9 - The Balance sheet

Question 1

What information does a balance sheet convey to users of accounting information?

Answer 1

A business’s balance sheet is important because it provides internal and external users with information to help them evaluate the business’s ability to achieve its primary goals of earning a satisfactory profit and remaining solvent.

A balance sheet provides information about a business’s economic resources and the claims on those resources (its financial position) on a specific date.

Users need to know that a business’s classified balance sheet shows important subtotals, in related groupings, for the assets, liabilities of the business. The groupings include current assets and non-current assets, as well as current liabilities and non-current liabilities.

Question 2

What is the purpose of the balance sheet?

Answer 2

A balance sheet provides information that helps internal and external users to evaluate a business’s ability to achieve its primary goals of earning a satisfactory profit and remaining solvent.

Question 3

Why is the balance sheet important?

Answer 3

A business’s balance sheet is important because it provides internal and external users with information to help them evaluate the business’s ability to achieve its primary goals of earning a satisfactory profit and remaining solvent.

A balance sheet provides information about a business’s economic resources and the claims on those resources (its financial position) on a specific date.

Question 4

What is the link between the balance sheet and the income statement?

Answer 4

An income statement presents a summary of a business’s operating activities for an accounting period: revenues earned, expenses incurred and the net income that results. So the income statement reports on a business’s actions over a period of time, representing the ‘flow’ of a business’s operating activities.

In contrast, a balance sheet presents a business’s financial position on a specific date, allowing users to take stock of a business’s assets, liabilities, and owner’s equity on that date. By examining the balance sheet, businesses can find out how much money customers owe the business (accounts receivable), see the total dollar amount of the inventory on hand at year-end, and discover how much money the business owes its creditors (accounts payable).

Question 5

What are drawing analogies?

Answer 5

Making connections among facts, ideas, or experiences that are normally considered separately

Question 6

What is the balance sheet?

Answer 6

Accounting report that summarises a business’s financial position (assets, liabilities and owner’s equity) on a given date; also known as a statement of financial position.

Question 7

What is the accounting equation?

Answer 7

Assets = Liabilities + Owner’s equity

Question 8

What is a classified balance sheet?

Answer 8

A balance sheet that shows subtotals for assets, liabilities, and owner’s equity in related groupings

Question 9

Why is it important to classify assets and liabilities into groups when preparing a balance sheet?

Answer 9

Current assets are cash and other assets that a business expects to convert into cash, sell or use up within one year. Current assets include cash, marketable securities, receivables, inventory, and prepaid items. Non-current assets are assets other than current assets; these include items such as long-term investments, and property and equipment.

Current liabilities are obligations that a business expects to pay within one year by using current assets. They include accounts payable and salaries payable, unearned revenues, and short-term notes (and interest) payable. Non-current liabilities are obligations that a business does not expect to pay within the next year and include items such as long-term notes payable, mortgages payable, and bonds payable.

Question 10

What are assets?

Answer 10

A business’s economic resources that it expects will provide future benefits to the business

Question 11

What are long-term investments?

Answer 11

Items such as notes receivable, government bonds, bonds and capital stock of companies, and other securities which a business intends to hold for more than one year

Question 12

What are current assets?

Answer 12

Cash and other assets that a business expects to convert into cash, sell or use up within one year.

Question 13

What are financial assets?

Answer 13

Items such as notes receivable, government bonds, bonds and share capital of companies, and other securities.

Question 14

What are property and equipment?

Answer 14

All the physical (tangible), long-term assets a business uses in its operations

Question 15

What is book value?

Answer 15

Asset’s original cost minus the related accumulated depreciation

Question 16

What is accumulated depreciation?

Answer 16

The total amount of depreciation expense recorded over the life of an asset to date.

Question 17

What are intangibles?

Answer 17

Intangibles are assets that do not have a tangible or physical substance, but the ownership of which entitles the owner to future economic benefits.

Question 18

What are liabilities?

Answer 18

A business’s economic obligations (debts) owed to its creditors

Question 19

What is creditors’ equity?

Answer 19

Claims by creditors against the assets of a business

Question 20

What are current liabilities?

