FINANCE Developing and Understanding a Balance Sheet Overview

FINANCE Developing and Understanding a Balance Sheet

Overview Before to delve into the discussion of understanding the BALANCE SHEET, we must understand the Balance sheet accounting equation.

Overview The Balance Sheet accounting equation. This equation holds that the items in a business as owned by the business man can not be more in value than the total amount of money invested into the business by both the owner and those he borrowed from to bring the business to life

Overview In other words; THE ASSETS OF ANY BUSINESS MUST ALWAYS EQUAL THE SUM OF THE BUSINESSES' LIABILITIES AND EQUITY. ASSETS = LIABILITIES + EQUITY

Definition The Balance Sheet is a statement used to determine the financial strength and weakness of a business. It lists everything a company owns and everything a company owes at a specific point in time. For example, an existing business may develop a balance sheet on July 8, 200 X in order to see what it owns and owes on that specific date. The same company may develop another balance sheet on August 20, 200 X to view the items it owns and the money it owes on that date. The company then can compare the two Balance Sheets (on July 8 and on August 20) to determine whether their financial position is improving.

Definition Technically, the Balance Sheet is a financial statement drawn up at a specific point in time to show the resources of a business, the obligations of the business on those resources and the Equity (or capital) belonging to the owners of the business. It is also called The Statement of Fund Position (SOFP)

Components of Balance Sheet (SOFP) Our definition of the subject has thrown up THREE major components of the Balance Sheet, they are; • The Assets (resources) • The liabilities (obligations) • The Capital (owner’s equity)

Components of Balance Sheet (SOFP) Assets are items that have economic value to a company. Liabilities are items that have an economic burden on the company - usually items a business owes to other businesses. Equity consists of all the investments made into a company over the years - usually in the form of capital or shareholder's investments and retained earnings. One very important thing to remember about the Balance Sheet is this: THE ASSETS OF ANY BUSINESS MUST ALWAYS EQUAL THE SUM OF THE BUSINESSES' LIABILITIES AND EQUITY. ASSETS = LIABILITIES + EQUITY

Components of Balance Sheet (SOFP) Every Balance Sheet must have a HEADING (which most scholars consider as a component). The Heading must show the name of the business or company, a clear statement that it’s a Balance Sheet and the date the statement of Balance Sheet is drawn up. It is a very important aspect of drawing up a balance sheet and MUST not be excluded

Components of Balance Sheet (SOFP) Lets now separately explain the three major components of the Balance Sheet. To do this we will use the following balance sheet example of TOY COMPANY.

Components of Balance Sheet (SOFP) The TOY Company Balance Sheet As at 31 December 2007 ASSETS: Current Assets: Cash N 10, 122 Accounts Receivable N 5, 000 Prepaid Fire Insurance N 1, 200 Inventory N 12, 558 Total Current Assets N 28, 880 Fixed Assets: Office Equipment (2 yr life) N 12, 500 Less Accumulated Depreciation N 6, 250 Net office Equipment N 6, 250 Building (5 year life) N 22, 500

Components of Balance Sheet (SOFP) Less Accumulated Depreciation N 2, 250 Net Building N 20, 250 Total Fixed Assets N 26, 500 TOTAL ASSETS N 55, 380 LIABILITIES: Current Liabilities: Accounts Payable N 12, 254 Income Taxes Payable N 5, 676 Short-Term Loan Payable N 5, 179 Total Current Liabilities N 23, 109

Components of Balance Sheet (SOFP) Long-Term Liabilities: Mortgage on Building N 19, 757 TOTAL LIABILITIES N 42, 866 EQUITY: Capital - Donald Sutherland N 12, 514 TOTAL EQUITY N 12, 514 TOTAL LIABILITIES & EQUITY N 55, 380 As you can see the Asset = Liabilities + Equity (N 55, 380 = N 42, 459 + N 12, 921

Components of Balance Sheet (SOFP) As you can see the company is called THE TOY COMPANY, the statement is the Balance Sheet and the date is "As at December 31, 2007". The date is the most important section of the Heading. As mentioned earlier, the date indicates the "time" at which the account values apply. If the date was AS AT 31 DECEMBER 2006, the account balances (values) would be different. For example, the amount of cash the Toy Company had on December 10 would be different than the amount of cash it had on December 31.

