The Balance Sheet

The Balance Sheet

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Before establishing the accuracy of the balance sheet as a valuation tool it is important to understand that to produce a document that shows the exact value of a company is virtually impossible. The combination of all assets, liabilities, owners equity and many other factors must be calculated in order to reach a final value. However, the methods used when valuing, and the constant changes in the economy and inflation make the value of the company itself a constantly changing figure. Therefore should an accurate value of the company be produced it would only be accurate at the time it is produced. Throughout this essay I will discuss the different aspects of the balance sheet and how the way they are presented affects the figures on the balance sheet. But firstly it is important to understand what the balance sheet comprises of and the role it is intended to carry out.

The balance sheet is a financial document which identifies the company’s assets and liabilities of a company. By deducting the assets from the liabilities the net worth is calculated, this is a key indicator of the value of the company to its owners.
It shows the financial of the company on a particular date, “it is a snapshot of the business and is the best measure that we have for looking at financial health” . However, the fact that it is a snapshot means that it is only valid at the time it is produced thus it may not represent a true and fair view. It is possible that a firm may pick a certain day which benefits.

The balance sheet can be used to determine how much credit a company will get or whether or not they should be invested in, it is therefore a very important document and managers are aware of this. It is therefore possible that companies will try to format information and calculate figures using methods that present a better financial picture. The opportunity to adopt creative accounting occurs when choices are made about the basis of deprecation, stock and cost of goods sold. The methods used to calculate these figures can make a vital difference to the balance sheet.

The accuracy of valuation within the balance is a vital point to consider as the various methods used to calculate lead to dramatically different results. The capitalisation of costs is when a cost is treated as an asset as opposed to an expense, thus increasing total assets.

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It is hard to challenge this as we are unaware whether money spent on an asset is done so to repair, maintain or improve it, thus the decision is left to the managers judgement.

There are also a variety of ways to calculate the depreciation of an asset. “By using the straight-line method the cost is spread evenly over the life of the asset…..accelerated depreciation basis the depreciation charges are greater in the early years” . Again the chosen method is left to the judgement of the manager and therefore may not be the most appropriate method of valuation.
The basis of deprecation can also be changed or the anticipated life of the asset retrieved in order to alter figures, such alterations may go unnoticed in published accounts.
There are also advantages and disadvantages to the different ways stock and cost of goods sold are established. The two main conventional methods are First In First Out (FIFO), and Average Cost (AVCO). By there being a variety of valuation methods it is not always very accurate and can be hard to adopt.

There is also the issue of valuing assets using historic cost accounting. This is a useful method of accounting as it is good as “it permits accounts to be produced by collecting information about business transactions….amounts are determined by the transaction as opposed to by individuals” . This therefore means that there is no opportunity for figures to be based on judgments or the possible abuse of individuals, thus making it more reliable in that aspect.
This is one of the reasons why historic cost is still a main basis for accounting. However, large problems can occur when using the historic cost method. Increasingly the cost of assets change over time, whether it be due to inflation or advancing technology. This results in a value being presented on the balance sheet that is out dated and unrealistic.

These are several ways in which the figures that appear on the balance sheet can alter the results of important figures. It could therefore be argued that the balance sheet, when read without studying the underlining notes and accounts, does not clearly represent the value of a company. In order for a document to be useful it must be “relevant, reliable, valid and comparable to other similar figures” . There are ways in which the balance sheet does fall into this category and ways in which it does not. For example although it is easy to compare the figures on the balance to sheet to those of previous years, it is harder to accurately compare them to other companies. This is mainly due to the variation of valuation methods or even the point at which a firm recognises its sales.

It is evident that the main problem with the balance sheet is that it is a basic financial account than can be calculated in a number of different ways.
“The difficulty is to find methods of measurement that are theoretically sound, produce useful and verifiable information, and are practicable, give the time and expertise available to the business” . If a company does not achieve this then the balance sheet can be a misleading projection of their financial value.
In the case of bad or doubtful debts a firm may never receive payments owed, therefore if they recognised the sale at the point of transaction as opposed to the point when cash is received then turnover recorded is not accurate. This is why in many cases a provision for bad debts is made.

The balance sheet can be a very useful tool as it is the best way of identifying the company’s progress. Assuming that each year the company elects to produce accounts during times of strength we can see whether they are improving or not. This helps provide information for decision making, it is often assumed that a firm that has been growing financially over the previous years will continue to do so or at the least maintain its strong position. This is why investors either lend money or buy shares in companies. The fact that the balance sheet is used a tool for decision making may be a clear sign that it is a good indicator of the value of a company. It is also possible that it is mainly used in this sense as it is a way of monitoring progress thus identifying whether or not the value of the company is likely to increase.

So far I have simply discussed the value of the balance sheet to groups outside of the company. However it also plays key roles within the firm, “accounts help owners decide how much can be drawn out for personal use” . This shows that figures are seen as reliable by members within the firm and are therefore a good indication of the company’s wealth.
Often the balance sheet is purely produced to form the basis of the charge for taxation, therefore is designed to be an accurate reflection of the company’s financial situation.
Regardless of whom the balance sheet is produced for or what methods are used to calculate various values, the most important point to remember is that it is only relevant at the time it is produced. It is an insight into the company’s financial position at a particular point in time and is therefore often out of date.

Although the balance sheet is “a statement of the financial value (or "worth") of a business or other organization (or person)” , it is the only financial document that applies to a specific moment in time. Therefore once that time has passed the financial situation may have changed dramatically.
It is therefore likely that although the balance sheet does show a brief account of the believed value of the company, it should only be used as evidence of the company’s past performance not as an accurate account of the value of the company at the time it is being read.

In order for someone to gain a true understanding of the value of the company they must analyse the four main financial accounts as well as reports and notes. In addition to the balance sheet these are the profit and loss account, income statement and cash flow statement. By using the information found in all of these documents and combining them, a much more accurate picture can be created. In order to achieve this the audience must have good understanding of financial accounts. The balance sheet is structured in a way that simplifies this information. However by simplifying it, it becomes distorted and less accurate. If someone is aware of the floors behind the balance sheet they should be able to take them into consideration when reading it.

Bibliography

McKenzie, W. (1994) The Financial Times Guide to Using and Interpreting Company Accounts. Pitman Publishing.

Gillespie, I. Principles of Financial Accounting 3rd Edition. Financial Times, Prentice Hall

Thomas, A. (1996) An Introduction to Financial Accounting. McGraw-Hill.

Nobes, C (1997). Introduction to Financial Accounting. International Thomson

Britton, A(1996). Financial Accounting. Longman

Dyson, J.R (1997). Accounting for Non-Accounting Students, 4th Edition. Pearson Professional.

Berry, A (1997). Accounting in a Business Context, 3rd Edition. Thomson.

Hall, D (1999) Business Studies 2nd edition. Causeway Press Ltd

Gillespie, A (2001) AS and A level Business Studies. Oxford Press

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