ASSETS (second component of the Balance Sheet)

Assets are economic resources of a business. For example, cash is an asset which allows a company to buy other assets or resources, pay debts a company may have, or pay Operating Expenses. Assets can be classified into two categories; - Current Assets and Fixed Assets.

Current Assets:
Current assets consist of cash and other resources (assets) that are expected to be converted into cash within one year or less. Examples of other resources expected to be converted into cash would include inventory (products a company sells to its customers), accounts receivable (money customers owe a business for products purchased on credit) and marketable securities (short term investments made by a company). Current assets also include items that add "value" to a business and become "used up" or "consumed" in less than a one year. Examples of these current assets would include: office supplies, store supplies, and prepaid items such as prepaid fire insurance, & prepaid rent. When these items become used up or consumed, they are no longer considered assets to the company - they are considered expenses.

The Toy Company's Current Assets on its Balance Sheet as of December 31, 200X are as follows;

Let examine each component in detail !!!

Cash
Cash is the amount of money a company has in its bank account. Cash is necessary for paying bills and for maintaining the day to day operations. As you can see, The Toy Company has $10,122 cash in its bank account on December 31, 200X. This balance will change on the following day if any of the following activities take place: if the company makes cash sales, pays on its debt, receives additional investments or loans, pays on expenses, and other transactions requiring cash.

Many businesses, having extra cash in the bank, may decide to pay down liabilities, invest into new markets, or buy marketable securities. A marketable security, in most cases, is a very short term investment a business purchases from the government, for instance.

Accounts Receivable
An account receivable is a promise by a customer to pay for a product or service at a later point in time. Many of us have purchased items on credit, promising to pay for them in the future. Companies offer credit terms as an added service to customers in an attempt to increase sales. When you, as a consumer, purchase something on credit, the company you purchase the product or service from will consider you an account receivable. If you, as a business owner, allow customers to buy your products on credit, then those customers are considered accounts receivable. As of December 31, 200X, The Toy Company has $5,000 outstanding in accounts receivable. This means, some of the company's customers purchased $5,000 worth of toys, and as of December 31, 200X, haven't paid for them.

Usually businesses will give their customers 30 days to pay for items placed on credit. The pay back period, however, depends on the industry norm and the company's credit granting policy. Most businesses charge interest to customers who fail to pay within an allotted time frame. The interest rate varies from company to company, however, it usually ranges between 2 and 5 percent of the amount owed.

Prepaid Items
Prepaid items are expenses businesses pay for in advance. Common prepaid expenses include, prepaid rent and prepaid insurances. You may ask why would a business pay for something that is not due. Proper cash management dictates "not to pay for something unless it's due". Some contracts , however, call for payment of goods and services up front. Think about your personal car insurance. If you are not on a monthly payment plan, chances are you're required to pay for your automobile insurance in advance; usually six months in advance.

Prepaid items are considered assets because full payment is made for services that have not been fully rendered. As a company receives the service, the prepaid item is no longer an asset, but rather an expense. To explain this concept, lets refer back to one of our assumptions which stated.

"On July 1, 200X, The Toy Company purchased fire insurance on its building and its inventory of toys. The insurance company quoted a yearly rate of $2,400. The insurance contract called for 1 year payment to be made in advance".

In short, on July 1, 200X Donald wrote a $2,400 check to his insurance company. The fire insurance "covers" the building and inventory for a 1 year period. Therefore, on July , 200X, The Toy Company's balance sheet would show an account called prepaid fire insurance for $2,400. The company's balance sheet as of December 31, 200X, however, shows the prepaid fire insurance account balance as $1,200. From July 1 through December 31, 200X, the prepaid fire insurance account reduced by $1,200 ($2,400 - $1,200 = $1,200). The reason behind the reduction is simple. The $2,400 paid on July 1 protects the company against fire for a 1 year period (from July 1, 200X to July 1, 200Y). Since six months of the insurance has expired ( July to December of 200X), only six more months is left on the insurance policy (from January to July 1 of 200Y). Therefore, only six months (or half) of the policy still has value to the Toy Company. The other six months of the insurance has no value and is considered to be an expense. The Income Statement on December 31, 200X would show an account called Fire Insurance Expense. The fire insurance expense would have a value of $1,200 - the used or consumed portion of the insurance policy.