Components of Balance Sheet (SOFP) ASSETS Assets are economic resources of a business. For example, cash is an asset which allows a company to buy other assets or resources, pay debts a company may have, or pay Operating Expenses. Assets can be classified into two categories; - Current Assets and Fixed Assets. Current Assets: Current assets consist of cash and other resources (assets) that are expected to be converted into cash within one year or less. Examples of other resources expected to be converted into cash would include inventory (products a company sells to its customers), accounts receivable (money customers owe a business for products purchased on credit) and marketable securities (short term investments made by a company). Current assets also include items that add "value" to a business and become "used up" or "consumed" in less than a one year. Examples of these current assets would include: office supplies, store supplies, and prepaid items such as prepaid fire insurance, & prepaid rent. When these items become used up or consumed, they are no longer considered assets to the company - they are considered expenses.

Components of Balance Sheet (SOFP) The Toy Company's Current Assets on its Balance Sheet as of December 31, 200 X are as follows; Current Assets: Cash N 10, 122 Accounts Receivable N 5, 000 Prepaid Fire Insurance N 1, 200 Inventory N 12, 558 Total Current Assets N 28, 880 Let examine each component in detail

Components of Balance Sheet (SOFP) Cash is the amount of money a company has in its bank account. Cash is necessary for paying bills and for maintaining the day to day operations. As you can see, The Toy Company has N 10, 122 cash in its bank account on December 31, 2007. This balance will change on the following day if any of the following activities take place: if the company makes cash sales, pays on its debt, receives additional investments or loans, pays on expenses, and other transactions requiring cash. Many businesses, having extra cash in the bank, may decide to pay down liabilities, invest into new markets, or buy marketable securities. A marketable security, in most cases, is a very short term investment a business purchases from the government, for instance.

Components of Balance Sheet (SOFP) Accounts Receivable An account receivable is a promise by a customer to pay for a product or service at a later point in time. Many of us have purchased items on credit, promising to pay for them in the future. Companies offer credit terms as an added service to customers in an attempt to increase sales. When you, as a consumer, purchase something on credit, the company you purchase the product or service from will consider you an account receivable. If you, as a business owner, allow customers to buy your products on credit, then those customers are considered accounts receivable. As AT December 31, 2007, The Toy Company has N 5, 000 outstanding in accounts receivable. This means, some of the company's customers purchased N 5, 000 worth of toys, and as of December 31, 2007, haven't paid for them. Usually businesses will give their customers 30 days to pay for items placed on credit. The pay-back period, however, depends on the industry norm and the company's credit granting policy. Most businesses charge interest to customers who fail to pay within an allotted time frame. The interest rate varies from company to company, however, it usually ranges between 2 and 5 percent of the amount owed.

Components of Balance Sheet (SOFP) Prepaid Items Prepaid items are expenses businesses pay for in advance. Common prepaid expenses include prepaid rent and prepaid insurances. You may ask why a business would pay for something that is not due. Proper cash management dictates "not to pay for something unless it's due". Some contracts, however, call for payment of goods and services up front. Think about your personal car insurance. If you are not on a monthly payment plan, chances are you're required to pay for your automobile insurance in advance; usually six months in advance. Prepaid items are considered assets because full payment is made for services that have not been fully rendered. As a company receives the service, the prepaid item is no longer an asset, but rather an expense. To explain this concept, let’s refer back to one of our assumptions which stated. "On July 1, 2007, The Toy Company purchased fire insurance on its building and its inventory of toys. The insurance company quoted a yearly rate of N 2, 400. The insurance contract called for 1 year payment to be made in advance".

Components of Balance Sheet (SOFP) Prepaid Items Contd. In short, on July 1, 2007 Donald wrote a N 2, 400 check to his insurance company. The fire insurance "covers" the building and inventory for a 1 year period. Therefore, on July , 2007, The Toy Company's balance sheet would show an account called prepaid fire insurance for N 2, 400. The company's balance sheet as of December 31, 2007, however, shows the prepaid fire insurance account balance as N 1, 200. From July 1 through December 31, 2007, the prepaid fire insurance account reduced by N 1, 200 (N 2, 400 - N 1, 200 = N 1, 200). The reason behind the reduction is simple. The N 2, 400 paid on July 1 protects the company against fire for a 1 year period (from July 1, 2007 to July 1, 2008). Since six months of the insurance has expired ( July to December of 2007), only six more months is left on the insurance policy (from January to July 1 of 2008). Therefore, only six months (or half) of the policy still has value to the Toy Company. The other six months of the insurance has no value and is considered to be an expense. The Income Statement on December 31, 2007 would show an account called Fire Insurance Expense. The fire insurance expense would have a value of N 1, 200 - the used or consumed portion of the insurance policy.

