BALANCE SHEETS. A balance sheet is a summary of the balances remaining in the books of a business after those books have been closed by preparing and completing a proper revenue or profit and loss account. If the accounts have been properly pre pared, the vital distinction between revenue items and balance sheet items will have been made ; but if any balances have been wrongly excluded from the revenue account on either side, they will necessarily come into the balance sheet, and conversely any balances wrongly included in the revenue account will necessarily have been omitted from the balance sheet. Hence, it is difficult to criticize a balance sheet intelligently in the absence of the rev enue account, and vice versa.
It is usual for balance sheets to be prepared annually, and save in the case of quite unimportant concerns owned by private indi viduals or partnerships, it is usual for the accounts to be audited, and for the auditor to report upon the balance sheet submitted. In the case of public utility concerns, the law usually requires the accounts to be submitted in a prescribed statutory form, but there is no statutory form for the accounts of ordinary commercial con cerns. Opinion is divided as to whether so much latitude is alto gether desirable.
"Fixed" and "Floating" Items.—What are technically known as fixed items are those which, in the ordinary course of events, are not continually changing, while floating items are those which, in the ordinary course of events, are continually in a state of flux. Fixed liabilities comprise the capital of the undertaking, any de benture debt that there may be, and any undivided profits which it is not intended to divide in the near future, i.e., those liabilities, the payment of which has not to be provided for, at least for the time being. Floating liabilities, on the other hand, are those which in the ordinary course of business will fall due for payment at more or less fixed dates in the near future, the due payment of which has to be provided for if the undertaking is to continue in business. As regards assets, fixed assets are those which, in a broad sense, represent the equipment of the undertakings : the posses sions which it owns with the object of continuing to hold them in their existing form, and to use them as a means, directly or in directly, of making profits. They are held for use. The floating assets, on the other hand (apart from cash balances) are those which in the ordinary course of business it is the aim of the under taking to convert into money with all convenient speed, making a profit in the process. Normally, the due payment of floating liabil ities as they fall due can only be provided for by the liquidation of the floating assets ; hence the ability of the undertaking to con vert its floating assets into money sufficiently quickly to enable it to meet its floating liabilities as they fall due, is of vital impor tance. Thus no balance sheet can be regarded as satisfactory which fails to disclose quite clearly the full extent of the floating assets and liabilities.
Depreciation.—But because the fixed assets of an undertaking are not intended for sale, but rather for use, their precise realizable value at any given moment is comparatively unimportant, so long as there is always a sufficiency of floating assets to meet the float ing liabilities as they fall due. Accordingly it is quite legitimate to treat fixed assets as outlays which affect current profits only in the sense that probably they will not for ever continue to be equally useful as equipment and will, therefore, from time to time, require to be replaced by others. The usual—and by far the most convenient—way of regarding fixed assets is to treat them as outlay to secure the temporary purpose of providing the necessary equipment, the cost of which must accordingly be treated as a working expense chargeable against the profits of the undertaking during the time they are in use. If the whole of the outlay on the original equipment had been exhausted before the balance sheet were prepared, the whole of such outlay would, of course, be charged against current profits. If only a part of the outlay has been exhausted, it follows that a corresponding part should be charged against the profits, to the earning of which it has con tributed. When due provision is made for the depreciation of equipment it has this effect, and from year to year that portion of the original outlay not as yet charged against profits is carried forward in the balance sheet to be dealt with in future years. In this way the whole outlay is equitably apportioned over the series of years during which the equipment is in use, but the amount included in successive balance sheets does not profess to be the then realizable value of the equipment then in existence. For obvious reasons it is important to arrive at the most accurate statement of profits year by year, but it is by no means equally important year by year to arrive at an accurate realizable valuation of property which there is no intention of realizing.
Extent of Information Supplied.—The pro forma balance sheet here shown is not supposed to represent a "model" balance sheet, but rather one typical of the practice at present usual among public companies. It will be observed that, without stating why, it suggests that there are assets worth a total of 1175,000. No indication is given of how these figures are arrived at. For reasons already stated it is not reasonable in all cases to assume that the figures attached to the various items of a balance sheet represent in the view of the accounting parties their respective current realizable values ; but it is submitted that, if the published bal ance sheet is to serve any useful purpose, the basis of valuation should be stated in each case. It is further suggested that as regards floating assets, and particularly stock in trade and work in progress, it would be an advantage if the identity of the indi viduals respectively responsible for the figures were to be stated. If that were done, it is possible that the responsible parties might take their duties somewhat more seriously. Certainly, it could do no harm. Similarly, as regards the sundry debtors, those responsible for making provision for bad and doubtful debts might very well be mentioned by name; and in the case of invest ments, it would always be advantageous to know whether these are included in the balance sheet at cost price, at current mar ket price, or at what other figure.