Inventory
Inventory is the product a company buys or produces and sell to end consumers (you and I). For example, The Toy Company is a retailer that buys products from a wholesaler and sells them to end consumers. Most retailers and service providers buy finished inventory and sell it to end consumers. A manufacturer, on the other hand, buys raw materials and manipulates (manufactures) those materials into finished products. A retailer's inventory generally is "finished" and ready for resale upon unpacking the products. Where as a manufacturer may have three types of inventory - raw materials, work in process, and finished goods inventory.

If you are a retailer/service provider your inventory is always recorded at its cost (IE historical value). That is; the money you pay your suppliers for the goods you buy for resale plus any shipping charges. Thus, as of December 31, 200X The Toy Company has finished inventory on hand valued at $12,558. Therefore, The Toy Company paid wholesalers and shipping companies $12,558 for the toys that are on display and that are in storage. The inventory will decrease in value if the company makes sales to customers.  The inventory account will increase when more inventory is purchased. Remember when a sale is made the inventory is removed and is recorded as a cost of good sold (COGS). Cost of Goods Sold appears on the Income Statement.

If you are a manufacturer, your inventory will be recorded at the cost of all raw materials, plus direct labour costs (labour costs directly related to producing the finished product), plus factory overhead charges required in manufacturing the raw materials into finished products. Usually, manufacturers will separate finished goods (products ready for resale) from non-finished goods (raw materials and work in process) on the balance sheet.

Total Current Assets
Total current assets is the sum of all the current assets listed on a company's balance sheet. As indicated below, The Toy Company has total current assets valued at $28,880.

Fixed Assets:
The second classification of an asset is known as a Fixed Asset. Fixed Assets are economic resources that have long lives before they become "used up" or consumed. Unlike current assets which are used up or consumed in less than 1 year, fixed assets generally take more than one year before they become consumed. Don't be confused with the term FIXED ASSET; it does not mean assets that are stationary or immobile - it's simply a financial term. Examples of fixed assets include; office equipment (computers, fax machines, photocopiers, etc) office furniture (office desk, fixtures, etc), buildings, automobiles, production equipment, land, patents, trademarks, copyrights.

When current assets such as inventory, office supplies and store supplies are used up or consumed, they are no longer considered assets, but rather they are considered expenses. Fixed assets undergo a similar process called depreciation. Depreciation attempts to estimate the reduction in the value of fixed assets. When fixed assets are depreciated, two accounts are created; namely, Depreciation Expense and Accumulated Depreciation. The depreciation expense appears on the income statement while the accumulated depreciation appears on the balance sheet. To explain these terms, lets look at the fixed assets section for the Toy Company on December 31, 200X.

As you can see, The Toy Company's fixed assets include office equipment and a building. Let's look at each fixed asset separately and line by line.

OFFICE EQUIPMENT:

THE FIRST LINE - Office Equipment ($12,500):

As indicated under the assumption section of our example, The Toy Company purchased two computers for $4,400, a fax machine for $300, and a mobile photocopier for $7,800. These assets were purchased on January 1, 200X and were grouped together into one account called Office Equipment. When added together, the office equipment account balance is $12,500.

As you can see, the first line (office equipment - 2 year life) has a balance of $12,500. This figure represents the amount the fixed assets were "worth" at the time of purchase. This is known as the asset's historical cost. The account balance of $12,500 (historical cost) will remain at this amount each year unless The Toy Company purchases more office equipment or sells off any of the existing office equipment.

