Understanding the Statement of Financial Position (Balance Sheet) and Its Importance in Financial Reporting

Definition:

The Balance Sheet, also known as the Statement of Financial Position, is one of the five essential Financial Statements that provide crucial financial information about an entity at the end of the balance sheet date.

The Balance Sheet presents three key pieces of information, including Assets, Liabilities, and Equity. It is typically presented in a comparative format, such as for example, as of 31 December 20X1 and 31 December 20X0.

Assets in the Balance Sheet are divided into two categories based on their nature and accounting classification: Current Assets and Non-Current Assets.

Non-Current Assets typically include the company’s tangible assets, such as buildings, land, and machinery, while current assets encompass the company’s liquid assets, such as cash, accounts receivable, and inventories.

By presenting these important financial details, the Balance Sheet allows stakeholders to gain insight into a company’s financial position and make informed decisions regarding investment, lending, or partnership opportunities. It is an essential tool for financial analysis, risk assessment, and decision-making.

Same as assets, liabilities are also separated into two classifications: Current Liabilities and Non-Current Liabilities. For example, the company will need a long-term loan to pay off in more than twelve months from the reporting date reports under the non-current liabilities.

Current liabilities include short-term loans, accounts payable, and others payable that the company will need to pay within twelve months.

The equity section contains the information that records the resources that owners invested and invested into the entity with the recording of gain or loss accumulation.

The balance of equity is affected by an income statement as well as assets and liabilities.

Noted, IFRS now has changed the words to call Balance Sheet to Statement of Financial Position.

So if your financial statements are prepared based on IFRS, then you should use Statement of Financial Position instead of Balance Sheet.

Formula:

Accounting Equation for Balance Sheet : Assets = Liabilities + Equity

Three Main Elements

The following are the three main elements of the statement of financial position:

  • Assets
  • Liabilities
  • Equity

Here is the detail,

Assets: First Items in the Balance Sheet

Assets are the resources belonging to the entity. Total assets here will report all types of entity’s assets. These include current assets and non-current assets. Current asset rank above non-current assets.

The common examples of assets are land, building, cars, cash in the bank and on hand, inventories, and accounts receivable. Any assets that bong to the owners or shareholders do not include here.

In the Balance Sheet, Assets are reported in the first part before Equity and Liabilities.

Current Assets:

1) Cash and Cash Equivalence:

Report the balance of cash and cash equivalence that is to the entity at the reporting date. It could be cash on hand, petty cash, cash deposit in the bank, or other financial note that are equivalent to cash. Equivalence to cash means easily converting into cash.

2) Accounts Receivable:

Accounts receivable are the receivable amount by the entity from its customers as the result of credit sales. This amount is expected to be received in a period of fewer than twelve months from the reporting date or Balance Sheet date.

If part of receivables is expected to receive over twelve months, then they have to class into long-term assets.

3) Prepaid Expenses:

Prepaid is the amount that the entity pays to its suppliers in advance to secure, through, services or products.

For example, if the company wants to purchase computers, and because the computers are limited in the stores, or the computer needs to order from an outside country, the supplier requires the company to make a certain deposit.

At the time of deposit, the entity does not receive the computer from its supplier yet. Prepaid expenses are the entity’s assets and have to be recorded in the balance. They are not expenses yet.

4) Inventories:

Inventories here include all kinds of inventories: Raw material, work in process, and finish goods. At the end of the accounting period, the entity usually performs physical counts of all inventories and then qualifies them.

Auditors normally accompany the inventory count. Inventories are the main items in the Balance Sheet of a manufacturing company. Inventories normally record at selling prices less cost to sell.

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5) Due to related parties:

This amount is required to be reported as a result of the accounting standard requirement. Amounts due from related parties are required to be present in the balance sheet and need to be disclosed properly in the note to financial statements.

This amount results from selling products or rendering services to its related parties—for example, parent company, associate, and subsidiary.

Non-Current Assets:

Non-current assets here include both tangible and intangible assets of an entity. Here is the detail of all of them.