Components of Balance Sheet (SOFP) Inventory is the product a company buys or produces and sells to end consumers (you and I). For example, The Toy Company is a retailer that buys products from a wholesaler and sells them to end consumers. Most retailers and service providers buy finished inventory and sell it to end consumers. A manufacturer, on the other hand, buys raw materials and manipulates (manufactures) those materials into finished products. A retailer's inventory generally is "finished" and ready for resale upon unpacking the products. Whereas a manufacturer may have three types of inventory - raw materials, work in process, and finished goods inventory. If you are a retailer/service provider your inventory is always recorded at its cost (IE historical value). That is; the money you pay your suppliers for the goods you buy for resale plus any shipping charges.

Components of Balance Sheet (SOFP) Thus, as of December 31, 2007 The Toy Company has finished inventory on hand valued at N 12, 558. Therefore, The Toy Company paid wholesalers and shipping companies N 12, 558 for the toys that are on display and that are in storage. The inventory will decrease in value if the company makes sales to customers. The inventory account will increase when more inventories are purchased. Remember when a sale is made the inventory is removed and is recorded as a cost of good sold (COGS). Cost of Goods Sold appears on the Income Statement. If you are a manufacturer, your inventory will be recorded at the cost of all raw materials, plus direct labour costs (labour costs directly related to producing the finished product), plus factory overhead charges required in manufacturing the raw materials into finished products. Usually, manufacturers will separate finished goods (products ready for resale) from nonfinished goods (raw materials and work in process) on the balance sheet.

Components of Balance Sheet (SOFP) Total Current Assets Total current asset is the sum of all the current assets listed on a company's balance sheet. As indicated below, The Toy Company has total current assets valued at N 28, 880. Current Assets: Cash N 10, 122 Accounts Receivable N 5, 000 Prepaid Fire Insurance N 1, 200 Inventory N 12, 558 Total Current Assets N 28, 880

Components of Balance Sheet (SOFP) Fixed Assets: The second classification of an asset is known as a Fixed Assets are economic resources that have long lives before they become "used up" or consumed. Unlike current assets which are used up or consumed in less than 1 year, fixed assets generally take more than one year before they become consumed. Don't be confused with the term FIXED ASSET; it does not mean assets that are stationary or immobile - it's simply a financial term. Examples of fixed assets include; office equipment (computers, fax machines, photocopiers, etc) office furniture (office desk, fixtures, etc), buildings, automobiles, production equipment, land, patents, trademarks, copyrights.

Components of Balance Sheet (SOFP) When current assets such as inventory, office supplies and store supplies are used up or consumed, they are no longer considered assets, but rather they are considered expenses. Fixed assets undergo a similar process called depreciation. Depreciation attempts to estimate the reduction in the value of fixed assets. When fixed assets are depreciated, two accounts are created; namely, Depreciation Expense and Accumulated Depreciation. The depreciation expense appears on the income statement while the accumulated depreciation appears on the balance sheet. To explain these terms, let’s look at the fixed assets section for the Toy Company on December 31, 2007.

Components of Balance Sheet (SOFP) Fixed Assets: Office Equipment (2 yr life) N 12, 500 Less Accumulated Depreciation N 6, 250 Net office Equipment N 6, 250 Building (5 year life) N 22, 500 Less Accumulated Depreciation N 2, 250 Net Building N 20, 250 Total Fixed Assets N 26, 500 As you can see, The Toy Company's fixed assets include office equipment and a building. Let's look at each fixed asset separately and line by line.

Components of Balance Sheet (SOFP) Office Equipment THE FIRST LINE - Office Equipment (N 12, 500) As indicated under the assumption section of our example, The Toy Company purchased two computers for N 4, 400, a fax machine for N 300, and a mobile photocopier for N 7, 800. These assets were purchased on January 1, 2007 and were grouped together into one account called Office Equipment. When added together, the office equipment account balance is N 12, 500. Office Equipment (2 yr life) N 12, 500 Less Accumulated Depreciation N 6, 250 Net office Equipment N 6, 250

Components of Balance Sheet (SOFP) As you can see, the first line (office equipment - 2 year life) has a balance of N 12, 500. This figure represents the amount the fixed assets were "worth" at the time of purchase. This is known as the asset's historical cost. The account balance of N 12, 500 (historical cost) will remain at this amount each year unless The Toy Company purchases more office equipment or sells off any of the existing office equipment.

