Department of Recreation, Park & Tourism Administration Western Illinois University RPTA 323: Recreation Administration II The basic principle of accounting is What you have minus what you owe is what you re worth. Restated more formally, the basic accounting equation is Assets - Liabilities = Equity The balance sheet presents the basic accounting equation in a modified table format. This table is divided into two sections: (1) Assets and (2) Liabilities and Equity. The basic accounting equation must always be in balance (thus the name balance sheet ), so Assets must always equal Liabilities and Equity. Any change to one must be balanced by a corresponding change to the other. The balance sheet presents a summary of an organization s financial condition on a specific date. The balance sheet is static, a snapshot. The snapshot is essential, but other information is necessary to develop a dynamic understanding of how an organization operates financially. Assets 1. Assets consist of Things you already have for example, cash, stocks, bonds, land, buildings. Things to which you have a right for example, the money owed you by customers. 2. Assets must be quantifiable before they can appear on the balance sheet. This means they must be given a monetary value. Generally, this is not a problem but with certain forms of intellectual property (e.g., patents or copyrights) it can be very difficult to establish monetary values. 3. Assets are listed on the balance sheet in order of liquidity, from most liquid to least liquid. Liquidity: The ease with which an asset can be converted into cash. Cash itself is obviously the most liquid asset. Fixed assets like land and buildings are usually regarded as the least liquid assets. 4. Asset types are listed below in the same order as they appear on the attached sample balance sheet and using the same letters to identify them. A. Cash: Money in the bank, in the office, or in the wallet. B. Accounts Receivable: Money owed to an organization by customers who have already received goods and services but have not yet paid for them. Organizations have rights to this money and can usually expect to receive it within a reasonably short time, so it is regarded as an asset. Bad or uncollectable debts: Some accounts will not be paid, so most organizations include a balance sheet line for bad debts, some percentage of the total accounts receivable. The percentage is usually an estimate, based on experience or information about specific customers. C. Inventory: Finished goods waiting for purchase and/or materials used for finished goods. Manufacturers identify three classes of inventory: raw material inventory, work-in-process inventory, and finished goods inventory. Service organizations use different types of inventory, but must nonetheless account for it on the balance sheet. 1
2 D. Prepaid Expenses: Organizations often pay for goods or services in advance (e.g., annual insurance premiums). Such prepaid goods and services are assets because the organization is entitled to receive them because it has already paid for them. The value of these assets declines as they are consumed. E. Current Assets: By definition, current assets are those assets expected to be turned into cash during the twelve months after the date of the balance sheet. These are the assets that will be used to pay the bills in the near term. Current Assets = Cash + Accounts Receivable + Inventory + Prepaid Expenses E = A + B + C + D F. Other Assets: These are assets whose worth is difficult to quantify, that is, difficult to assign a dollar value. Such assets are often intangible, including things like trademarks and intellectual property like copyrights and patents. G. Fixed Assets at Cost: These assets are necessary to the organization s basic operations and are used over and over. They are therefore not intended to be converted into cash. Fixed assets commonly include land, buildings, equipment and machinery, vehicles, and office furniture. Another name for this category of assets is property, plant, and equipment or PP & E. On the balance sheet, the value of these assets is recorded at cost, which means the original price paid for them. H. Accumulated Depreciation: Depreciation is the accounting technique used to spread the cost of an asset over the asset s useful life. It represents the rate at which an asset is used up, which allows calculating how much an asset s dollar value has decreased at any point in its projected useful life. An asset s accumulated depreciation is the amount by which that asset s dollar value has deceased since the asset was originally purchased. The number entered on the balance sheet is the sum of all assets accumulated depreciation. For example, straight-line depreciation is a very common technique in which an asset s value is assumed to decrease at the same rate throughout the asset s useful life (resulting in a straight line when graphed). Suppose a vehicle whose original cost was $10,000 has a useful life of five years so that at the end of the fifth year the vehicle is worth nothing (leaving aside for the moment the question whether it would have any salvage value). Dividing the vehicle s original cost by its useful life, we find that its value decreases $2000 each year, or 20 percent. The result is an accumulated depreciation table like this: Year Starting Value Annual Depreciation Accumulated Depreciation 1 $10,000 $2000 $2000 2 $8000 $2000 $4000 3 $6000 $2000 $6000 4 $4000 $2000 $8000 5 $2000 $2000 $10,000 6 $0
