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Lesson 1: Introduction to Financial Statements
The Balance Sheet
Andy and Nick have decided to name their lawn care company A & N Lawn Care. It's important to think about the company as an entity apart from its owners. Once Andy and Nick have provided their initial investment of $1,000, the money becomes a resource of A & N Lawn Care and will be used by the company. Likewise, it's the company that will earn money using its resources. Of course, the company accomplishes this through the work of its managers, Andy and Nick, but it's essential that they keep their personal finances separate from the transactions of the company. The financial information they're tracking for the company has the characteristics outlined in the FASB conceptual framework and can be summarized and presented using the four basic financial statements. First, we’ll consider the balance sheet.
The balance sheet contains information about a company’s financial position at a point in time—often the end of a year, quarter, or month. It's divided into three major sections, representing three of the elements in the conceptual framework:
- Assets: Resources that will benefit the company in the future. After the initial investment and purchases, A & N Lawn Care owns mowing and trimming equipment that cost $310 and a bank account with a balance of $690 (the original $1,000 deposit minus the $310 spent on the mower and trimmer). The company also has the use of the truck and trailer, worth $8,000. Although the company doesn't own the truck and trailer, they're still assets because they're resources that will benefit the company in the future.
- Liabilities: Obligations of the company. A & N Lawn Care has an obligation to return the truck and trailer to Nick’s dad in substantially the same condition, so the value of its liability is $8,000.
- Equity: The amount of financing provided by owners, plus amounts the company earns and keeps to financially sustain the business. Owners Andy and Nick provided $1,000 of financing, or contributed capital. So far the company has no earnings. Thus A & N Lawn Care’s equity section contains $1,000 of contributed capital.
On June 1, 20xx, after the initial investment and purchases of equipment and supplies, A & N’s balance sheet looks like Figure 1.1.
Please watch Video 1.1 to learn more about the balance sheet.
Here is A & N Lawn Care's balance sheet after they have set up the business, but just before they begin to mow lawns for their customers. The heading at the top includes the name of the company, the title of the financial statement, the balance sheet, and the date. Notice the date is at June 1st 20XX. Stating the date in this way indicates that this is the financial position of A & N Lawn Care on this particular date, which is often called the balance sheet date.
The balance sheet gives financial information about what the company owns, its assets, and what it owes, its liabilities as of the balance sheet date. Likewise, the equity section shows amounts contributed by owners as of the balance sheet date. The balance sheet is organized in a standard way, with assets listed first, then liabilities, then equity. Each of these elements represents a class of items, which are listed in the appropriate section.
For example A & N's assets include two items, cash, which they keep in their bank account, and the equipment they will use, the mower, the trimmer, the truck, and the trailer. The amount shown for equipment is $8,310, which includes the $310 cost of the mower and trimmer, plus the $8,000 value of the truck and trailer. These items are combined and shown in one line on the balance sheet.
Many companies call this category of assets, property, plant, and equipment, or PPE. Sometimes it's called fixed assets. They are long term assets that will be used over a period of time, typically more than one year. In contrast, assets that are used up and replaced in less than a year are considered short term, or current assets. So we have here that cash is a current asset, and equipment is a long term-- which I'll abbreviate LT, long term asset. We'll talk more about current assets later. So total assets equal $9,000.
The next section is the liabilities and equity section. Liabilities are listed first. The only liabilities that A & N Lawn Care has is a note payable, and this is for $8,000. This represents the obligation that Andy and Nick have to return that truck and trailer to Nick's father. A note payable is actually a formal legal agreement between a company and a creditor that states the amount borrowed and all terms of the agreement, including interest rate and timing of payments.
Andy and Nick have only an informal agreement with Nick's dad, but in the balance sheet we're showing it as a note payable. Both assets and liabilities are listed on the balance sheet in order of liquidity. Liquidity refers to how quickly an asset can be used or converted to cash, or how quickly a liability will be paid off. Under assets, cash is the most liquid asset, and it is listed first. The equipment helps the company earn money over time, so it converts the value of equipment into cash more slowly. When we look at the balance sheets of larger companies, we'll see that certain liabilities are paid off quickly, and others would be paid off over a longer period of time. The current liabilities will be shown first, and the long term liabilities would be shown underneath.
Lastly, we see the equity section. The only item that A & N Lawn Care has in the equity section right now is contributed capital. After Andy and Nick begin conducting business, the company will have earnings that will also be listed under equity. The amounts in the liability section and the equity section are added, for a total-- total liabilities in equity of $9,000. The amounts in liabilities and equity equal the amounts in assets. These two totals must always be in balance. And that is why we call it the balance sheet.
In the balance sheet, assets must always “balance with,” or equal, liabilities and equity. The relationship can be written as an equation (Figure 1.2):
This relationship is called the accounting equation. Later, you will learn how the accounting system records transactions to always keep the accounting equation—and the balance sheet—in balance. For now, it's important to be able to identify specific business items as assets, liabilities, or equity items. Click "Next" at the bottom of the page for a practice exercise.