The financial position of an organisation is communicated by a statement called balance sheet. As the name suggests, it is a statement whose two sides ? or categories ? get balanced, i.e, its right-hand side total is exactly equal to that of the left-hand side (in a horizontal balance sheet). This rule is based on the accounting equation that states that, at any point of time, an entity?s assets should be equal to the total of its liabilities and owner?s equity.
What makes the accounting equation? Accounting equation is made up of three components, namely assets, liabilities and owner?s equity. Note that the accounting equation does not consider non-monetary transactions. For instance, your pleasant smile does not have any monetary value and, hence, does not appear in the financial statements.
Assets: Assets are the belongings of an individual. Whatever non-monetary objects and monetary assets, such as cash and marketable securities, that are owned by an him are his assets. Based on the life of an asset, we can categorise it either as a fixed asset or a current asset.
Current assets are belongings of an individual that are supposed to provide the benefits for a short period of time, normally a year or one operating cycle. On the other hand, fixed assets are those that offer benefits which last beyond a year or operating cycle.
Items such as cash, bank loan given to a relative, inventory of materials and the prepaid insurance are current assets.
The remaining are fixed assets, which include land, building, vehicles, household articles and furniture, long-term investments and jewellery. In other words, fixed assets or non-current assets offer benefits to its owners over a long period of time. Note that all non-current assets are presented at their depreciation-adjusted historical acquisition cost. Assets are normally presented in the order of their liquidity.
Liabilities: It refers to the amount owed by an individual to outsiders such as banks/financial institutions or others. This amount is not contributed by the owner in his entity. Liabilities can be sub -divided into two categories: current liabilities and long-term liabilities. Current liabilities are owings/financial obligations of an individual which need to be settled within a year or operating cycle and long-term liabilities are owings/financial obligations that need to be repaid over a longer term.
Owner?s equity: It is the amount of capital contributed and accumulated by the owners of the entity. An individual may start his entity from the contribution of resources by his parents and ancestors. The initial capital contributed by the owners gets added by the surplus (profit or excess of revenue over the expenses) or subtracted with the deficit (loss or shortage of revenue to the expenses) on a period basis. Liabilities are presented before the owner?s equity as outsiders have the priority in getting back their capital before the owner at the time of bankruptcy of the entity. Hence, owners are called as residual claim holders of an entity.
Conclusion: The objective of an individual is to maximise owner?s equity in his balance sheet. But one may not know what he has done so far in his efforts to maximise his net-worth unless he prepares the balance sheet on a periodic basis to take stock of his progress in personal wealth creation process. The content of balance sheet provides a snapshot view of the overall financial position of an entity or an individual.
* The writer teaches accounting and finance courses at IIM Ranchi