CHAPTER 4 - THE BALANCE SHEET

INTRODUCTION
When we talk about a set of accounts we are essentially talking about the profit and loss account
statement (discussed in the previous Chapter) and the balance sheet statement, to which we now turn.
This is not to deny the existence of a third statement dealing with cash flow, which also plays an
important role in informing managers and other parties as discussed in Chapter 5.

A balance sheet is a snapshot picture at a moment in time. On the one hand it shows the value of assets
(possessions) owned by the business and, on the other, it shows who provided the funds with which to
finance those assets and to whom the business is ultimately liable. Here we have an example of the dual
aspects of recording which explains why a balance sheet must always balance.

DUAL ASPECTS OF RECORDING

Another way of expressing the dual aspect of a balance sheet is by the equation:

Assets = Liabilities
This balance sheet equation can best be understood by showing a few simple examples of how a
balance sheet will look after transactions that affect either assets or liabilities, or both at the same time.

Example 1
Joe Bloggs starts up a business and pays £1,000 into a newly opened business bank account. The balance
sheet now reflects the asset of £1,000 cash and the liability of the business to the owner who provided
the £1,000 capital. This is to reflect the accounting convention of separate entity when the accounts of
each business enterprise are kept apart and distinct from the proprietor’s personal transactions.

Balance sheet for Joe Bloggs

Assets Liabilities

Cash 1,000 Share Capital 1,000

Example 2
If some of the cash is now spent on stock costing £400, there is no change to the balance sheet totals on
either side, but a switch from cash to stocks on the assets side as follows:

Balance sheet for Joe Bloggs

 Assets Liabilities

Stock 400 Share Capital 1,000

Cash (1,000 – 400) 600

Example 3
Further stock costing £200 is now bought on credit. The asset of stock is now increased in value by £200,
which is balanced by the new liability of creditors on the other side for the same amount, as follows:

Balance sheet for Joe Bloggs

Assets Liabilities

Stock (400+200) 600 Share Capital 1,000

Cash 600 Creditors 200

Example 4
Some stock originally costing £100 is now sold for cash of £150, making a profit of £50. This shows as a
switch from one asset to another asset, but also partly shows as an increased liability. Stock reduces by
£100, but cash increases by £150. The seeming imbalance of £50 is corrected by showing the owner’s
capital increasing by £50 to £1,050 on the liabilities side. This is because retained profits in any business
belong to the owner(s) who would ultimately get that amount if all the assets were turned back into cash
and the liabilities were then paid off. The balance sheet now looks like this:

Balance sheet for Joe Bloggs

Assets Liabilities

Stock (400+200) 500 Share Capital 1,000

Cash 750 Reserves 50
Creditors 200

Having justified as to why a balance sheet must always balance, let us return to examining this
statement in some detail. Assets are of two main types and are classified under the headings of either
fixed assets or current assets. Fixed assets are the hardware or physical things used by the business itself
and which are not for sale to customers.

Examples of fixed assets include buildings, plant, machinery, vehicles, furniture and fittings.

Other assets in the process of eventually being turned into cash from customers are called current
assets, and include stocks, work-inprogress, debts owed by customers and cash itself. Therefore we can
say:
Total assets = Fixed assets + Current assets
Assets can only be bought with funds provided by the owners or borrowed from someone else, for
example, bankers or creditors. Owners provide funds by directly investing in the business (say, when
they buy shares issued by the company) or indirectly, as we have seen earlier, by allowing the company
to retain some of the profits. Therefore for a limited company:

Total liabilities = Share capital & Reserves + Borrowings & creditors

This same identity is also true for non-incorporated businesses when the owner’s capital comprises the
initial investment plus any retained profits, while further finance is provided by borrowings and,
indirectly, by credit from suppliers. Borrowed capital can take the form of a long-term loan at a fixed
rate of interest or a short-term loan, such as a bank overdraft, usually at a variable rate of interest. All
short-term liabilities owed by a business and due for payment within 12 months are referred to as
creditors falling due within one year, and long-term indebtedness is called creditors falling due after one
year. Having identified all the items in a balance sheet, we can show the total picture as in Figure 4.1,
keeping to the balance sheet equation of assets equal liabilities for the moment. You may be correct in
thinking that assets and liabilities are on the wrong sides, but the convention grew up for some
unknown reason that the sides were reversed in the balance sheet. This is now all irrelevant as
explained below. This horizontal presentation is rarely used, certainly in the case of published accounts
that have to comply with the relevant standards. A vertical presentation is now the norm and the same
balance sheet items shown above are now represented vertically below