Answer 20

Obligations that a business expects to pay within one year by using current assets.

Question 21

What are non-current liabilities?

Answer 21

Obligations that a business does not expect to pay within one year.

Question 22

What is owner’s equity?

Answer 22

Owner’s current investment in the assets of a business

Question 23

What is the relationship between the accounting equation and the balance sheet?

Answer 23

The balance sheet is the report that documents a business’s economic resources and the claims on those resources over a given time. So that it looks like:

Economic resources = Claims on economic resources

This can be broken down into the accounting equation we know:

Economic resources = Assets
Claims on economic resources = Liabilities + Owner’s equity

Therefore,

Assets = Liabilities + Owner’s equity

Question 24

What is liquidity?

Answer 24

The measure of how quickly an asset can be converted into cash or a liability can be paid.

Question 25

How do users evaluate liquidity?

Answer 25

Users evaluate a business’s liquidity by studying its working capital (Current assets – Current liabilities), current ratio (Current assets / Current liabilities), and quick (acid-test) ratio (Quick assets / Current liabilities)

Question 26

What is the current ratio?

Answer 26

Current assets divided by current liabilities.

Current Ratio = (Current Assets) / (Current Liabilities)

Question 27

What is the quick ratio?

Answer 27

Quick assets divided by current liabilities.

Quick Ratio = (Quick Assets) / (Current Liabilities)

Question 28

What are quick assets?

Answer 28

Consist of cash, short-term securities, accounts receivable and short-term notes.

Question 29

What is financial flexibility?

Answer 29

A business’s ability to adapt to change.

Question 30

How do users evaluate financial flexibility?

Answer 30

Users study a business’s current ratio and quick ratio to evaluate its short-term financial flexibility. They study a business’s debt ratio (Total liabilities / Total assets) to evaluate its long-term financial flexibility.

Question 31

What is the debt ratio?

Answer 31

Total liabilities divided by total assets.

Debt ratio = (Total Liabilities) / (Total Assets)

Question 32

What is a return on total assets?

Answer 32

Net income and interest expense are added together and then divided by average total assets.

Question 33

Why and how do users evaluate a business’s profitability?

Answer 33

Users evaluate a business’s profitability to determine how well it has met its profit objectives in relation to the resources invested. They study a business’s return on total assets ([Net income þ Interest expense] / Average total assets) and return on owner’s equity (Net income / Average owner’s equity) ratios to evaluate a business’s profitability.

Question 34

What is a return on owner’s equity?

Answer 34

Net income divided by average owner’s equity

Question 35

What is operating capability?

Answer 35

A business’s ability to continue a given level of operations

Question 36

What is a business’s operating capability, and how do users evaluate it?

Answer 36

A business’s operating capability is its ability to sustain a given level of operations. Measures of a business’s operating capability are used to assess how well the business is maintaining its operating level, and to predict future changes in its operating activity.

Users study a business’s activity ratios to determine the length of the parts of the business’s operating cycle. These ratios include inventory turnover (Cost of goods sold / Average inventory) and accounts receivable turnover (Net credit sales / Average accounts receivable).

Question 37

What is inventory turnover?

Answer 37

Cost of goods sold divided by average inventory.

Question 38

What is the number of days in the selling period?

Answer 38

Number of days in a business’s business year divided by its inventory turnover.

Question 39

What is accounts receivable turnover?

Answer 39

Net credit sales divided by average accounts receivable.

Question 40

What is the number of days in the collection period?

Answer 40

Number of days in a business’s business year divided by its accounts receivable turnover.

Question 41

What is day’s sales in receivables?

Answer 41

A ratio that tells us how many days’ worth of sales are tied up in accounts receivable.

Question 42

What are the limitations of the income statement and balance sheet?

Answer 42

Even though concepts and principles help to build a useful accounting system, they also set limits on the types of information the financial statements provide. These limits restrict the usefulness of the information.

Another limitation of the income statement and the balance sheet is that they do not provide much information about a business’s cash management because they are based on accrual accounting.

Hence investors and creditors also need a financial statement that provides a summary of a business’s cash flows during an accounting period. A business thus prepares and reports a third financial statement, the cash flow statement.