the size of a company or business, information is needed in order for decisions
to be made. The major function of
accounting is to provide periodic reports to management, owners, and outsiders.
Specifically, accounting is defined as the process of identifying, measuring,
and communicating economic information to permit informed judgments and decisions
by users of the information (Porter & Norton, 1998). Users of the information are classified into
two categories, internal and external. Internal
users consist of management who are a part of everyday operations, whereas external
users are not involved in the everyday operations, such as stockholders,
bondholders, bankers, creditors, and government agencies. So the question is, how
do they obtain the information they need?
Key information containing detailed transactions are summarized and
reported in a set of standardized reports called financial statements.
Financial statements are useful for
determining the ability of a business to generate cash, determining whether a
business has the capability to pay back its debts, derive financial rations
that can indicate the condition of the business, and being able to track
financial results on a trend line to spot any impending profitability issues (Financial Statements, 2017). The financials are typically made up of four
main statements: the balance sheet, income statement, retained earnings
statement, and statement of cash flows.
The balance sheet summarizes resources owned by a company and the claims
against those resources at a specific point in time. The income statement shows
how well a company is performing operations over a period of time. The retained earnings statement allows users
to see how much of the company’s income is retained in the business and how
much is paid out to its investors. Lastly, the statement of cash flows reports
the source and use of a company’s cash over a period of time (Rich, Jones, Heitger, Mowan, & Hansen, 2012). For the purpose of this paper, we focus
primarily on the balance sheet, by taking a detailed look at it and the
elements that make it up.
sheet is also commonly known as the statement of financial position, where its
purpose is to report the financial position of the entity at a specific point
in time. It is made up of accounts that
are classified, meaning similar items are grouped together to equal a subtotal.
This allows users to see different relationships that exist between
accounts. There are three elements included
in the balance sheet: assets, liabilities, and equity. Each will be discussed in further detail in
the following sections. The relationship between the elements can be explained
by the following fundamental equation:
Liabilities + Stockholder’s Equity
By looking at this equation, we see how the balance sheet
gets its name. The economic resources of
a company must always equal the claims against those resources ( (Rich, Jones,
Heitger, Mowan, & Hansen, 2012).
the probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events (Kieso, Weygandt, & Warfield, 2013). They are a resource with economic value that
a company possess the right to use at its discretion. These resources are
usually recorded at their acquisition cost, and reduced when they are used up
or depreciated. Because it is difficult
to determine the actual value of an asset at regular intervals in a completely
objective way, assets values are no permitted to move upward (Walgenbach, Hanson, & Hamre, 1990). Assets have the
characteristics of being tangible, having a physical presence, or intangible,
nonphysical items. They are also listed
in order of liquidity, meaning those that can be converted to cash quickly are
listed first. To organize this process
and help the users better understand the relationships between accounts, assets
are divided into the following sub-classifications: current assets, long-term
investments, property, plant, and equipment, intangible assets, and other
assets. Table 1, the financial balance
sheet of GAP Inc., is presented as an example to show how these classifications
Current assets are
cash and other resources that are expected to be converted into cash, used up,
or sold within one year or one operating cycle, which ever is longer. An operating cycle is the average period of
time required for a business to produce goods, sell those goods, and receive cash
in exchange for goods (Financial Statements, 2017). Majority of entities is short than one year,
so they use one year as the measurement for classifications of current and
noncurrent assets. Current assets are
those used to fund day-to-day operations.
As previously stated, items on the balance sheet are listed in order of
liquidity. There are five major items
found in the current assets section: cash, short-term investments, receivables,
inventories, and prepaid expenses.
Cash consists of monies that are currently on hand and are
ready to be exchanged for other goods or services. Detailed cash accounts
consist of petty cash and cash held in financial institutions. Since it is
already converted, it is the most liquid asset.
Table 1 presents the financial balance sheet of The GAP Inc., the
largest specialty retailer in the United States. Cash
and cash equivalents are the first items listed. The GAP’s financial notes state that cash
includes funds deposited in banks and amounts in transit from banks for
customer credit and debit card transactions that process in less than seven
days (United States Treasury, 2017). Short term investments allow companies to earn
interest income by investing cash into stock and bonds that they then will
convert back to cash within one year. Held-to-maturity securities, debt
securities that a company has the positive intent and ability to hold to
maturity, trading securities, securities bought and held primarily for sale
near the end of the term, and available-for-sale securities, debt and equity
securities not classified as one of the other two securities, are three common
security portfolios for valuation and reporting purposes (Kieso, Weygandt, & Warfield, 2013).
represent the rights of a company to collect amounts due from customers. A sale has been made, revenue has been
recorded, but no cash has been exchanged.
This account also has a contra-account, allowance for doubtful accounts.