THE SECOND LINE - Less: accumulated depreciation-office equipment:

The second line (less: accumulated depreciation - office equipment) keeps track of the reduction in value of the office equipment over time. Furthermore, from January 1 to December 31, 200X, the office equipment reduced in value by $6,250. In other words, the office equipment depreciated in value by $6,250. How was this reduction in value calculated? Recall, under the assumption section of our example, Donald's accountant estimated the office equipment would have a useful life of 2 years, after which time, the equipment would be worthless. In addition, the accountant suggested the office equipment should be depreciated using a straight line method (straight line method of depreciation attributes an equal reduction in value each year of the asset's useful life). Since Donald is using the straight line method of depreciation, he would simply divide the asset's historical cost ($12,500) by the asset's useful life (2 years), to arrive at the depreciation amount for one full year. Therefore, The Toy Company estimates the office equipment will depreciate $6,250 each year ($12,250 / 2 years).

As mentioned earlier two accounts are created when depreciating fixed assets; depreciation expense and accumulated depreciation. In our example, the depreciation expense, appearing on The Toy Company's December 31, 200X income statement, will have a account balance of $6,250 each year. And the accumulated depreciation, appearing on The Toy Company's December 31, 200X balance sheet, will have an account balance of $6,250 as of December 31, 200X. If you refer to the accumulated depreciation - office equipment account as of December 31, 200X, you will see $6,250.

PLEASE NOTE: If no other office equipment is purchased, then the depreciation expense for the office equipment (appearing on the income statement) will always remain the same each year throughout the asset's useful life ( ie $6,250). The accumulated depreciation shown on the balance sheet, however, accumulates the office equipment's reduction (loss) in value each year, for the useful life of the office equipment. Therefore, the depreciation expense on the income statement for the year ending December 31, 200Y will have an account balance of $6,250, while the office equipment's accumulated depreciation on the December 31, 200Y, balance sheet will show an account balance of $12,500 ($6,250 depreciation for 200X and $6,250 depreciation for 200Y = $12,500 accumulated depreciation for office equipment).

THE THIRD LINE- net office equipment

The third line is called Net Office Equipment. This line is calculated by subtracting the historical cost of the office equipment ($12,500) and the accumulated deprecation of the office equipment ($6,250). The resulting figure ($6,250) is an estimation of the economic value remaining on the office equipment on December 31, 200X. Recall the office equipment was worth $12,500 when it was purchased on January 1, 200X. Donald's accountant estimated the equipment would reduce in value (depreciate) by $6,250 each year of its useful life. Therefore, on December 31, 200X, the office equipment is estimated to be worth $6,250.

How much would the office equipment be worth one year from December 31, 200X; (which would be December 31, 200Y)? The answer should be apparent. Since the office equipment was estimated to have a two year life, and December 31, 200Y represents the equipments two year anniversary, it would have a economic value of zero. Furthermore, if no other office equipment was purchased during 200Y, the office equipment section of the balance sheet on December 31, 200Y would look like this.

Remember the accumulated depreciation account, accumulates the depreciation estimated each year. Thus, 200X depreciation was $6,250 and 200Y depreciation was $6,250, resulting in total (accumulated) depreciation of $12,500. Now lets briefly look at the Toy's Company's second fixed asset; namely Building.

BUILDING
The following has been taken from the fixed asset section of The Toy Company's balance sheet as of December 31, 200X.

As you can see, the same structure is used for the building as was used for the company's office equipment. The first line describes the name of the fixed asset along with its historical cost. The second line estimates how much the building has depreciated over the years. And the third line estimates the "net worth" of the building on the balance sheet date (December 31, 200X). To explain where these values came from, lets look at each line separately.

FIRST LINE - Building
The first line represents the historical value of the building. Recall, The Toy Company received a bank loan on July 1, 200X. The bank loan was used to purchase a $22,500 building. Therefore, the historical cost of the building is $22,500.

The building's historical cost account on the balance sheet will always remain at $22,500 unless any of the following events occur;

1.    Major renovations are made to the existing building;

2.    If the Toy Company's sells the existing building; or

3.   An additional building(s) is purchased by the company.

Notice the building was purchased using borrowed money. Although, the bank loan was used to buy the building, it's still considered an asset of The Toy Company. Our point is this,

DON'T think of an asset (current or fixed) as something a business owns. Rather, view an asset as a resource that can be used to strengthen a business. Although, The Toy Company doesn't really "own" the building, it's still considered the company's fixed asset. It's an economic resource that can be used to strengthen their business. In addition, when assets are purchased with borrowed money, an asset account and a liability account will be created and placed on the Balance Sheet. This will become clearer to you when we discuss the liabilities section of balance sheet.

