Balance Sheet equation and components of balance sheet equation

A balance sheet is a financial statement of an entity that is prepared for reporting of financial position of the business as of a particular date. The balance sheet is divided into two sides, with assets on one side and liabilities and shareholders’ equity on the other. The left side of the balance sheet outlines all of a business’s assets. On the right side, the balance sheet outlines the business’s liabilities and shareholders’ equity.

The balance sheet is so called because the structure of the balance sheet is in the ‘T’ form with both sides of it equally balanced [i.e. (Owner’s Equity+ Total outside liabilities at one side) = (Total Assets shown on the other side).

The balance sheet equation is A= L+E (Assets = Liabilities + Shareholders’ (or Owner’s) Equity)

Balance Sheet is also known as a statement of net worth or statement of financial position because the Net worth of the owners in the business = Assets-Liabilities or E=A-L

This equation is the foundation of the balance sheet and ensures that the assets and sources of capital are in balance.

The balance sheet is divided into two sides, with assets on one side and liabilities and shareholders’ equity on the other. The left side of the balance sheet outlines all of a business’s assets. On the right side, the balance sheet outlines the business’s liabilities and shareholders’ equity.

Though there is no restriction to prepare a balance sheet ‘as at’ on any date, the Income Tax Act prescribes that all the business concerned must prepare their financial statements as on 31^st March of every year.

Components of a Balance Sheet

A concise format of Balance Sheet: 

A corporate balance sheet as per Schedule VI of the Companies Act is in a concise format of 7 heads viz. Equity, Long-term liabilities, Current liabilities, contingent liabilities, Current assets, Fixed Assets (Long-term investments in property, plants, and equipment), and intangible assets. In this format, the comparison of the balance- sheet of a reporting period with previous years tells us the changes in the position of the owner’s investment in the business year by year. It shows how the capital is distributed, and how much of investment is identified with various accounts.

There is no standard format for balance sheets of non-corporate. Normally, we find the following 8 heads appearing on a balance sheet.

Share capital:

The share capital comprises a subscription of all kinds of shares like equity shares and redeemable and irredeemable preference shares. Since 1988, companies have been permitted to issue redeemable and irredeemable shares with a redemption period not exceeding 10 years. The redeemable and irredeemable shares with a redemption period of below 12 years from the date of the balance- sheet are treated by the banks as debt and not as equity. This is because the repayment obligation of the company is certain and time-bound.

2. Reserve and Surplus:

The Reserve and Surplus head in a balance sheet shows the amount separated from the profit of the business for some specific purposes like Revenue Reserve, General Reserve, Capital Reserve, etc. In other words, the reserve and surplus are the retained profits of the business, not distributed as dividends. As per the Companies Act, all kinds of reserves including the Revaluation of Properties, Reserve for Tax, Reserve for Bad Debt, and Depreciation Reserves are considered Reserve Funds.  However, banks classify the above items as ‘Provisions’ for known and certain liabilities and exclude them from equity, as there is no actual cash flow and they are only for the book entries. (To know in detail about reserves, provisions, accounts payable and accruals click “the difference between reserves and provisions explained“)

3. Long-term liabilities:

Long-term liabilities are all liabilities other than current liabilities. The term loans availed by the firms from banks and financial institutions, for the purchase of plants and machinery, with longer repayment periods (more than a year) or under deferred credits are examples of ‘Long-term liabilities’. Long-term liabilities include debentures and bonds, due beyond a year. The borrowings from close friends and relatives of a proprietor or partners of a firm and acceptance of fixed deposits by reputed firms from retail investors are other examples of long-term liabilities. The debentures (not maturing within one year), Preference shares (redeemable after one year), Term loans (excluding installments payable within one year), Deferred Payment Credits (excluding installments due within one year), Term Deposits payable after one year, and other term liabilities are examples of long-term liabilities.

4. Current Liabilities:

The current liabilities are those dues, to be settled within 12 months from reporting date, including overdraft and loan installments payable within a period of 12 months.  The facilities like Cash Credit, Overdraft, Packing credit, short-term loans, etc. availed from banks, Creditors for the purchase of raw materials and consumable spares, Advance received from customers, Statutory liabilities, debentures maturing within one year, Preference shares redeemable within one year, Term loans installments payable within one year, Term Deposits accepted by the company maturing within one year, etc. are the examples of current liabilities.

5. Contingent liabilities:

Arrears of cumulative dividends, Gratuity liability not- provided for, Disputed excise/customs /tax liabilities, Pending lawsuits (possibility of liability arises only on court judgment), and other liabilities not provided for are examples of contingent liabilities.

A liability is called contingent liability or an asset is called contingent assets if that liability or the asset materializes only on the happening of a future event. A contingent liability or asset is no liability or asset of an entity as of now, as neither the amount nor the liability/asset is certain. Thus, contingent liabilities or contingent assets refer to only the possibility of a future liability or an asset on the happening of a certain event. Schedule 12 in the balance sheet -CONTINGENT LIABILITIES will not be added to the total of the assets and liability but will be reflected as a note and it will be for contingent liabilities. So these are the contingent liabilities which need to be shown in the form of foot note or notes to accounts under schedule 12.

6. Current Assets:

Current Asset is defined as ‘Any assets of a business organization that is expected to realise within 12 months from the reporting date or normal operating cycle which includes cash in hand and bank balance (including deposits maturing within one year). The inventories viz. raw materials, work-in-progress, finished goods, including those in transit, and stores (coal, fuel, oil, lubricants, packing materials, labels, etc., coming under stores.), are classified as current assets.

7. Fixed Assets:

Fixed assets are tangible assets; usually referred to as property viz. ‘plants and equipment’. The land and buildings, plant, machinery, motor vehicles, furniture, and fixtures, are examples of fixed Assets. The Fixed assets are normally not for sale and they are used for production or trade. The useful lives of the fixed assets are more than a year. Unlike current assets, the value of the fixed assets cannot be traced through the value of goods or services sold by the business enterprise. The valuation of fixed assets is made based on their original cost and the value of each item is reduced every year by providing depreciation, taking into account the useful life of the asset. The value of the fixed assets at cost is usually referred to as ‘Gross Fixed Asset’ or ‘Gross Block’ and the amount of depreciation to date, as ‘Accumulated Depreciation’.  The Net value of the asset is usually referred to as a ‘Net Fixed Asset’ or Net Block’.

8. Intangible assets:

The assets which are in the form of physical substances are called tangible assets. Land, buildings, motor vehicles, furniture, and inventories are few examples of tangible assets. The intangible assets are, any long-term assets useful to the business, but they do not have any physical dimension. The assets like brand franchises, trademarks, royalty, patents, copyrights, distribution right, etc., which do not have physical substance are called intangible assets. The intangible assets; although do not have physical characteristics, they represent value, rights, privileges, and economic benefits, just like tangible assets.

Information available in the balance sheet by Schedule VI of the Companies Act

Part I of Schedule VI of the Companies Act lays down the details of the form and contents of the balance sheet. Part II specifies the requirement of a Profit & Loss Account. Schedule VI of the act specifies large numbers of quantity and non-monetary information to be given and the following information are important parts of a financial statement. They are (a)  Contingent liabilities and other items, (b)Uncalled liability on partly paid shares,(c) Arrears fixed cumulative dividends, and (d) Estimated amount of contract remaining to be completed and not provided for.

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