1) Tangible Non-Current Assets:

  • Machinery needs to class and reported as non-current assets as its useful life of it are longer than one year. The machinery is recorded in the Balance Sheet at cost. And then depreciation based on entity depreciation policies. Once the entity disposes of, the cost and accumulated depreciation related to machinery need to be removed from the fixed assets schedule and Balance Sheet as well.
  • Equipment: This is the kind of equipment that uses in the entity which has a useful life of more than twelve months period. The same as machinery and other long-term assets, equipment is recorded as costs.
  • Leasehold Improvements: this type of asset happens when the entity does not own the building or office that it is using. The office or building is rented from others, and because of business requirements, the entity makes an improvement on it. For example, the entity rents an office building. The owner of the building provides only the building space. All other decorations and rooms for staff are the responsibility of the entity. In this case, to make decoration and room, the entity will incur costs that are not immediately classified as expenses. They treat as assets and depreciate as expenses over the period of time in the income statement.
  • Buildings: Buildings here could be the office building for the head office or brand. They are recorded as non-current assets and depreciate based on their useful life.
  • Vehicles: they include cars for use in the company or similar types of vehicles are included here. Vehicles’ rental experience should not record as fixed assets. The expenses should be recorded in the income statement.
  • Long-term notes receivable: This is the same as the account receivable that we record in the current assets. The reason we record this here is that part of receivables is expected to receive in a period of more than twelve months.

2) Intangible Non-Current Assets:

  • Investments:  this is referring to long-term investment that expects to be recovered into cash in the long term or more than twelve months. The kind of investment is like stock or bond something.
  • Goodwill: This kind of asset happens when the entity purchases the new subsidiary while the net book value of the assets of that subsidiary is less than what the entity offers.
  • Trademarks: the costs of assets that the entity purchases probably from the government or professional body.
  • Patent: This is the cost that an entity purchases the right to operate the services or sales of the products in the country. This is usually a year.

Liabilities: Second Item in the Balance Sheet

There are two types of liabilities in the Balance Sheet. They are,

1) Short-term liabilities

Short-term liabilities are the liabilities that are expected to be paid within a period less than twelve months from the Balance Sheet date.

  • Accounts Payable is the amount that the entity owes to its suppliers as the result of purchases of goods, materials, or the rendering of services.
  • Accrued Expenses: The accrual is almost the same as the account payable. But just because you are not receiving the invoices from your suppliers yet, you can not book what the entity owns as payable.
  • Unearned Revenue is a type of liability, and this is a contrast to the deposit. For example, you are offering services to your customers, and they pay you in advance. In this case, you have not provided the services to them yet. In such a case, you have to book as unearned revenue rather than revenue.
  • Current Portion of Long-term Debt: this is part of the long-term debt. For example, the entity owns the bank for 10,000, and the loan needs to install on a monthly basis. In this case, you have to figure out how much the amount that the entity has to pay within one year. That amount is the current portion of long-term debt.
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2) Long-term Liabilities

Here is a sample of long-term liabilities.

  • Mortgage Payable this is the number of mortgage liabilities that are expected to be paid longer than twelve months period, and for that amount that is payable less than twelve months, we need to class them out to current liabilities.
  • Notes Payable is quite the same as the account payable. These amounts are what we expected to pay in longer than twelve months periods.
  • Long-term Loans: these are the long-term liabilities that are expected to pay in a period of more than twelve months.
  • Finance Lease is the kind of financing that a company occurs assets by obtaining finance from another company or the entity that they are purchasing.

Shareholders’ Equity: Third Items in the Balance Sheet

Shareholders’ Equity, Owner’s Equity, or Stockholders’ Equity are called differently in the Balance Sheet because of the nature of the business.

For a private company, we usually called owner equity, and for a corporation, we usually call it shareholders or stockholder equity.

The total amount of shareholders’ equity is the leftover amounts from assets and liabilities as well as from business operations. For example, if the company operating a loss, the equity will be reduced eventually.

There are many sub-components that are recorded under shareholders’ equity. These include Common Stock, Prefer Stock, Retained Earnings, and Accumulated Other Comprehensive Incomes.

All sub-elements that record or class under equity elements are increasing in credit site and decrease in debit side the same as liabilities element.

1) Common Stock:

Common Stock or Ordinary shares are the same, and this class of shares normally has voting right. The ordinary share is recorded at par value in the balance sheet under equity sections.

Detail of it could be found in the statement of change in equity and Noted to Financial Statements.

This types of stock represent the ownership of the corporation. If the corporation goes into liquidation, then the holders of this stock have less priority to get payments than others preferred shareholders or lenders.

2) Retain Earning or Accumulated Losses/ Profit :

Retain earnings or accumulated losses are recording the equity section of the balance sheet. This is the accumulation of profits or losses that a corporation or entity has earned so far.

The balance of return earnings could be reduced once the entity makes dividend payments to its shareholders or reinvestment.

It is depending on the company’s investment and financial strategy. Retain earnings can be calculated by the accumulation of the beginning balance of retained earnings plus net income during the year and minus dividend payments during the year.

3) Reserve:

It is normally the statutory or standard requirement for the company to make a reservation for a special occasion that could happen unexpectedly.