SECOND LINE - Less Accumulated Depreciation - Building

As you can see, the "less accumulated depreciation" account shows an amount of $2,250 on December 31, 200X. To explain how this was calculated, we will have to refer back to the assumptions section of our example. Recall;

"Donald's accountant suggested the building will have a useful life of 5 years and will be depreciated in equal amounts per year over these 5 years using a straight line method of depreciation. Therefore, depreciation expense on the building for one full year will be $4,500 ($22,500 divided by 5 years = $4,500 per year)."

Notice the above assumption indicates that deprecation expense will be $4,500 for one full year. In other words, the accountant is estimating the building will reduce in value each year by $4,500. Since the building was purchased on July 1, 200X, it has only depreciated 6 months (from July 1 to December 31 = 6 months). Therefore, the depreciation expense and accumulated depreciation as of December 31, 200X would be half of the yearly amount or $2,250. If you look at the amount in the accumulated depreciation account on December 31, 200X, you will see $2,250. If the building had been purchased on January 1, 200X, then the full depreciation rate of $4,500 would apply.

What amount will appear in the accumulated depreciation account on December 31, 200Y (one full year from the December 31, 200X). To answer this, we must determine the amount the building is estimated to depreciate each year. This was already calculated above to be $4,500 per year ($22,500 / 5 years = $4,500).

Since the accumulated depreciation account "tallies" the depreciations for each year, the amount showing in the accumulated depreciation account on the December 31, 200Y balance sheet would be $6,750 ($2,250 depreciation from July to December 200X + $4,500 depreciation from January to December 200Y = $6,750). Below shows the changes in the accumulated depreciation account from December 31, 200X to December 31, 200Y.

THIRD LINE - Net Building

The third line (Net Building) is calculated by subtracting the total reduction in economic value of the building (depreciations over the years) from the historic cost of the building. The result is known as - Net Building. The Net Building estimates the value of the building on the balance sheet date. Therefore, on December 31, 200X the building is estimated to be worth $20,250.

What is the building's estimated worth at the end of the company's second year of operation (IE on December 31, 200Y). To determine this, we will have to know the historical cost of the building and the accumulated depreciation of the building on December 31, 200Y. The historical cost of the building is known ($22,500) and the accumulated depreciation as of December 31, 200Y has already been calculated. The following chart has been extracted from above;

Therefore, the building would have an estimated value (worth) of $15,750 on December 31, 200Y. The building reduced in value by $4,500 from the previous year. The $4,500 is the depreciation or reduction in value estimated by The Toy Company's accountant.

This concludes our discussion on The Toy Company's fixed assets. Remember that all fixed assets will consist of three lines;

1.    The name and historical cost of the fixed asset

2.    The accumulated deprecation of the fixed asset; and

3.    The NET fixed asset name and its estimated worth

The next balance sheet item to be discussed will be Total Fixed Assets.

Total Fixed Assets
Total Fixed Assets is the sum of all the Net Fixed Assets listed on a company's balance sheet. As indicated below, The Toy Company has Total Fixed Assets on December 31, 200X valued at $26,500.

As you can see, Total Fixed Assets of $26,500 was arrived at by adding the Net Office Equipment of $6,250 to the Net Building of $20,250. In essence, on December 31, 200X The Toy Company Total Fixed Assets are estimated to be worth $26,500. The next section explains Total Assets.

Total Assets:
Total Assets are the sum of the total current assets and the total fixed assets. Below depicts The Toy Company's current assets and fixed assets as of December 31, 200X.

Total Assets of The TOY Company as of December 31, 200X

As you can see, The Toy Company has Total Assets on December 31, 200X of $55,380 In other words, The Toy Company's assets on December 31, 200X have an estimated value of $55,380. This concludes the total assets section as well as the Asset Component of the Balance Sheet.  Next we will look at the Third Component of the Balance Sheet, namely Liabilities.