This account reduces the total receivables by an amount that recognizes a bad
debt loss from accounts the entity expects to not to receive funds from. The GAP Inc. does not have either of these
accounts listed as a current asset. It does report the current asset of
inventory. Inventories are goods or
products the company has on hand that they intend to sale within the year. Inventory may be valued by a variety of ways,
a few of them being FIFO, LIFO, and weighted-average cost. For The GAP Inc., inventory consists of all
of the clothing, shoes, and accessories they intend to sell to customers. This inventory is valued at the lower of cost
or market, with cost determined using the weighted-average cost method and
market value determined based on the estimated net realizable value. The last common current asset is prepaid
expenses. These represent payments made in advance for services such as rent
and insurance that will expire or be consumed within the year or operating
cycle. For GAP Inc., this account may be
reported under other current assets, a catch all account for smaller current
asset accounts like prepaid expenses and supplies.
Long-term investments begin the noncurrent asset portion of the balance sheet.
These investments are like short-term investments, but they are either held for
longer than one year or one operating cycle or were bought with the intention
of never selling them. Long-term investments include both tangible and
intangible assets. Tangible investments
consist of land or buildings owned by the entity that are not currently used in
operations. On the other hand,
intangible assets include bonds, common stock, or long-term notes, and
investments in special funds such as pensions and plant expansions. While these assets are readily marketable,
they are not included in current assets because the entity does not intend to
convert them within the year. The GAP
Inc. does not show any signs of having such investments during the years of 2017
Property, plant and equipment represents
the tangible, long-lived, productive assets used by a company in its operations
to produce revenue (Rich, Jones, Heitger, Mowan, & Hansen, 2012). Such assets include land, machinery, office
equipment and furniture, buildings, and manufacturing equipment. These items are a vital part of an entity and
its operations, but they are not in a state that can easily be converted to
cash. Property, plant, and equipment
are recorded at cost when it is obtained, and then depreciated over the course
of its useful life. Depreciation allows
an entity to distribute the cost of these assets over the periods the asset is
used to produce revenues. Depreciation
expense is recorded on the income statement and totals depreciation just in the
current period, whereas accumulated depreciation is presented on the balance
sheet as a contra-asset account of property, plant, and equipment to represent
the total amount of depreciation that the company has expensed over the life of
the asset. On their balance sheet, The
GAP Inc. reports a net total of $2,616,000 during 2017. The financial notes
state that such property includes leasehold improvements, furniture and
equipment, software, and building and improvements. Depreciation is computed using the
straight-line method over the estimated useful of the related assets (United States Treasury, 2017).
Intangible assets represent assets that have
no physical substance. Examples of these
include patents, trademarks, goodwill, and copyrights. Like property, plant, and equipment,
intangible assets provide benefits to a company over a number of years, but
their valuation is rather difficult to determine. Also in comparison to property, plant, and
equipment, these assets are written off, or amortized, over their useful
life. Intangible assets like name brand
play a key role for companies like The GAP Inc.
The would not be one of the leading apparel retailers in the country had
they not obtained its brand-name recognition.
As previously mentioned, assets are
the sum liabilities and stockholder’s equity.
Liabilities represent the probable future sacrifices of economic
benefits arising from present obligations of a particular entity to transfer
assets or provide services to other entities in the future as a result of past
transactions or events (Kieso, Weygandt, & Warfield, 2013). Basically, liabilities report the amount of
money or services an entity owe to others.
They are vital to operations as they provide financing for day-to-day
events as well as for expansions of the entity.
Like assets, liabilities are listed in a specific order, which is their
due date. Two of the major sections being current liabilities which are due at
any point with in the year, and long-term liabilities that have due dates
surpassing one year.
liabilities consist of
obligations that will be satisfied within one year or the operating cycle,
which ever is longer. Say, for example,
GAP takes out a mortgage that will be paid over the next twenty years, which is
a long term liability, but GAP will report the amount that’s due this year
under current liabilities and the remaining amount will stay in the long-term
liability account. Accounts payable,
salaries payable, unearned revenue, interest payable, and income taxes payable
are common accounts reported under current liabilities.
Accounts payable represent the
obligations of a company to pay for materials or services that were provided by
other entities. For retail companies
like GAP, merchandise is bought from outside providers under a set of terms,
such as net 30 days or net 90 days, that indicate how long the entity has to pay
for the merchandise. The company already
receives the merchandise, but still has an outstanding obligation to pay the
invoices. This obligation amount is what
is reported under accounts payable. For
The GAP Inc., as of January 31, 2017, they had $1,243,000 of obligations
outstanding. Salaries payable are
reported to show the amount due to employees for services performed. This liability typically occurs when the end
of the year and pay day do not hit on the same day. For example, the end of the
year is on Wednesday, but employees are not paid until Friday for the services they
performed that week. The amounts they earned
for Monday through Wednesday would be reported as salaries payable at the end of
the year because they have earned the amount, but have yet to be paid. Payroll taxes payable and income taxes payable
also tend to have the same issue and represent the amount of taxes that are owed
to governmental entities but have yet to be paid due to timing differences. The GAP
Inc. has an obligation to pay $32,000 in income taxes at the beginning of 2017.