Balance Sheet
£000 £000
Capital and reserves 200 Fixed assets 100
Creditors falling due after 1 year 50 Current assets 250
Creditors falling due within 1 year 100
350 350
_____________________________________________________________________________________
Figure 4.1 Balance sheet structure (horizontal format)

_____________________________________________________________________________________
Balance sheet
£000 £000
Fixed assets 100
Current assets 250
Less
Creditors falling due within one year 100
Net current assets (ie working capital) 150
Total assets less current liabilities 250
Less
Creditors falling due after one year 50_
Net assets (wealth owned by shareholders) 200
Capital and reserves 200
____________________________________________________________________________________
Figure 4.2 Balance sheet structure (vertical format)
ASSETS
A business’s possessions or assets are normally divided into two broad categories based on a time
distinction: fixed or long-term assets, and current or short-term assets. These various categories of asset
are normally valued at the original cost of the items which is referred to as the historic cost convention.
Sometimes a valuable building maybe revalued to its current value, but this is the exception rather than
the rule.

It may come as a surprise but some assets are not disclosed in a balance sheet. Internally generated
goodwill, including the value of many brands that have been developed over many years, never appear
in a balance sheet. The skills of the workforce, probably any firm’s most valuable asset, do not appear at
all in a balance sheet. This is because the firm does not own its employees, who can leave and go to
work for someone else. There would also be a valuation problem here as it can not be assumed that
training costs incurred by a current employer equate to skill value. An exception here might be the
transfer fees paid to recruit professional football players which some clubs are treating as a capital
asset. Other clubs pass transfer fees paid and received through their profit and loss account as
expenditure and income respectively.

It merely records what assets the organization has spent its money on and who provided that money.
With this big proviso in mind, let us now examine the balance sheet in detail.

Fixed Assets/Property Plant and Equipment

These are assets held in the business for use rather than for resale and can be regarded as long-term
assets to be used for a number of years.
Fixed assets can be grouped under three possible headings:
 tangible assets;
 intangible assets;
 investments.

Tangible assets are likely to appear in every balance sheet. They embrace land and buildings, plant and
machinery, motor vehicles and furniture and fittings. They are normally shown in the balance
sheet at their original cost deducted by the amount of depreciation written off to the profit and loss
account so far.

The main object of depreciation is to spread the original cost of the asset over its expected life so that
the profit and loss account for any period bears a fair share of the original cost of fixed assets.
Consequently, the value of fixed assets in the balance sheet may not reflect their saleable value at that
time because of inflation, or because of changing technology, or other reasons. This practice of
depreciating owned fixed assets is extended to some leased assets. First, a distinction has to be made
between operating leases and finance leases. The former would describe the short-term hire of an
asset, for example, the renting of a vehicle or piece of equipment for a few weeks or months. These
operating lease payments are charged to the profit and loss account when incurred, and no entry is
needed in the balance sheet.

Finance leases, however, are seen as conferring all the benefits of outright ownership except that the
asset is financed in a way somewhat akin to hire purchase. In this case, the assets being leased are
originally shown in the balance sheet at their full cost together with the capital amount outstanding on
the finance agreement. The asset value is then depreciated each year and the outstanding liability is
reduced by the element of capital repaid. It is a mammoth task in large organizations to keep records of
all fixed assets showing their cost and depreciation amounts over time. In a business of some size,
maintenance of the asset register is computerized, and accounting packages for this specific purpose are
available.

Intangible assets embrace goodwill, brands, patents, trade marks, licences, etc. Such items will only
appear on a balance sheet if they are separately identifiable and money is spent on their acquisition.
Goodwill and brands have been very contentious items where UK accounting standards have not been in
accord with international standards.

Investments only appear under the umbrella of fixed assets if they are long-term in nature and
represent stakes in subsidiaries, joint ventures, or related companies. Sometimes this part ownership of
another business relates to a supplier, competitor, or customer and the stake is held for strategic
reasons and, possibly, eventual takeover.

Current assets
These are short-term assets which are already cash or which are intended to be turned back into cash in
the course of normal trading activity. There are three main types of current assets, namely:
 stocks;
 debtors;
 investments,
 cash and bank balances.

Here we briefly examine each in item.

1. Stocks can be of up to three main types, depending on the nature of the business. The three
categories are:
 raw materials;
 work-in-progress;
 finished goods.

