C H A P T E R
The Balance Sheet
Old accountants never die; they just lose their balance.
A balance sheet, also called the statement of condition or statement of financial position, provides a wealth of valuable information about a business firm, particularly when examined over a period of several years and evaluated in relation to the other financial statements. A prerequisite to learning what the balance sheet can teach us, however, is a fundamental understanding of the accounts in the statement and the relationship of each account to the financial statements as a whole. Consider, for example, the balance sheet inventory account. Inventory is an important component of liquidity analysis, which considers the ability of a firm to meet cash needs as they arise. (Liquidity analysis will be discussed in Chapter 6.) Any measure of liquidity that includes inventory as a component would be meaningless without a general understanding of how the balance sheet inventory amount is derived. This chapter will thus cover such issues as what inventories are, how the inventory balance is affected by accounting policies, why companies choose and sometimes change methods of inventory valuation, where to find disclosures regarding inventory accounting, and how this one account contributes to the overall measurement of a company’s financial condition and operating performance. This step-by-step descriptive treatment of inventories and other balance sheet accounts will provide the background necessary to analyze and interpret balance sheet information.
The balance sheet shows the financial condition or financial position of a company on a particular date. The statement is a summary of what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to internal owners (stockholders’ equity). By definition, the account balances on a balance sheet must balance; that is, the total of all assets must equal the sum of liabilities and stockholders’ equity. The balancing equation is expressed as: Assets Liabilities Stockholders’ equity ISBN: 0-536-48044-3
Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc.
The Balance Sheet
This chapter will cover account by account the consolidated balance sheet of Recreational Equipment and Clothing, inc. (R.E.C. Inc.) (Exhibit 2.1). This particular firm sells recreational products through retail outlets, some owned and some leased, in cities located throughout the southwestern United States. Although the accounts on a balance sheet will vary somewhat by firm and by industry, those described in this chapter will be common to most companies. Consolidation Note first that the statements are “consolidated” for R.E.C. Inc. and subsidiaries. When a parent owns more than 50% of the voting stock of a subsidiary, the financial statements are combined for the companies in spite of the fact that they are separate legal entities. The statements are consolidated because the companies are in substance one company, given the proportion of control by the parent. In the case of R.E.C. Inc., the subsidiaries are wholly owned, which means that the parent controls 100% of the voting shares of the subsidiaries. Where less than 100% ownership exists, there are accounts in the consolidated balance sheet and income statement to reflect the minority interest in net assets and income. Balance Sheet Date The balance sheet is prepared at a point in time at the end of an accounting period, a year, or a quarter. Most companies, like R.E.C. Inc., use the calendar year with the accounting period ending on December 31. Interim statements would be prepared for each quarter, ending March 31, June 30, and September 30. Some companies adopt a fiscal year ending on a date other than December 31. The fact that the balance sheet is prepared on a...
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