Components of Balance Sheet (SOFP) THE SECOND LINE - Less: accumulated depreciation-office equipment: The second line (less: accumulated depreciation - office equipment) keeps track of the reduction in value of the office equipment over time. Furthermore, from January 1 to December 31, 2007, the office equipment reduced in value by N 6, 250. In other words, the office equipment depreciated in value by N 6, 250. How was this reduction in value calculated? Recall, under the assumption section of our example, Donald's accountant

Components of Balance Sheet (SOFP) estimated the office equipment would have a useful life of 2 years, after which time, the equipment would be worthless. In addition, the accountant suggested the office equipment should be depreciated using a straight line method (straight line method of depreciation attributes an equal reduction in value each year of the asset's useful life). Since Donald is using the straight line method of depreciation, he would simply divide the asset's historical cost (N 12, 500) by the asset's useful life (2 years), to arrive at the depreciation amount for one full year. Therefore, The Toy Company estimates the office equipment will depreciate N 6, 250 each year (N 12, 250 / 2 years). As mentioned earlier two accounts are created when depreciating fixed assets; depreciation expense and accumulated depreciation. In our example, the depreciation expense, appearing on The Toy Company's December 31, 2007 income statement, will have a account balance of N 6, 250 each year. And the accumulated depreciation, appearing on The Toy Company's December 31, 2007 balance sheet, will have an account balance of N 6, 250 as of December 31, 2007. If you refer to the accumulated depreciation - office equipment account as of December 31, 2007, you will see N 6, 250.

Components of Balance Sheet (SOFP) Office Equipment (2 yr life) N 12, 500 Less Accumulated Depreciation N 6, 250 Net office Equipment N 6, 250 PLEASE NOTE: If no other office equipment is purchased, then the depreciation expense for the office equipment (appearing on the income statement) will always remain the same each year throughout the asset's useful life ( ie N 6, 250). The accumulated depreciation shown on the balance sheet, however, accumulates the office equipment's reduction (loss) in value each year, for the useful life of the office equipment. Therefore, the depreciation expense on the income statement for the year ending December 31, 2008 will have an account balance of N 6, 250, while the office equipment's accumulated depreciation on the December 31, 2008, balance sheet will show an account balance of N 12, 500 (N 6, 250 depreciation for 2007 and N 6, 250 depreciation for 2008 = N 12, 500 accumulated depreciation for office equipment).

Components of Balance Sheet (SOFP) THE THIRD LINE- net office equipment The third line is called Net Office Equipment. This line is calculated by subtracting the historical cost of the office equipment (N 12, 500) and the accumulated deprecation of the office equipment (N 6, 250). The resulting figure (N 6, 250) is an estimation of the economic value remaining on the office equipment on December 31, 2007. Office Equipment (2 yr life) N 12, 500 Less Accumulated Depreciation N 6, 250 Net office Equipment N 6, 250

Components of Balance Sheet (SOFP) Recall the office equipment was worth N 12, 500 when it was purchased on January 1, 2007. Donald's accountant estimated the equipment would reduce in value (depreciate) by N 6, 250 each year of its useful life. Therefore, on December 31, 2007, the office equipment is estimated to be worth N 6, 250. How much would the office equipment be worth one year from December 31, 2007; (which would be December 31, 2008)? The answer should be apparent. Since the office equipment was estimated to have a two year life, and December 31, 2008 represents the equipment two year anniversary, it would have a economic value of zero. Furthermore, if no other office equipment was purchased during 2008, the office equipment section of the balance sheet on December 31, 2008 would look like this.

Components of Balance Sheet (SOFP) Office Equipment (2 year life) N 12, 500 Less Accumulated Depreciation N 12, 500 Net office Equipment N 0. 00 Remember the accumulated depreciation account, accumulates the depreciation estimated each year. Thus, 2008 depreciation was N 6, 250 and 2008 depreciation was N 6, 250, resulting in total (accumulated) depreciation of N 12, 500. Now let’s briefly look at the Toy's Company's second fixed asset; namely Building.

Components of Balance Sheet (SOFP) All other assets of Toy Company will be accounted for in the same manner as the Equipment This concludes our discussion on The Toy Company's fixed assets. Remember that all fixed assets will consist of three lines; 1. The name and historical cost of the fixed asset 2. The accumulated depreciation of the fixed asset; and 3. The NET fixed asset name and its estimated worth The next balance sheet item to be discussed will be Total Fixed Assets is the sum of all the Net Fixed Assets listed on a company's balance sheet. As indicated below, The Toy Company has Total Fixed Assets on December 31, 2007 valued at N 26, 500.

