Introduction No matterthe size of a company or business, information is needed in order for decisionsto be made. The major function ofaccounting is to provide periodic reports to management, owners, and outsiders.Specifically, accounting is defined as the process of identifying, measuring,and communicating economic information to permit informed judgments and decisionsby users of the information (Porter & Norton, 1998).
Users of the information are classified intotwo categories, internal and external. Internalusers consist of management who are a part of everyday operations, whereas externalusers are not involved in the everyday operations, such as stockholders,bondholders, bankers, creditors, and government agencies. So the question is, howdo they obtain the information they need? Key information containing detailed transactions are summarized andreported in a set of standardized reports called financial statements.
Financial statements are useful fordetermining the ability of a business to generate cash, determining whether abusiness has the capability to pay back its debts, derive financial rationsthat can indicate the condition of the business, and being able to trackfinancial results on a trend line to spot any impending profitability issues (Financial Statements, 2017). The financials are typically made up of fourmain statements: the balance sheet, income statement, retained earningsstatement, and statement of cash flows. The balance sheet summarizes resources owned by a company and the claimsagainst those resources at a specific point in time. The income statement showshow well a company is performing operations over a period of time.
The retained earnings statement allows usersto see how much of the company’s income is retained in the business and howmuch is paid out to its investors. Lastly, the statement of cash flows reportsthe source and use of a company’s cash over a period of time (Rich, Jones, Heitger, Mowan, & Hansen, 2012). For the purpose of this paper, we focusprimarily on the balance sheet, by taking a detailed look at it and theelements that make it up.
Classifications The balancesheet is also commonly known as the statement of financial position, where itspurpose is to report the financial position of the entity at a specific pointin time. It is made up of accounts thatare classified, meaning similar items are grouped together to equal a subtotal.This allows users to see different relationships that exist betweenaccounts. There are three elements includedin the balance sheet: assets, liabilities, and equity. Each will be discussed in further detail inthe following sections. The relationship between the elements can be explainedby the following fundamental equation:Assets =Liabilities + Stockholder’s EquityBy looking at this equation, we see how the balance sheetgets its name. The economic resources ofa company must always equal the claims against those resources ( (Rich, Jones, Heitger, Mowan, & Hansen, 2012). Assets Assets arethe probable future economic benefits obtained or controlled by a particularentity as a result of past transactions or events (Kieso, Weygandt, & Warfield, 2013).
They are a resource with economic value thata company possess the right to use at its discretion. These resources areusually recorded at their acquisition cost, and reduced when they are used upor depreciated. Because it is difficultto determine the actual value of an asset at regular intervals in a completelyobjective way, assets values are no permitted to move upward (Walgenbach, Hanson, & Hamre, 1990). Assets have thecharacteristics of being tangible, having a physical presence, or intangible,nonphysical items.
They are also listedin order of liquidity, meaning those that can be converted to cash quickly arelisted first. To organize this processand help the users better understand the relationships between accounts, assetsare divided into the following sub-classifications: current assets, long-terminvestments, property, plant, and equipment, intangible assets, and otherassets. Table 1, the financial balancesheet of GAP Inc., is presented as an example to show how these classificationsare reported. Current assets arecash and other resources that are expected to be converted into cash, used up,or sold within one year or one operating cycle, which ever is longer. An operating cycle is the average period oftime required for a business to produce goods, sell those goods, and receive cashin exchange for goods (Financial Statements, 2017). Majority of entities is short than one year,so they use one year as the measurement for classifications of current andnoncurrent assets.
Current assets arethose used to fund day-to-day operations. As previously stated, items on the balance sheet are listed in order ofliquidity. There are five major itemsfound in the current assets section: cash, short-term investments, receivables,inventories, and prepaid expenses. Cash consists of monies that are currently on hand and areready to be exchanged for other goods or services. Detailed cash accountsconsist of petty cash and cash held in financial institutions. Since it isalready converted, it is the most liquid asset. Table 1 presents the financial balance sheet of The GAP Inc., thelargest specialty retailer in the United States.
Cashand cash equivalents are the first items listed. The GAP’s financial notes state that cashincludes funds deposited in banks and amounts in transit from banks forcustomer credit and debit card transactions that process in less than sevendays (United States Treasury, 2017). Short term investments allow companies to earninterest income by investing cash into stock and bonds that they then willconvert back to cash within one year. Held-to-maturity securities, debtsecurities that a company has the positive intent and ability to hold tomaturity, trading securities, securities bought and held primarily for salenear the end of the term, and available-for-sale securities, debt and equitysecurities not classified as one of the other two securities, are three commonsecurity portfolios for valuation and reporting purposes (Kieso, Weygandt, & Warfield, 2013). Accounts receivablerepresent the rights of a company to collect amounts due from customers. A sale has been made, revenue has beenrecorded, but no cash has been exchanged. This account also has a contra-account, allowance for doubtful accounts.This account reduces the total receivables by an amount that recognizes a baddebt loss from accounts the entity expects to not to receive funds from.
