The Balance Sheet
The balance sheet is the accounting equation. It lists the firm’s assets, liabilities, and equity as of a specific date. In this respect it’s a position statement rather than flow statement. The balance sheet is the company’s solvency report card. Typically, the date is the end of the firm’s reporting fiscal year. However, computer software has made generating reports vastly easier. It’s not uncommon for a manager to run off last night’s balance sheet to read with coffee in the morning.
The balance sheet always balances because of the doubleentry system and debit-credit recording rule correctly applied. Each asset increase in the equation must have one or more of the following:
• asset decrease
• liability increase
• equity increase
• revenue increase
• gain increase
• expense decrease
• loss decrease
It’s all contained algebraically within the equation. There are no other options. Recall that the balance sheets for Enron and WorldCom were mathematically correct.
The balance sheet reports the resources and obligations of the firm. Because it’s a mixture of many different assets and liabilities with varying cost structures, it can be a bit confusing. Remember the consistency aspect of GAAP quality? That’s the one that said land bought for $100,000 20 years ago is still carried on the books at $100,000, even though it may be worth $10,000,000. Similarly, that new $1,000,000 machine that you bought a year ago may have been overtaken by such superior technology that you can’t even give it away. Still, it’s on the books for $1,000,000, less accumulated depreciation.
There are some other accounts that have some inherent risk. The accounts receivable may not all collect. If the inventory is particularly high, that could be a sign that the product is not moving. The balance sheet consists of many accounts that are actually estimates that may or may not come true. Understanding the potential limitations helps when considering the balance sheet in conjunction with other financial statements.