Overview of the Balance Sheet; As an in-house lawyer, you should have a fundamental understanding of how to interpret your company’s financial statements. The balance sheet is particularly important because it represents the company’s financial condition at a particular moment in time. This contrasts with the other main types of financial statements, namely the income statement and the statement of cash flows, which reflect measurements during quarterly or annual time periods.
The basic equation of the balance sheet is:
Assets = Liabilities + Shareholders’ Equity
Assets represent economic resources that can generate future value for the company. On the balance sheet, assets are ordered based on relative liquidity, with the most liquid assets appearing at the top.
Current assets are also known as short-term assets. They are assets that the company expects to be able to turn into cash, sell, or consume within a year.
Common categories of current assets on a balance sheet include:
- Cash and equivalents
- Accounts receivable (AR)
- Prepaid expenses
Noncurrent (Long-Term) Asset
Noncurrent assets are also known as long-term assets. They are assets that the company expects to hold or use for longer than a year.
- Property, plant, and equipment (PP&E)
- Intangible assets
The liabilities section of the balance sheet contains the company’s third-party financial obligations. In order for the obligation to be considered a liability for purposes of the balance sheet, it must meet specific criteria. In particular, liabilities must have a high probability of occurring, with the rule of thumb being an at least 80% chance of occurring. Liabilities must also have estimable amount and date for when payment is due.
Based on this criteria, contingent liabilities are typically not included on the balance sheet. For example, if a company is involved in large-scale litigation and could potentially owe millions of dollars if it loses the lawsuit, it would not list this amount on its balance sheet. However, the company would be required to add a footnote to its financial statements disclosing the ongoing litigation and potential future liability.
Liabilities are divided into two broad categories in a similar manner to assets. Current liabilities are also known as short-term liabilities. They are obligations that the company expects to pay within one year.
Common categories of current liabilities on a balance sheet include:
- Notes and Other Short-Term Debt Payable to Banks
- Current Portion of Long-Term Debt
- Accounts Payable (AP)
- Accrued Expenses
Noncurrent liabilities are also known as long-term liabilities. They are obligations that the company expects to pay beyond one year.
Common categories of noncurrent liabilities on a balance sheet include:
- Long-Term Debt
- Capitalized Long-Term Leases
- Retirement Obligations
Shareholders’ equity, sometimes known by the term “book value,” represents the amount that the owners of the company have invested in the business. The following line items are typically listed in this section of the balance sheet:
- Par Value
- Additional Paid-In Capital
- Retained Earnings
- Treasury Stock
Other Balance Sheet Concepts: Net Working Capital
The concept of net working capital is not a specific line item on the balance sheet, but the value is derived from the difference between the company’s current operating assets and current operating liabilities. It is a key measure of operational efficiency, with a lower working capital value equating to better efficiency. It also provides an indication of the company’s short-term financial outlook.
Net Working Capital = Current Operating Assets – Current Operating Liabilities
Other Balance Sheet Concepts: Leases
There are two different accounting treatments for long-term leases. The capital lease method requires the renter to book assets and liabilities associated with the lease. In contrast, the rental expense directly impacts the income statement under the operating lease method but does not directly impact the balance sheet.
Capital leases have a much more complex impact on the financial statements than operating leases. Both an asset and a liability, each equal to the present value of the lease expenses, are created on the balance sheet.
An example of a capital lease is a company’s lease on an office building for 30 years that entails the company assuming primary responsibility of all taxes, electricity payments, and other operating costs for the building.
Other Balance Sheet Concepts: Deferred Tax Assets and Liabilities
Deferred taxes are amongst the most complex accounting topics. A deferred tax asset (DTA) will be created on the balance sheet when a company recognizes an expense earlier for financial reporting than for tax reporting purposes. A deferred tax liability (DTL) will appear on the balance sheet when a company recognizes an expense earlier for tax reporting than for financial reporting purposes.
Companies may want to time the depreciation of assets differently for financial reporting and tax reporting purposes. Lower depreciation expense results in higher net income and therefore higher earnings per share. It can be advantageous for a company to report higher net income to investors during certain time periods.