Balance sheet: its contents and informational aims
The balance sheet reports the financial situation of an entity, by showing its assets, liabilities and equity, where the equity equals the difference between total assets and total liabilities, as illustrated in figure 2.
Figure 2 - the main components of the balance sheet and their relationship
Assets: definition, classification, valuation
As a general rule, the assets are all those items over which the entity exercises enough control to enable it to receive the benefits emanating from them. A more technical definition goes along the lines of assets being entity's rights to future economic benefits. In addition, for the assets to be reported in the balance sheet, they must be measurable in a fairly objective way. The economic benefit should be exclusive of the entity, i.e. is not emanating from a public good. The assets are normally owned by the entity that reports them, however, it is common that non-owned assets are reported in the balance sheet, if the entity can exercise enough control over them. This is the result of the application of a principle (called 'substance over form'), whereby the substantial truth is more relevant than the formal reality, e.g. an asset is considered as if it was owned, if is going to be used exclusively and for most of its useful life by one entity under an agreement (normally called 'leasing'), with the third party that legally owns the asset, that payments should be made to the owner of the asset, which amount to a total that is substantially equal or higher than the value of the asset.
All assets are classified as non-current and current assets. The non-current, also called fixed assets, are assets whose economic benefits are expected to emanate to the entity in more than one go and, normally, over a period of time longer than one year. Typically, these are: machinery, property, equipment, vehicles, software, patents, licenses, right to exploit others' intellectual property or to use others' brands, investments etc. You will also find less obvious non-current assets, such as capitalized costs, pension related items and others. For example, capitalized costs refer to expenses that were incurred by the entity for the development of products, ideas, formulae, etc. from which revenues will be obtained in the future, but have not been obtained as yet. This refers to the 'time matching principle', which we will explore later on when focusing on the income statement. Pension related items refer to investments that the entity has made, in order to be able to face its obligations towards its employees, when the respective pension payments fall due. For each of these and any other non-current assets, you should always refer to the definition of non-current asset and try to devise in what sense their economic benefit will flow to the entity in more than one occasion over a period of time longer than one year. A very good help for this interpretation is often represented by the notes to the accounts.
The current assets, instead, are expected to be used only once, as they will exhaust all of their economic benefit in one go. Typically, these are: inventories, i.e. row materials, finished goods, components; debtors, i.e. rights to receive cash from clients and customers or any other third party; cash, etc. You will also find other less obvious items, classified as current assets. For example, pre-payments refer to the entity's right to receive services or goods for which payment has been already made. Once again, however, these are current assets as their economic benefit will flow to the entity in one go and anyway within one year. The notes to the accounts can represent a valuable help also for the interpretation of these items.