Components of Balance Sheet (SOFP) LIABILITIES Thus far we have discussed the Heading and the Assets of the Balance Sheet. The other component of the balance sheet is known as Liabilities are those items a business owes to other businesses, governments, shareholders, employees, and so on. Think of liabilities as items placing an economic burden onto a company. Examples of liabilities include accounts payable, taxes payable, interest payable, wages payable, bank loan payable, property taxes payable, and mortgage payable.

Components of Balance Sheet (SOFP) LIABILITIES Like Assets, Liabilities are broken down into two main classifications; ü Current Liabilities ü Long-Term Liabilities Current Liabilities are liabilities that are due in a short period of time; - usually within one year or less. Long-term Liabilities, on the other hand, are liabilities that require payment beyond a company's operating cycle (i. e longer than one year). Let’s look at both classification of liabilities and examine examples of each.

Components of Balance Sheet (SOFP) Current Liabilities: As mentioned above, current liabilities are items a company owes that must be paid within one year. Examples of current liabilities would include; accounts payable, wages payable, property taxes payable, insurance payable, interest payable, notes payable, taxes payable, utilities payable, short-term bank loan payable and so on. The Toy Company's Current Liabilities on its Balance Sheet as of December 31, 2007 are as follows;

Components of Balance Sheet (SOFP) Current Liabilities: Accounts Payable N 12, 254 Income Taxes Payable N 5, 676 Short-Term Loan Payable N 5, 179 Total Current Liabilities N 23, 109 An account payable is a short-term liability a company incurs when it purchases items on credit. Furthermore, many businesses buy inventory, offices supplies, office equipment, store supplies, etc. and elect to pay for them at a later date. As of December 31, 2007, the Toy Company still owes N 12, 254 for office supplies, equipment, store supplies, inventory, and so on. As the company pays for these items, the account balance (N 12, 254) will decrease: Also, when the company purchases more items on credit, the accounts payable increases.

Components of Balance Sheet (SOFP) Accounts payable are considered current liabilities because payment is usually due in less than one year. Further, a company offering credit will usually request payment within 30, 60, or 90 days from the date of payment. Income Taxes Payable The second current liability shown on The Toy Company's balance sheet is income tax payable. Businesses, like individuals, must pay taxes on the income they make. The amount of income tax obligation a business is responsible for depends upon several factors. Four important factors include;

Components of Balance Sheet (SOFP) 1. Whether the business is a sole-proprietorship, partnership or corporation. Sole proprietorships and partnerships are generally taxed at the same rate as individuals (non-business owners). Corporations have their own tax rates and rules which is currently 30% in Nigeria. 2. Whether the business made a profit or a loss in the year in question. 3. What is determined as the Taxable income of the business or company. 4. Whether the business or company has tax credit notes from her operations available for claim against tax liability. Income tax is an extremely specialized field and should be left to professionals. If you are an existing business owner, chances are you already have an accountant preparing your tax returns. If however, you are planning to open a business and preparing your financial forecasted statements, it would be wise to contact an accountant. The accountant will be able to tell you the tax implications of your operations or your planned operations. Now let’s return to our Toy Company example. The following assumption applies to our example.

Components of Balance Sheet (SOFP) "The Net Income before taxes for the Toy Company in 2007 (from January 1 to December 31) is N 14, 190. Donald's accountant determined a tax rate of 40% would apply to the net income before tax. Therefore, the income taxes to be paid will be N 5, 676 (N 14, 190 x 40% = N 5, 676). As of December 31, 2007, the tax obligation has not been paid and therefore is considered income taxes payable".

Components of Balance Sheet (SOFP) Remember that Net Income Before Taxes must be calculated before a business can determine its income tax obligation. Net Income Before Taxes is a calculated by subtracting business expenses from business revenues. After the Net Income Before Taxes have been calculated, an accountant will apply a percentage(s) to this amount to arrive at your tax obligation. Moreover, The Toy Company's Net Income Before Taxes (Revenue - Expenses) was N 14, 190. The accountant applied a rate of 40% to arrive at The Toy Company's tax obligation. In other words, the company is obligated to pay N 5, 676 in income tax (N 14, 190 x 40% = N 5, 676). Since the company didn't pay the income tax as of December 31, it's considered a payable. When the company pays the tax, the income tax payable account will be reduced to zero. For more information on how to calculate net income before taxes, refer to the Income Statement.