The GAP Inc. does not have either of theseaccounts listed as a current asset. It does report the current asset ofinventory.
Inventories are goods orproducts the company has on hand that they intend to sale within the year. Inventory may be valued by a variety of ways,a few of them being FIFO, LIFO, and weighted-average cost. For The GAP Inc., inventory consists of allof the clothing, shoes, and accessories they intend to sell to customers. This inventory is valued at the lower of costor market, with cost determined using the weighted-average cost method andmarket value determined based on the estimated net realizable value. The last common current asset is prepaidexpenses. These represent payments made in advance for services such as rentand insurance that will expire or be consumed within the year or operatingcycle.
For GAP Inc., this account may bereported under other current assets, a catch all account for smaller currentasset accounts like prepaid expenses and supplies. Long-term investments begin the noncurrent asset portion of the balance sheet.These investments are like short-term investments, but they are either held forlonger than one year or one operating cycle or were bought with the intentionof never selling them.
Long-term investments include both tangible andintangible assets. Tangible investmentsconsist of land or buildings owned by the entity that are not currently used inoperations. On the other hand,intangible assets include bonds, common stock, or long-term notes, andinvestments in special funds such as pensions and plant expansions. While these assets are readily marketable,they are not included in current assets because the entity does not intend toconvert them within the year. The GAPInc. does not show any signs of having such investments during the years of 2017and 2016.Property, plant and equipment representsthe tangible, long-lived, productive assets used by a company in its operationsto produce revenue (Rich, Jones, Heitger, Mowan, & Hansen, 2012).
Such assets include land, machinery, officeequipment and furniture, buildings, and manufacturing equipment. These items are a vital part of an entity andits operations, but they are not in a state that can easily be converted tocash. Property, plant, and equipmentare recorded at cost when it is obtained, and then depreciated over the courseof its useful life. Depreciation allowsan entity to distribute the cost of these assets over the periods the asset isused to produce revenues. Depreciationexpense is recorded on the income statement and totals depreciation just in thecurrent period, whereas accumulated depreciation is presented on the balancesheet as a contra-asset account of property, plant, and equipment to representthe total amount of depreciation that the company has expensed over the life ofthe asset.
On their balance sheet, TheGAP Inc. reports a net total of $2,616,000 during 2017. The financial notesstate that such property includes leasehold improvements, furniture andequipment, software, and building and improvements. Depreciation is computed using thestraight-line method over the estimated useful of the related assets (United States Treasury, 2017). Intangible assets represent assets that haveno physical substance. Examples of theseinclude patents, trademarks, goodwill, and copyrights.
Like property, plant, and equipment,intangible assets provide benefits to a company over a number of years, buttheir valuation is rather difficult to determine. Also in comparison to property, plant, andequipment, these assets are written off, or amortized, over their usefullife. Intangible assets like name brandplay a key role for companies like The GAP Inc. The would not be one of the leading apparel retailers in the country hadthey not obtained its brand-name recognition.
Liabilities As previously mentioned, assets arethe sum liabilities and stockholder’s equity. Liabilities represent the probable future sacrifices of economicbenefits arising from present obligations of a particular entity to transferassets or provide services to other entities in the future as a result of pasttransactions or events (Kieso, Weygandt, & Warfield, 2013). Basically, liabilities report the amount ofmoney or services an entity owe to others. They are vital to operations as they provide financing for day-to-dayevents as well as for expansions of the entity. Like assets, liabilities are listed in a specific order, which is theirdue date. Two of the major sections being current liabilities which are due atany point with in the year, and long-term liabilities that have due datessurpassing one year. Currentliabilities consist ofobligations that will be satisfied within one year or the operating cycle,which ever is longer.
Say, for example,GAP takes out a mortgage that will be paid over the next twenty years, which isa long term liability, but GAP will report the amount that’s due this yearunder current liabilities and the remaining amount will stay in the long-termliability account. Accounts payable,salaries payable, unearned revenue, interest payable, and income taxes payableare common accounts reported under current liabilities. Accounts payable represent theobligations of a company to pay for materials or services that were provided byother entities. For retail companieslike GAP, merchandise is bought from outside providers under a set of terms,such as net 30 days or net 90 days, that indicate how long the entity has to payfor the merchandise. The company alreadyreceives the merchandise, but still has an outstanding obligation to pay theinvoices.
This obligation amount is whatis reported under accounts payable. ForThe GAP Inc., as of January 31, 2017, they had $1,243,000 of obligationsoutstanding. Salaries payable arereported to show the amount due to employees for services performed. This liability typically occurs when the endof the year and pay day do not hit on the same day. For example, the end of theyear is on Wednesday, but employees are not paid until Friday for the services theyperformed that week. The amounts they earnedfor Monday through Wednesday would be reported as salaries payable at the end ofthe year because they have earned the amount, but have yet to be paid.
Payroll taxes payable and income taxes payablealso tend to have the same issue and represent the amount of taxes that are owedto governmental entities but have yet to be paid due to timing differences. The GAPInc. has an obligation to pay $32,000 in income taxes at the beginning of 2017.