Sometimes it is named Capital Reserve. For example, if the corporation is the bank, then the central banks might require the corporation to have certain amounts of capital reserve for liquidation.

4) Dividend:

The dividend is the amount that reduces the total shareholders’ equity. It is what the company pays its shareholders and is mostly decided by the board at the end of the year.

A dividend might be reported as the contract to retain earnings, or sometimes recorded as the net off retain earnings.

Statement of Financial Position Template and Example:

ABC Limited Liability Company

Statement of Financial Position

As of December 31, 2021 and 2022

20212022
Assets  
Current assets$100,000$120,000
Non-current assets$200,000$250,000
Total assets$300,000$370,000
   
Liabilities and equity  
Current liabilities$50,000$70,000
Non-current liabilities$100,000$120,000
Total liabilities$150,000$190,000
Shareholders’ equity$150,000$180,000
Total liabilities and equity$300,000$370,000
Liabilities and equity  

In this example, we can see that ABC Limited Liability Company’s total assets increased from $300,000 in 2021 to $370,000 in 2022.

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This was primarily driven by an increase in both current and non-current assets. Meanwhile, the company’s total liabilities also increased from $150,000 in 2021 to $190,000 in 2022, primarily due to an increase in both current and non-current liabilities.

Despite the increase in liabilities, the company’s shareholders’ equity also increased from $150,000 in 2021 to $180,000 in 2022. This suggests that the company’s financial position improved over the year, even though it took on additional liabilities.

Overall, this statement provides a clear and standardized view of ABC Limited Liability Company’s financial position, and allows for easy comparison between the two years.

Benefit that Statement of Financial Position Provide to Users

The Statement of Financial Position, also known as the Balance Sheet, provides several benefits to users, including:

  1. Snapshot of a company’s financial position: The Statement of Financial Position provides a snapshot of a company’s financial position at a specific point in time. This includes a breakdown of the company’s assets, liabilities, and equity, which can help users understand the company’s financial health and stability.
  2. Comparison of financial position over time: By providing comparative figures for different periods, the Statement of Financial Position allows users to compare a company’s financial position over time. This can help users identify trends and patterns and assess the company’s financial performance and stability.
  3. The basis for financial analysis: The information provided in the Statement of Financial Position can be used as a basis for financial analysis. By comparing a company’s assets and liabilities, users can assess its liquidity, solvency, and financial leverage. This can help investors and other stakeholders make informed decisions about whether to invest in or support the company.
  4. Basis for decision-making: The Statement of Financial Position can also be used as a basis for decision-making. For example, lenders may use the information in the statement to assess a company’s creditworthiness and decide whether to provide a loan. Investors may use the information to decide whether to buy or sell shares in the company.
  5. Transparency and accountability: By providing a clear and standardized view of a company’s financial position, the Statement of Financial Position promotes transparency and accountability. This can help build trust between the company and its stakeholders, and demonstrate the company’s commitment to sound financial management practices.

Limitation of Statement of Financial Position Provide to Users

While the Statement of Financial Position (Balance Sheet) is a useful financial statement for understanding a company’s financial position, there are some limitations to its usefulness for users. These limitations include:

  1. Limited to a specific point in time: The Statement of Financial Position only provides a snapshot of a company’s financial position at a specific point in time. The statement does not show how the company’s financial position has changed over time, which can limit its usefulness for assessing trends and patterns.
  2. Historical cost basis: The assets and liabilities in the Statement of Financial Position are recorded at their historical cost, which may not reflect their current market value. This can limit the usefulness of the statement for assessing the current value of a company’s assets and liabilities.
  3. Limited information on future cash flows: The Statement of Financial Position does not provide information on a company’s future cash flows, which can limit its usefulness for predicting future financial performance.
  4. Limited information on non-financial factors: The Statement of Financial Position does not provide information on non-financial factors that may impact a company’s financial performance, such as changes in market conditions, technological developments, or changes in customer preferences.
  5. Differences in accounting policies: Different companies may use different accounting policies to prepare their Statement of Financial Position, which can make it difficult to compare the financial position of different companies.
  6. Limited information on intangible assets: The Statement of Financial Position may not provide detailed information on a company’s intangible assets, such as intellectual property or brand value, which can be a significant component of a company’s overall value.

Conclusion:

  • Balance Sheet is the statement that shows the balance of assets, liabilities, and equity of the entity at the end of accounting periods.
  • This statement can be prepared base on a monthly, quarterly, or annual comparative basis.
  • It provides useful data about the entity’s financial status or position.
  • It provides useful data for Financial ratio analysis.

Written by Sinra