Components of Balance Sheet (SOFP) Income tax payable will always be considered a current liability since payment is due in less than one year. The Toy Company will most likely pay the N 5, 676 tax obligation before July 31, 2008.

Components of Balance Sheet (SOFP) Short-Term Loan Payable Short-term loans that require payment in less than one year are classified into an account called Short-Term Loan Payable. For example, on August 10, 2007 The Toy Company received a N 7, 000 short-term loan (1 year) from a local bank. The loan is considered a current liability because it's due in less than one year. The company is required to make monthly payments on the loan until it's fully paid on July 30, 2008. As of December 31, 2007 the outstanding balance owed on the loan is N 5, 179 (see balance sheet above). This means that from August to December, 2007, the company paid N 1, 821 on the loan (N 7, 000 - N 5179). Long-Term Liabilities: The second classification of business liability is called Long. Term Liability. As mentioned earlier, a long-term liability is money owed by a business that must be paid beyond a company's operating cycle. In other words, it is debt that is due beyond a one year period. To put liabilities into perspective we can say;

Components of Balance Sheet (SOFP) Current liabilities are debts that must be paid in one year or less, while long term liabilities are debts that must be paid sometime beyond one year. Examples of long term liabilities include; a 3 year business bank loan, a 5 year business car loan, a mortgage on a corporate building, a 2 year loan from a family members who invests into your company, and the list goes on and on. Think of a mortgage on your house for a moment. Your house mortgage is a long-term liability to you personally - not your business. Therefore, the balance sheet for your business would not include your house mortgage as a long term liability. In other words, personal items are personal items and business items are business items; they are considered to be separate entities.

Components of Balance Sheet (SOFP) Total Liabilities represent the sum of all Current Liabilities plus the sum of all Long Term Liabilities. Simply stated Total Current Liabilities plus (+) Total Long-Term Liabilities = Total Liabilities (N 23, 109 + N 19, 757 = N 42, 866). Below depicts the Liabilities of the Toy Company as of December 31, 2007. As of December 31, 2007, The Toy Company owes N 42, 866 to other businesses (banks, governments and other businesses). N 23, 109 is required to be fully paid within one business year (short-term liabilities), while N 19, 757 is required to be paid later than one year (long-term liabilities). This concludes the Liabilities section of the Balance Sheet. The next component of the balance sheet is called the Equity.

Components of Balance Sheet (SOFP) EQUITY The equity section of the balance sheet represents all investments made into a company. Equity comes in the form of cash investments or other asset investments. Other asset investments might include personal items invested into a company by its owners such as office equipment, office furniture, automobile, and land. When such items are invested by their owners, it's imperative that each item be appraised and shown on the company's "books" at their current market value. It's important to note that personal assets invested into a business become the property of the business and should appear under the company's asset section of the Balance Sheet.

Components of Balance Sheet (SOFP) The appearance of the equity section will depend on the Legal Form of Your Business (sole- proprietor, partnership or a corporation). Moreover, the equity section of a corporation is quite different for the equity section of a sole proprietorship and a partnership. Let’s look at the equity section for each form of business structure, starting with the equity section of the balance sheet for a sole proprietor.

Components of Balance Sheet (SOFP) The Equity Section for a Sole Proprietor A sole proprietorship is a business owned by only one person. The equity section of a sole proprietorship is rather simple. It consists of only one account called CAPITAL. Capital can be referred to as an owner's direct investment into their company. These investments usually occur within the initial stages of the company's formation, however, a owner may contribute cash or other assets into the company at anytime. Recall under the assumption section of our example the following; "Donald Sutherland is the sole-proprietor of The Toy Company. He invested his life savings of N 10, 000 (cash) into the business. The Company buys preassembled wooden toys from a supplier in Maine and sells them to end consumers (you and I). Donald registered the company as a sole proprietor on January 1, 2007 and has been operating it since then".