Reserves.—On the truth of the figures attached to the various items on the assets side of the balance sheet must inevitably depend the truth of the figures put against the items reserve fund and profit and loss account. The true significance of the former is not always understood. A reserve fund is merely profits which have been set aside, or reserved, from immediate distribu tion by way of dividend. It is impossible for a company to pro tect its reserve fund from all possibility of subsequent loss. If anything happens to impoverish the concern the first thing to go is, of course, the balance of undivided profits as appearing on the profit and loss account. When this has been exhausted, if fur ther losses occur the reserve fund must necessarily be reduced. It is normally a good practice for companies to acquire invest ments to an amount equal to their reserved profits ; but this prac tice does nothing to protect the reserve fund itself against loss if anything happens to reduce the aggregate value of the assets as a whole. All that it does is to keep a corresponding amount of the company's resources in liquid form, available to be turned into money at short notice to meet any urgent need. Con versely, if the true value of the assets of the concern in question exceeds £175,000, the true extent of its undivided profits is to a corresponding amount in excess of that stated on the face of the balance sheet, and such excess is sometimes called an internal reserve or secret reserve. Similarly, if the actual amount of the liability to creditors is less than the balance sheet shows, there is a secret reserve in existence of a corresponding amount. Most successful companies have fixed assets actually worth more than the figures set against them in the balance sheet, and the pro vision for outstanding liabilities is commonly upon the generous side. Usually, therefore, a successful concern has in fact a secret reserve.
Foreign Balance Sheets.—In Latin, Teutonic and Scandina vian countries it is usual to present balance sheets showing assets upon the left-hand side and liabilities upon the right-hand side, and the items are often shown in considerably greater detail than is usually the case in Great Britain and its dependencies.
The British practice is based upon the form that a balance sheet would naturally take if one were to open a new set of books in connection with an established business, whereas the Continental and South American practice is based upon the form that a balance sheet would take if at the end of the financial period the balances remaining after the completion of the revenue ac count were to be transferred to another account, called closing balance or balance de sortir. If, however, the books be literally "closed" in this way at the end of the financial period, they must necessarily be reopened at the commencement of the ensuing period, thus giving rise to a second "opening" balance sheet, which would take the form of the balance sheet customary in this country. It is submitted that inasmuch as books must be "opened" before they can be "closed," if the duplication of balance sheets is to be dispensed with, the form of the opening balance sheet is the more reasonable form to retain in current use.
See F. W. Pixley, How to Read a Balance Sheet (1924) ; L. R. Dicksee, Published Balance Sheets and Window Dressing (1927). See also under BOOK-KEEPING. (L. R. D.) There are some differences in the balance-sheet, in regard both to principles and to practice in the United States, as compared with that in Great Britain. These will be commented on under the three heads : form; (2) content ; and (3) interpretation.
The other form of balance-sheet known as the account form as distinguished from the report form, is built up in accordance with the same basic equation; it is expressed, however, in the following form: Assets = Liabilities + Proprietorship. In the United States, as is generally true elsewhere, most balance-sheets issued for the purpose of publication are drafted in the account form. Under this form the right-hand elements, namely, liabilities and net worth, are frequently intermingled. The tendency at the present time is, however, to segregate the group of liabilities from the net worth group and secure totals for these separate groups just as is done in the case of the report form. It is customary here to show the assets on the left-hand side and liabilities and net worth on the right-hand side. Within these main groups practice varies as to the showing of the classified sections. If there is any prevailing prac tice it can be said to rest on the probable use to be made of the balance-sheet. In those concerns where the balance-sheet is used mostly for presentation to the banker as a basis for the granting of short term credit, it is customary to show the classified section containing the current assets first. This will then be followed by the fixed assets, and a similar arrangement as between current and fixed will be followed in the set-up of the liabilities. In other con cerns, such, for example, as railroads and large manufacturing enterprises where the investment in fixed assets is very large com pared with that in current assets, the fixed assets are frequently shown first on the balance-sheet, followed by the current. In such cases on the other side of the balance-sheet, when set up in account form, the capital stock item may be shown first, along with the bonds and other fixed liability items, in an effort to show the sources of the investment in exact juxtaposition with the properties acquired by that investment. When this is done, the final item of the proprietorship element, namely, surplus, appears as the last item on the right-hand side of the balance-sheet, and is thus sepa rated from the other proprietorship element, capital stock. How ever, there is a rather decided trend to show in all balance-sheets, regardless of the purpose for which they are drawn up or the char acter of the company, the current assets and liabilities first, followed by the fixed assets and liabilities, and an entirely separate group for the showing of the proprietorship element.
