A Balance Sheet is one of the financial statements that lists business assets, liabilities, and owner’s equity on a specified date. It is a synopsis of the business’s financial health as of the last date of the accounting period.
The Balance Sheet is also called the Statement of Financial Position, and it lists out three parts, what the business owns (assets), the business owes (liability), and the net worth of the business (Assets fewer Liabilities).
Or we can say that it lists three important elements of financial statements. The Asset’s side must equal the Liabilities and Owners’ equity. The common accounting standards that use to prepare balance sheets are IFRS and US GAAP.
Hence, this is called the Balance Sheet.
This thereon also forms the most fundamental concept of accounting called the accounting equation. Balance Sheet has many advantages to users to help them assess the entity’s financial position, but it also has many other limitations that we should know:
Here are the lists of Balance Sheet’s Limitations:
- Valuation of Internally Generated Assets: The major limitation of the balance sheet is that only acquired assets are accounted for. Hence, when the assets are developed internally by going through research and development works, these assets are not recognized at market value, but rather at a cost that tends to generally be lower than the value or sometimes higher than the market value. Suppose, the business builds the website and starts e-commerce. The balance sheet largely ignores the value capability of the cost of the website.
- Mis-stated Long-term assets: Long-term assets are expected to last more than one year and include plant and machinery, buildings, etc. The Balance Sheet records the value of the assets at historical or book value. The depreciation that has been calculated is for tax purposes or is reliably estimated as per accepted policies. However, this does not reflect the true wear and tear of assets. The Balance Sheet also ignores the money value that the business would require to replace the assets in use. For instance: Machinery was purchased in 2015 with an estimated life of 5 years. In 2019, the machinery is recorded at historical cost less accumulated depreciation. If the straight-line method is employed, machinery would be completely written off by the end of the 2020 financial year. This should not be the case. Machinery does have a market value that may be higher or lower than the recorded value. Salvage value can be estimated but again, this is not a reality but only based on certain accounting policies and assumptions.
- Snapshot at a particular date: As a balance sheet depicts financial position on a particular date, the management or the owners want a balance sheet as healthy as possible. They would just repay the bank debt on the last date, so, as to reduce the debt on that date. Businesses can manipulate the cash, debtors, and creditors’ data so as to manipulate the lenders. For instance, a high cash balance at the end date of the accounting period should confirm strong liquidity reserves. However, the company’s intention for the application of cash can be different. Hence, at a given period of time, the figures for the balance sheet can be misleading.
- Needs Comparison: To make complete usage of all the items in the balance sheet, one must compare the business balance sheet with that of competitors and their own balance sheet over the various accounting periods. It is, therefore, an essential task to make the comparison to bear the fruits of the balance sheet.