Components of Balance Sheet (SOFP) Three important points stem from the assumption; 1. The business is a sole proprietorship 2. Donald invested N 10, 000 cash into the company on January 1, 2007 3. No additional investments (cash or other assets) were made. On January 1, 2007 The Toy Company accounting records would show a capital account with a balance of N 10, 000. In essence, Donald gives The Toy Company N 10, 000 cash, in return, for a capital account valued at the same amount. If you're an existing sole proprietor and print off your financial statements every month, you may notice a different capital account balance each month. Did you every wonder why? Well it's simple, the capital account will always change if one of the following events occur; 1. When additional cash or other assets are invested into the company 2. When the owner withdraws cash from the business 3. When the company makes a profit or incurs a loss (income statement)

Components of Balance Sheet (SOFP) The Equity Section for a Corporation: As we have seen above, the equity section of a sole proprietorship and a partnership consist of only one account called capital. The equity section of a corporation, however does not use the capital account to illustrate the investments made into the company. Rather it uses "shares" accounts to show all the investments contributed by its owners. In addition, a corporation is required by law to distinguish between the company's investors (contributed capital by its owners) and the company's earnings over the years. Therefore, corporations use accounts called common shares, preferred shares (and/or other classes of shares), along with an account called retained earnings. The shares account show the investments made by owners (shareholders) into the company. The retained earnings account keeps track of all the company's earnings and all the dividends paid to the owners (shareholders) over the years of the corporation's life.

Components of Balance Sheet (SOFP) A graphical view of a typical corporation's equity section would be; SHAREHOLDER'S EQUITY: Ordinary (common) Shares NXXXXX Retained Earnings N XXXX Total Shareholders’ Equity NYYYYY Notice the title of the equity section of a corporation is called Shareholders Equity. Don't be confused with the term shareholder. It simply means all the people who own a share or portion of the corporation. A corporation can have one shareholder or 100 million shareholders. To further explain a corporation's equity section of the balance sheet, lets assume the following;

Components of Balance Sheet (SOFP) Suppose the following; 1. Donald Sutherland, Bill Jones and three other people formed a corporation on January 1, 2007. 2. Each of the five people invested N 4, 000 in the corporation by buying 1, 000 shares of its common stock. Therefore, the total investment by the shareholders was N 20, 000 (N 4, 000 * 5 investors). 3. The corporation earned N 12, 000 in its first year of operation (January 1 to December 31, 2007). 4. The Corporation's board of directors declared and paid dividends of N 5, 000 during 2007 On December 31, 2007 (the corporation' year end) the Shareholders' Equity section would look like this.

Components of Balance Sheet (SOFP) SHAREHOLDER'S EQUITY Common Shares N 20, 000 Total Shareholders Equity N 27, 000 Notice the common shares depict the investment made by the owners (5 Retained Earnings N 7, 000 shareholders x N 4, 000 Notice the common shares depict the investment made by the owners (5 shareholders x N 4, 000 invested by each = N 20, 000). The retained earnings, on the other hand, are comprised of two items; 1. The earnings (net income after taxes) of the corporation over the years. 2. The dividends paid to shareholders of the corporation. A dividend is similar to a withdrawal taken by owners of a sole proprietorship or a partnership. A corporation's board of directors declare when dividends will be given to its shareholders or owners. In this example, the board of directors declared N 5, 000 dollars of dividends during the

Components of Balance Sheet (SOFP) To calculate the retained earnings simply add the beginning retained earnings to the current year's net income (or net loss) and subtract any dividends. The following chart shows how the ending retained earnings were calculated for our corporation example. Beginning retained earnings (as of January 1, 200 X) N 0 Add: Net income(loss) after tax for 200 X N 12, 000 Less: Dividends declared and/or paid during the year N(5, 000) Equals Ending Retained Earning for December 31, 200 X N 7, 000

Components of Balance Sheet (SOFP) The beginning retained earnings has an account balance of zero because this is the first year of the corporation's operations. Therefore, prior to January 1, 2007, the corporation would not have any earnings nor dividends. The N 12, 000 represents the corporation's net income for the year (from January 1, 2007 to December 31, 2007). The N 5, 000 represents the dividends that had been either declared or paid to the shareholders during 200 X. In summary, beginning retained earnings account is added to the net income or net loss to arrive at the new contributed capital 7 amount. Dividends are then subtracted to give us the ending retained earnings. The December 31, 2007 ending retained earnings (N 7, 000) will become the beginning retained earnings for the 2008 business year.

Components of Balance Sheet (SOFP) In summary, the equity section of a corporation shows the same items as the equity section of a sole proprietorship or a partnership. The only difference, however, is the name applied to the accounts. Moreover, a unincorporated business only shows a capital account for each owner, while an incorporated business shows a shares account and a retained earnings account. Below summarizes the structure for each type of business.

