements
Chapter V: The Balance Sheet
In this chapter we look at the major and most common items on busi-
ness balance sheets. Although balance sheets will vary between in-
dustries, they share common characteristics and principles. Business
balance sheets have three components: assets, liabilities, and equity.
A. ASSETS
) Current Assets
Assets are resources that a business uses in its operations to earn in-
come. Current assets are a subset of assets that the business expects
to use or consume within the next year or within the operating cycle
of the business if the cycle is longer than one year. In a manufactur-
ing business, for example, current assets would typically include cash,
marketable securities, accounts receivable, inventories, and prepaid ex-
penses. ese are listed on the balance sheet in order of their liquidity.
a) Cash
Cash, the most liquid of all assets, includes all currency and bank ac-
counts that can be withdrawn at any time without restrictions. Cash
also includes “cash equivalents” — that is, short-term, liquid instru-
ments such as money market funds and commercial paper that are
readily available. Duggan Inc had a cash balance of , and
cash equivalents of , at the end of -.
Chapter V: The Balance Sheet 89
Restricted funds are not included in cash. For example, a bank
may loan money to a business, but require it to maintain a min-
imum cash balance. In eect, the minimum compensating balance
increases the eective rate of interest that the bank charges on its
loan. Assume, for example, that a bank loans a business million
at percent, but requires the business to maintain a minimum of
, in its account. en, ignoring any time value of money
considerations, the eective rate of interest on the loan is . per-
cent. Restricted funds are reported as “Other Assets.”
b) Marketable Securities
Marketable securities are liquid nancial instruments — debt and
equity — that the business holds as temporary investments. e se-
curities should be available for sale at any time in order to meet cash
requirements for the business. e rationale for holding marketable
securities is that they generate a higher rate of return than cash sit-
ting in a savings account. Marketable securities are reported on the
balance sheet at their market values.
A business also may hold marketable securities that it does not
intend to sell in the short term or that it is restricted from selling
by virtue of contractual obligations with nancial institutions. Such
instruments are classied as “investments” in the non-current por-
tion of the balance sheet.
c) Accounts Receivable
Accounts receivable, also called “trade receivables” arise from sales on
credit and are legal rights to receive cash in the future. For example,
assume that a business sells , of merchandise on terms of /,
net . is means that the business has extended credit and will give
a discount of percent if the customer pays , within ten days;
otherwise the full amount is due in thirty days. Under accrual ac-
counting principles the business would recognize the revenue from
the sale and the accounts receivable as an asset. If the purchaser does
not take the discount of ,, the business should record that as
“cash discounts not taken,” which is a form of interest revenue.
A business will record its receivables initially at their face value
90 Understanding Financial Statements
at the time that it sells the goods or services. Most businesses
know, however, that they will not collect all of their receivables. At
year-end, following the principle of conservatism, a business will
estimate the uncollectable portion of its accounts receivable and
set-up an “allowance for doubtful accounts” to recognize potential
uncollectability. us, a business should report its accounts receiv-
able at their “net realizable value” on the balance sheet date. Any
estimated uncollectable receivables should be recognized as “bad
debts” and charged to the income statement as an expense and set
up as an allowance for doubtful accounts on the balance sheet. In
Duggan Inc, for example, we see an accounts receivable balance as
at September - of ,,, against which the company has
created an allowance for doubtful accounts of ,.
e “allowance for doubtful accounts” is a “contra account” that
is deducted from the accounts receivable balance on the balance
sheet in the current assets section. is has the eect of showing
the accounts receivable at their net realizable value. An account re-
ceivable that goes from being “doubtful” to “bad” is written o and
the accounts receivable balance and the allowance for doubtful ac-
counts are both reduced by the amount. ere is no expense charge
to the income statement at that time because, under accrual ac-
counting principles, the charge was made at the time that the busi-
ness estimated the allowance for doubtful accounts.
Example
Assume that X Ltd has sales revenues of $1 million in 20-0 and accounts
receivable of $190,000 as at its year-end. The company estimates that it
will not collect 5 percent of its accounts receivable. Then:
Income statement (partial) for year ended 20-0:
Sales revenue $1,000,000
Bad debt expense $ 9,500
Net income $ 990,500
Balance sheet (partial) as at year ended 31 December 20-0:
Accounts receivable $ 190,000
Allowance for doubtful accounts $ 9,500
Net accounts receivable $ 180,500
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