Accounting Basics
and the Balance Sheet

Let's take a look at some Accounting Basics, and apply them to the Balance Sheet, also called the Statement of Financial Position.

Basic Accounting Principles all start with the Accounting Equation.
To review the Accounting Equation for this topic, please click here.

To understand all of the components of the Balance Sheet, let's trace how Sunny started his now successful business, Sunny Sunglasses Shop.

As an avid outdoorsman and golfer, Sunny recognized the need for quality sunglasses at a reasonable price. He researched the industry and saw profitable gross margins for retail sunglasses.

He decided to start his business, Sunny Sunglasses Shop, on January 1, 2007. On this day, he withdrew $50,000 from his own personal account and invested it in the business.



Assets:
Cash	$50,000
Liabilities:
Total Liabilities	$0
Owner's Equity:
Owner's Investment	$50,000





As a reminder, this affects the Accounting Equation as follows:

Assets = Liabilities + Owner's Equity

Assets (Cash) $50,000 = Liabilities $0 + $50,000 Owner's Equity



Sunny Sunglasses Shop purchases inventory for $4,500, and land for future use for $20,000.

Rather than use up valuable cash resources, Sunny Sunglasses Shop puts a $2,000 down payment on the land, and takes out a 15 year mortgage for the balance of $18,000. The mortgage stipulates that $900 is due and payable annually.

Sunny Sunglasses Shop also entered into a credit agreement with its supplier to pay $3,000 cash for the inventory, and pay the balance of $1,500 within 90 days.

Finally, Sunny insured the store for one year by paying $2,400 for insurance.

The Statement of Financial Position now looks like this:



Sunny Sunglasses Shop
Balance Sheet
January 1, 2007



Notice that the Accounting Equation remains in balance with the Balance Sheet:

Assets $69,500 = Liabilities $19,500 + $50,000 Owner's Equity.



or



Assets $69,500 - Liabilities $19,500 = $50,000 Owner's Equity.



The company spent a total of $7,400 in cash, leaving a balance of $42,600 ($50,000 - $7,400).

The company now has two more assets on the Statement of Financial Position: Inventory and Prepaid Expenses.

The inventory was purchased for $3,000 cash + $1,500 on credit, for a total value of $4,500. The company now has a liability of $1,500 due within 90 days. Accounts Payable represents this short-term liability for inventory purchased.

Prepaid expenses for insurance is an asset because it represents an insurance policy for one year, which is a future benefit to the company that has not been consumed yet.

The company also now has a noncurrent asset of $20,000 in land. It is a noncurrent asset because it is expected to last longer than one year.

Current and Noncurrent Assets

Assets are divided into two broad categories on the Balance Sheet: Current Assets and Noncurrent Assets. Current Assets, or Short-Term Assets, are cash and other assets that can be reasonably expected to be converted to cash or consumed during one year. Examples are cash, inventory, and accounts receivable. Accounts Receivable results from the sale of goods or services on account. It represents a claim to cash that is expected to be received within one year. NonCurrent Assets, or Long-Term Assets, are not expected to be consumed or converted to cash within a year. Examples are buildings, land, and equipment. In the above example, cash is a Current Asset, and land is a Noncurrent Asset. Intangible Assets do not have physical substance. They are valuable because of the rights and privileges they convey to the business. Examples are patents, copyrights, and trademarks. Intangible Assets add long-term value to the company and are not expected to be consumed within a year, so they are classified as noncurrent assets.



The land was purchased with $2,000 cash and a mortgage for $18,000. Part of the cash balance invested in the business that represented owner's equity was moved to the asset land. The land under the Accounting Equation is thus represented as:

Asset $20,000 = Liabilities $18,000 + $2,000 Owner's Equity.

The $18,000 balance less $900 is considered a long-term liability because it is not expected to be paid within one year. Only the $900 is classified as a current liability since it is due within one year.

Current and Noncurrent Liabilities

Like Assets, Liabilities are divided into two broad categories on the Balance Sheet: Current Liabilities and Noncurrent Liabilities. Current Liabilities, or Short-Term Liabilities, are those liabilities that are expected to be paid within one year. Examples are accounts payable, current portions of long-term debt, and short term notes payable. Accounts Payable represents a short-term debt mainly from the purchase of inventory. Accounts payable may also include the purchase of goods, services, and supplies on credit. Long-Term Liabilities are not expected to be paid within a year. Examples are long-term notes such as a mortgage or lease. For corporations, long-term liabilities may also include bonds payable, pensions payable, and deferred taxes. In the above example, a portion of the mortgage, $900, is a Short-Term Liability because it is due within one year. The remaining balance of $17,100 is not payable within one year and is classified as a Long-Term Liability.



Owner's Equity remains $50,000, even though the original cash balance of $50,000 that represented the original investment in the business was partially transferred to other assets. In the above example, $2,000 was transferred from cash to land.

Total assets were purchased for $7,400, so a portion of the cash asset simply transferred to other asset types. The Company then took on some additional debt to finance additional assets. Therefore, Sunny Sunglasses Shop's assets and liabilities increased by $19,500 ($18,000 mortgage plus $1,500 of inventory on credit), but the original Owner's Equity Balance remains the same at $50,000.

To analyze the financial position of Sunny Sunglasses Shop, Click Here to Navigate to Analyzing the Balance Sheet.


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