A manufacturing firm will have all three kinds whereas a retail outlet will only have finished goods for
resale.

2. Debtors arise only when firms sell on credit but, as credit sales are normal for all industries except
some retailing, it means debtors are found in most balance sheets. Also included under this heading are
payments made in advance of the goods or services being received when, say, rates were already paid
for a further period after the balance sheet date. These are termed prepayments.

The basis for valuing trade debtors is to take the value of the customer invoices outstanding at the date
of the balance sheet from the sales ledger. A small adjustment to this value is then made to reflect past
experience that all invoices never get settled in full. Usually this is because some dispute about the
goods or services delivered can arise at a later date, or some customers go bankrupt, or into liquidation,
and cannot pay their debts. For these reasons, firms make a small provision, based on past experience,
of the amount which they should classify as doubtful debts. This provision for bad debts is charged as an
expense in the profit and loss account and the global value of the debtors reduced accordingly in the
balance sheet. Depending on the actual bad debts occurring within the year, the provision is topped up
to a suitable level again at the next yearend.

3. Investments are not uncommon in the list of current assets and are of a different nature to those
investments already discussed in fixed assets. Current asset investments relate to short-term
investments of monies that are not immediately required and have been placed temporarily in the
money markets, or elsewhere, to get a good return. If the investments are quoted securities, such as
shares or gilts, then their current market value must be disclosed on the balance sheet or by way of a
supplementary note.

4. Cash and bank balances include cash floats, petty cash balances and any takings not yet banked.
Businesses always have at least one bank current account (which will be a liability if overdrawn!) and
may also have a deposit account. All these cash and bank balances pose no valuation problems.
Balance sheet sequence

The foregoing groups of assets are normally listed in order of permanence. Fixed assets are therefore
listed before current assets and within each group the same practice is recognized. This results in the
sequence land and buildings, plant and equipment, motor vehicles, fixtures and fittings for fixed assets.
The sequence for current assets becomes stocks of raw materials, work-in-progress, finished goods,
debtors, investments, ending with the least permanent assets of cash and bank balances.

LIABILITIES (OR SOURCES OF FUNDS)

We now turn our attention to a business’s sources of funds – where the money comes from with which
the assets are bought. The three main sources are:
 shareholders (or owners);
 borrowings;
 creditors

Each of these sources can be further divided as we shall see. In addition, a source of finance is usually
found in trade credit. This occurs when a firm buys goods or services from other firms, but is allowed a
number of weeks to pay. These trade creditors reduce the amount of working capital needed to be
provided from shareholders and borrowings. It is for this reason that creditors falling due within a year
are deducted from the total current assets to show the net amount of working capital in the
balance sheet. We now look at each source of finance in turn.

 EQUITY ie shareholders funds

Essentially this consists of the issued share capital and reserves. It represents the amount of money that
shareholders have invested directly into the company by buying shares, together with retained profits
that belong to shareholders but which the company uses as additional capital. We look at each of these
sources of finance separately.

1. Ordinary shares form the bulk of the shares issued by most companies and are the shares which carry
the ordinary risks associated with being in business – indeed, they are often referred to as risk capital or
equity. All the profits of the business, including past retained profits, belong to the ordinary
shareholders once any preference share dividends have been deducted. Ordinary shares have
no fixed rate of dividend, but companies hope to increase its size in line with the growth of company
profits over the years. A company does not have to issue all its share capital at once. The total amount it
is authorized to issue must be shown somewhere in the accounts, but only the issued share capital is
counted in the balance sheet. Although shares can be partly paid, this is a rare occurrence. Partly paid
shares on privatization of a publicly owned organization are not the same, as any outstanding monies
are owed to the government and not to the company concerned.

2. Preference shares get their name for two reasons. First, they receive their fixed rate of dividend
before ordinary shareholders. Second, in the event of a winding up of the company, any funds remaining
go to repay preference share capital before any ordinary share capital. In a forced liquidation this may
be of little comfort as shareholders of any type come last in the queue after all other claims from
creditors have been met.

3. Reserves is probably the most misleading term in all accounting! In general terms it means profits of
various kinds that have been retained in the company as extra capital. Also important is what the
term reserves does not mean. It does not mean actual money held back in reserve in bank accounts or
elsewhere. Reserves come from retained profits over many years but are probably reinvested in
buildings, equipment, stocks, or company debts, just like any other source of capital.

The main categories of reserves are as follows:

 Profit and loss account, ie cumulative retained profits from ordinary trading activities.
 Revaluation reserve being the paper profit that can arise if certain assets are revalued to current
price levels without the assets concerned being sold.

