The balance sheet
The objectives of this chapter are to:
explain the nature and purpose of the ‘entity’ concept; define the major components of a balance sheet; identify and explain the ‘accounting equation’; outline the relationship between ‘assets’ and ‘sources of finance’ as disclosed in the balance sheet; explain the impact of individual transactions on ‘net assets’ and ‘owner’s capital’ contained in the balance sheet; demonstrate the impact of profit on assets and on the owner’s capital; show how assets and sources of finance are presented in the balance sheet, distinguishing between ‘fixed assets’ and ‘current assets’ on the one hand and
‘capital’, ‘current liabilities’ and ‘non-current liabilities’ on the other; outline different possible ways of valuing assets; and explain why historical cost is widely used for reporting purposes.
THE ENTITY CONCEPT
n Chapter 1 we saw that there are three main forms of trading organization
(clubs and societies do not usually trade) within the private sector of the economy – the sole trader, the partnership and the limited company. There are two important differences between sole traders and partnerships (sometimes referred to as ‘firms’) on the one hand and limited companies on the other:
1 The relationship between ownership and management. In the case of firms, the owner or owners run the business, whereas in the case of the limited company there may well be a significant separation between the ownership and managerial functions. This is particularly likely in the case of the public limited company, where the bulk of the finance is provided by the general public.
2 The owner’s liability for business debts. Sole traders and partners normally have unlimited liability for the debts of their firm, whereas the shareholders of limited companies are not required to contribute beyond the amount originally paid for shares issued by the company.
The latter distinction is significant when a business runs into financial difficulties.
In the case of firms, the creditors claim first against the business assets; if these are insufficient to satisfy the amounts due, the creditors can then claim against the owner’s personal wealth. In an extreme situation, the owner of a bankrupt firm could be forced to sell his or her home and all other personal belongings to meet
THE BALANCE SHEET
demands from the firm’s creditors. (It is to avoid this outcome that a person in business sometimes transfers the ownership of personal assets to his or her partner.)
This contrasts with the relative position of investors and creditors of a limited company, where any deficiency of business assets compared with liabilities at the date of liquidation is borne by the creditors.
Company law, therefore, regards a limited company as a separate legal entity.
The creditor contracts with the company and can claim only against its assets. No such legal distinction is recognized where the business is carried on by a sole trader or by partners. The position in accountancy, however, is quite different. It is always assumed, for accounting purposes, that the business entity has an existence separate and distinct from its owners, managers or any other individuals with whom it comes into contact during the course of its trading activities. The assumption of a separate existence, usually referred to as the entity concept, requires a careful distinction to be drawn between business affairs and personal transactions. One of the reasons for requiring this distinction to be made is that it facilitates performance assessment. A sole trader forms a business in the hope that it will earn him or her a satisfactory profit and, to discover whether this objective has been achieved, profit must be calculated only on the basis of business transactions.
On 1 January 20X1 Mr Old was made redundant and received £30,000 in