Components of Balance Sheet (SOFP) Total Equity The total equity calculation will depend upon the legal structure of the business (a sole proprietorship, a partnership and a corporation). Total Equity for a sole proprietorship will simply be the amount specified in the owner's capital account. As presented below, Donald's capital account on December 31, 2007 shows an account balance of N 12, 514. Therefore, The Toy Company's total equity is N 12, 514.

Components of Balance Sheet (SOFP) Remember, the capital account was calculated by adding the Net Income After Tax of N 8, 514 (from the income statement) to Donald's investment in the company of N 10, 000 and subtracting Donald's drawings over the business year of N 6, 000. (N 10, 000 + N 8, 514 - N 6, 000 = N 12, 514). The total equity of a corporation is calculated by adding the value of all contributed capital (common shares, preferred shares, etc) to the ending balance in the retained earnings account. The contributed capital account(s) changes as more shares are sold, while the retained earnings account changes as earnings are made, loses are incurred, and when dividends are declared. The final caption of the balance sheet is the total liabilities and equity.

Components of Balance Sheet (SOFP) Total Liabilities and Equity The Total Liabilities (current liabilities + long-term liabilities) are added to the Total Equity to arrive at the company's Total Liabilities and Equity account balance. The Toy Company's total liabilities as of December 31, 2007 amount to N 42, 866 and its total equity as of December 31, 2007 amount to N 12, 514. Therefore the company's total liabilities and equity as of December 31, 2007 amount to N 55, 380

Some terms used in the Balance Sheet Let’s explain some Balance Sheet TERMS

Some terms used in the Balance Sheet Allowance for Bad Debts – Amount of estimated debt to the business that is not expected to be repaid and is subtracted from accounts receivable on the balance sheet. Also known as an allowance for doubtful accounts. Assets – Anything that a business owns that has monetary value. Accounts Payable – Debts of the business, often to suppliers, and generally payable within 30 days. Accounts Receivable – An amount owed to the business, usually by one of its customers, as result of the extension of credit. Accrued Payroll Taxes – Taxes payable for employee services received, but for which payment has not yet been made. Balance Sheet – A financial statement showing the assets, liabilities, and net worth of a business as of a specific date. Current Assets – Cash and other assets readily converted into cash. Includes accounts receivable, inventory, and prepaid expenses.

Some terms used in the Balance Sheet Current Liabilities – The debts of a company which are due and payable within the next 12 months. Current Ratio – Current assets divided by current liabilities. Debt/Worth Ratio – Total Liabilities divided by Net Worth. Depreciation – An accounting convention to take into account the physical deterioration of an asset. It is a systematic method to allocate the historical cost of the asset over its useful life. Fixed Assets – Also called long-term assets with a relatively long life that are used in the production of goods and services, rather than being for resale. GAAP – Abbreviation of Generally Accepted Accounting Principles. Conventions, rules, and procedures that define accepted accounting practice. Inventory – Goods held for sale, raw material and partially finished products which will be sold when they are finished. Liabilities – Debts of the business.

Some terms used in the Balance Sheet Liquidity – The ability to produce cash from assets in a short period of time. Long-Term Liabilities – Debts of a company due after a period of 12 months or longer. Net Worth – The business owner’s equity in a company as represented by the difference between assets and liabilities. Owners’ Equity – See Net Worth. Quick Ratio – Current Assets minus Inventory, divided by Current Liabilities. Also known as the acid test. Working Capital – Current Assets minus Current Liabilities.

USES OF the Balance Sheet The balance sheet can provide very useful information to users of financial statements. It, however, has several limitations to its use. Uses of the Balance Sheet q The balance sheet gives insight into a company’s financial condition at a particular point in time. It reflects the resources that are controlled by the company as well as how these resources were financed. q The balance sheet can assist analysts in assessing a company’s ability to: v pay for its near-term operating needs (liquidity position); v meet future debt obligations; and v make distributions to shareholders q Gives an insight into the strengths and weaknesses of the company. q Shows through analysis whether the company is highly or lowly geared

LIMITATIONS OF the Balance Sheet Ø Items on the balance sheet are not all measured in the same manner; some assets and liabilities are measured at historical cost, while others are measured based on their current market value. Ø The measurement method used can significantly impact the amounts that are reported. Ø Items measured at current value reflect the value that was ‘current’ at the end of the reporting period. These values can, however, change significantly after the balance sheet is prepared. Ø The balance sheet does not incorporate important aspects of a company’s ability to generate future cash flows such as its reputation and management skills. Ø Uses judgment and estimates which could differ between and amongst companies

QUESTIONS & DISCUSSIONS

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