Only the original par value is shown as issued share capital.

Creditors
This term means any money owed to other parties at this time, that is payable at some future date. It
embraces all borrowings and all money owed to suppliers plus other items mentioned below. The main
distinction of creditors in a published balance sheet is based on time, with one year hence being the
critical moment. Therefore, the two main headings of creditors in the balance sheet are:
 creditors falling due after one year;
 creditors falling due within one year.

Creditors falling due after one year fall into three main categories:

 borrowed capital;
 provisions or charges;
 other creditors.

Borrowing is attractive to a company if it thinks it can earn a greater return on the money used in its
business than it costs to service the interest payments. When the government throws in tax relief on the
interest payments, it becomes irresistible, although excessive borrowing gets risky if pushed too far.

Firms sometimes also make provisions against future events, say, a restructuring or reorganization and
redundancy programme. A provision is made by charging an estimated future cost as an expense in the
profit and loss account now. The money has not yet been spent as this action anticipates a future event.
Meanwhile, both the cash and the potential liability are shown in their respective places in the balance
sheet reflecting the dual aspects of recording.
Creditors falling due within one year. As well as bank overdrafts or other short-term borrowings, these
creditors are liabilities incurred in the normal course of trading. Examples are:
 bank overdrafts;
 amounts owing to suppliers (trade creditors);
 corporation tax and VAT payable
 dividends declared but awaiting the payment date.

As already indicated, it is the normal practice now for these current liabilities, as they are also known, to
be regarded as a negative current asset in the working capital cycle. This shows them as a deduction
from current assets which they help to finance rather than as a separate source of funds in their own
right.

The other borrowings and sources of funds

There are various hybrid types of finance that are neither pure share nor pure borrowing. A convertible
loan or a convertible preference share are cases in point. In both cases the original security is
convertible into ordinary shares at some future date(s) on predetermined terms.

There can also be various types of borrowing, some being secured on assets of the business, some not.
Loans, debentures, mortgages are all kinds of borrowing with different rights and obligations for the
parties concerned. Mezzanine finance provided by venture capitalists is a loan subordinated to major
finance and is common in management buy-outs or buy-ins. It is possible to raise finance by the special
use of existing assets. Occasionally one hears of a company selling off its valuable premises to
a financial institution, but continuing to occupy them on a long-term lease. This is known as sale and
leaseback. Capital previously tied up in the premises is now released for investment in other fixed assets
or in more working capital. Future profits earned in this way will be partly offset by the rent charges
hitting the profit and loss account. Another asset which can be turned into cash is trade debtors. This is
done by selling the invoices to a specialist finance house who collect the money from the customer later.
This is called Factoring and is a very fast-growing source of funds. Mention has already been made of
leasing or hire purchase. By this means, a business can acquire the use of fixed assets immediately but
pay for them by instalments (plus interest) over a number of years. The differences are mainly legalistic
ones regarding the terms of eventual ownership of the assets. When financed this way, both the assets
and the capital debt are included in the balance sheet in much the same way as if they had been
purchased from borrowed capital. When deciding which sources of funds to use, companies have to
consider such factors as availability, cost, risk, repayment burden if appropriate, and so on.

We can now look at a complete balance sheet

 Balance sheet
£m £m
Fixed assets
Tangible assets:
Buildings 40
Plant and machinery 26
Motor vehicles 8
Fixtures and fittings 6 80

Intangible assets:
Patents, licences 6

Investments 14_
100

Current assets
Stocks and work-in-progress 120
Debtors 110
Short-term investments 5
Cash and bank balances 15
250

Less
Creditors falling due within one year
Bank overdraft 35
Other creditors 65_
100

Net current assets 150

Total assets less current liabilities 250
Less
Creditors falling due after one year
Borrowings 40
Provisions and charges 10 50_

Net assets (wealth owed to shareholders) 200

Capital and reserves

Issued share capital 120
Retained profits 80 200
Self-check questions
1. Why must a balance sheet always balance?
2. What are the two main groups of assets called?
3. What are the main two sources of long-term capital for a company?
4. Why is the goodwill of a company, built up over many years, not shown as an asset in its balance
sheet?
5. Distinguish between operating leases and finance leases.
6. Name the three main types of stocks.
7. Why will there be a difference between the total value of customers’ invoices outstanding and the
amount shown as debtors in a company’s balance sheet?
8. Differentiate between ordinary shares and preference shares.