3 I. Net Fixed Assets: This is simply the value of all fixed assets, allowing for their accumulated depreciation or loss of dollar value during use. Net Fixed Assets = Fixed Assets at Cost - Accumulated Depreciation I = G - H Note that depreciation reduces profits for the period during which the depreciation charge is recorded, but does not reduce cash (which was expended when the asset was originally purchased). Organizations often time depreciation charges to reduce the profits on which they must pay taxes. J. Total Assets: The total dollar value of all assets held by an organization at a specific point in time. Liabilities Total Assets = Current Assets + Other Assets + Net Fixed Assets J = E + F + I 1. Liabilities are the organization s financial obligations to others, primarily money owed to lenders, vendors and suppliers, governments (in the form of taxes), and to employees (e.g., salaries, pension payments, benefits). The simplest way to think of liabilities is as debts that the organization must repay. 2. On the balance sheet, liabilities are organized by two criteria: To whom the liability is owed. When the liability must be paid. A current liability must be paid within the year, while a long-term liability may be paid over a longer time span. 3. Equity is a special type of debt representing the dollar value of the owner or shareholder stake in the organization (this applies, of course, only to for-profit organizations: non-profit and public organizations have no owners or shareholders as such). This debt is normally never repaid, but must be carried on the balance sheet to give a full picture of the organization s financial condition. 4. Liability types are listed below in the same order as they appear on the attached sample balance sheet and using the same letters to identify them. K. Accounts Payable: These are bills from other organizations, usually for equipment, materials, or supplies. If not paid on receipt, these bills become accounts payable and must usually be paid within 30 days, sometimes 60 days. Sometimes there are discounts for early payment. L. Accrued Expenses: Payments for employee salaries and benefits, utilities, services received (e.g., legal fees), interest due on loans, and similar items. M. Notes Payable [Current Portion of Debt]: These are debts, usually for loans, that the organization must pay off. There are two categories here, based on the deadline for repaying the debt. Notes Payable refer to debts whose terms require that they be repaid within twelve months (e.g., short-term loans from banks). Current Portion of Debt refers to that portion of long term debts (i.e., with terms longer than twelve months) that must be paid within twelve months of the date of the balance sheet. Mortgages are a common form of long-term debt paid off in installments. Mortgage payments due within the next twelve months would be included under Current Portion of Debt, while the remaining portion of the mortgage would appear under Long-Term Debt (see P below). N. Accrued Taxes Payable: Organizations make tax payments at regular intervals to local, state, and federal government. These payments are for income or property taxes owed by the organization and for various point-of-sale taxes (e.g., sales taxes) collected by the organization that must then be sent to the appropriate government.
4 O. Current Liabilities: By definition, these are payments that must be made within twelve months. Current Liabilities = Accounts Payable + Accrued Expenses + Notes Payable + Accrued Taxes Payable O = K + L + M + N P. Long-Term Debt: This is the balance of outstanding debts that falls due in more than twelve months after the date of the balance sheet. A line for Total Liabilities may or may not appear on the balance sheet. Total Liabilities are simply the sum of an organization s Current Liabilities and its Long-Term Debt. Q. Stock: Sometimes referred to as Capital Stock, this is the money that has been invested in a corporation by stockholders. There are two general types of stock, preferred and common, but the distinction is not important here. R. Retained Earnings: All earnings that have not been returned to a corporation s shareholders. This is money that may be reinvested in the organization or held to pay future dividends to stockholders. S. Stockholders Equity: The sum of investments made in the organization, adjusted for dividends paid and for profits or losses. This is the value owned by stockholders. T. Total Liabilities and Equity: The sum of all liabilities and equity. Total Liabilities & Equity = Current Liabilities + Long-Term Debt + Stockholders Equity The Balance Sheet & Business Structure T = O + P + S The preceding discussion and the attached sample balance sheet are for a corporation. The chief differences in balance sheets for other organizations appear in a much simpler equity section (3 on the attached sample balance sheet). For a sole proprietorship, the equity section would present the owner s equity as: Owner s Name, Capital For a partnership, the equity section would present each partner s equity as: Partner s Name, Capital Partner s Name, Capital For a limited liability corporation, the equity section would present each member s equity as: Member s Name Member s Name Total Members Equity
5 Sample Balance Sheet* Date of Balance Sheet 1.** Assets A. Cash B. Accounts Receivable C. Inventory D. Prepaid Expenses E. Current Assets A + B + C + D = E F. Other Assets G. Fixed Assets at Cost H. Accumulated Depreciation I. Net Fixed Assets G - H = I J. Total Assets E + F + I = J 2. Liabilities K. Accounts Payable L. Accrued Expenses M. Notes Payable [also called Current Portion of Debt] N. Accrued Taxes Payable O. Current Liabilities K + L + M + N = O P. Long-Term Debt [Total Liabilities] [O + P = Total Liabilities] [This line may or may not be included.] 3. [Beginning of equity section see discussion on p. 4 above] Q. Stock [Corporation only: Preferred stock + common stock = Q] R. Retained Earnings S. Stockholders Equity Q + R = S [corporation only] T. Total Liabilities & Equity O + P + S = T Notes: * All amounts would be entered in dollars. ** Line numbers and letters would not appear on actual balance sheet. They are used here to identify specific components of a balance sheet.