Accounting in the United States has had a development which has been remarkably free from legal requirements. The Interstate Commerce Commission, a body of the Federal Government having general supervision over the interstate railways and other agencies of interstate commerce, has been given authority to prescribe accounting methods and forms. Accordingly there is an established form of balance-sheet for common carriers in accordance with which all reports to the Interstate Commerce Commission must be set up. This requirement does not prevent a railroad company from publishing its balance-sheet for other purposes in whatever form it sees fit, although such practice is becoming more and more rare. Similarly, the Public Utilities Commissions of the various States have similar forms in accordance with which reports must be made to them by the various public utility companies under their jurisdiction. There is also a very decided trend toward uni formity in connection with various trade associations. Some i 50 of such associations have developed, or are undertaking to develop, uniform methods of accounting applicable to the entire industry. Such developments have resulted in the adoption of uniform balance-sheets and operating statements, the purpose of which is to provide for the building up of statistical data on a truly com parable basis. It should be noted that such uniformity is wholly voluntary on the part of the members of the associations or other users of the uniform statements. (See COST ACCOUNTING.) Content.—In connection with the content of the balance-sheet, two basic problems are involved. One relates to the items which shall be admitted to the balance-sheet, the other to the valuation basis on which they shall be admitted. It may be said briefly with regard to the first that all properties owned and all liabilities in curred relative to a particular business entity should be shown in its balance-sheet. In a great many instances even what are known as contingent assets and contingent liabilities are shown by incor poration in the content of the balance-sheet, although these are fre quently appended as foot-notes. Such items are typified by forward sales orders, that is, sales orders received for future delivery of goods, and purchase commitments covering goods bought but not yet received.
As to the valuation basis of the items admitted to the balance sheet, this rests largely on the uses to which the average balance sheet is to be put. At present time the chief use made of balance sheets is as a basis for the granting of short term credit, or for the determination of the degree of solvency of the concern. By sol vency is meant the ability of a business to pay its debts as they come due. For this purpose the current assets and liabilities are chiefly used, little attention or value being given to the fixed assets and liabilities. Accordingly, the principles of valuation applied to the current assets rest upon the assumption that these assets are to be used chiefly for the payment of the current debts falling due within, say, the next twelvemonth. This requires the valuation of the current assets on an extremely liquid basis. It may be said, therefore, that such assets are, with certain limitations, to be valued in accordance with their cash realizable value. That is, they should be stated at such values as represent, on the part of those best qualified to judge, the estimated amount of cash which will be realized when they are converted into cash. Accordingly, the accounts and notes receivable are stated, not at book value, but at such value less the estimated amount of loss through inability to collect. Similarly, current investments are usually to be valued on the basis of their cash realizable value on the date of the balance-sheet. Merchandise is usually valued on the basis of cost, or replacement cost, whichever is the lower, although that basis is not looked upon as entirely satisfactory in a great many cases. The fixed assets, because little regard is paid to them in the ordinary uses of the balance-sheet, are valued on the basis of cost less accrued depreciation to date. Seldom is any effort made to have the fixed assets reflect their true present value in accordance with the price trend at a given time. Thus, the standard practice results in a balance-sheet statement which does not reflect the present worth of a business, as distinct from its net worth, which is determined on the valuation basis referred to above. A physical appraisal of the properties becomes necessary to determine the present value of a business.
is a decided trend at the present time, on the part of accountants, towards paying much more attention to the interpretation of balance-sheets than has been paid in the past. Very few business executives know how to read a balance sheet intelligently. The accountant, who realizes better than any one else the way in which the items on the balance-sheet have been built up, is in a position to interpret them more readily than any one else. Accordingly, a great many accountants to-day are not satisfied merely with drawing up a balance-sheet and letting it speak for itself, but insist upon indicating in their reports the sig nificant facts which an intelligent reading of the balance-sheet brings to light. Such items as the sufficiency of valuation reserves, the reserve for doubtful accounts and the reserve for depreciation; the sufficiency of the working capital employed in the business ; the relationship between borrowed capital or funds and the owner's investment in the business; the relation of current assets to cur rent liabilities—these are some of the more patent things about which the balance-sheet gives information and which certainly should be called to the attention of the owners. More and more there is a tendency to relate the interpretation of the balance sheet to the position in the business cycle, and also to the price trend, as evidenced by price index numbers. All of this requires, on the part of the accountant, a grasp of the broad underlying economic condition of the country and also a knowledge of the basic conditions in the particular industry. Without such knowl edge a really sound and discerning interpretation of the balance sheet is not possible. Some accountants even go so far as to insist that the balance-sheet should reflect present valuations in both the current and fixed assets. Because of the relatively rapid turnover of merchandise and accounts and notes receivable, those items are for the most part valued on a basis which is fairly close to the current price level. The value of the fixed assets, particularly those with long lives, may be very far removed from a present valuation basis. Accounting methods have been devised whereby both the present value and the original cost value may be shown on the same balance-sheet and these present values incorporated in the books of account without disturbing the statement of operations of the business. While a good deal of research has been conducted in this direction, the matter is an extremely controversial one.
As to the frequency with which balance-sheets are prepared, there is an increasing trend toward the monthly balance-sheet. A great many concerns, particularly manufacturing and large retail establishments, use monthly balance-sheets for internal guidance.