Components of the Balance Sheet
Once the general concept of the balance sheet is established, it is appropriate to turn to define the elements or components of the balance sheet. The three components to be discussed here are assets, liabilities, and owners’ equity. Subsequently, the actual structure of the balance sheet will be analyzed.
Many definitions of assets have been proposed and used. For the purposes of this relatively brief presentation, an asset is defined as something of value owned or controlled by the entity. The “something” can be either tangible (such as a building or an inventory) or intangible (such as a right to collect cash from someone, goodwill, or a right to use a leased machine). The “value” comes from the asset’s ability to generate a future benefit or stream of benefits. That is, the asset can be used, sold, or collected and thereby bring cash into the firm or it can be used to avoid cash flowing out.
For example, prepaid casualty insurance has value in that it protects the insured party from having to pay out cash to replace or repair physical assets destroyed or damaged by a calamity. The asset must be “owned” in the sense that the entity somehow has unique control over it. If a large company maintained its own fire station on its grounds, the building and the equipment would be assets in the sense of this definition. On the other hand, if the company relied on publicly provided fire protection, neither the publicly owned building nor the equipment would be considered assets of the firm. The difference lies not in the value provided by the protection (which is essentially the same in either case) but in the unique control the company has over the facilities and their use.
Liabilities constitute one of two general categories of claims held against the entity. As a definition, the liabilities are the nonownership claims against the firm. It is also possible to define liabilities as obligations which the entity must satisfy through the sacrifice of some future benefit.
It should be noted that the claim is against the firm, not against any particular asset or assets of the firm. The firm is obligated by a liability merely to satisfy the claim with an appropriate amount of value in a medium that is acceptable to the creditor. Typically, the medium used to satisfy the claim is cash. In addition to the liability agreement, the two parties may choose to execute a collateral agreement (for example, a mortgage) whereby the borrower agrees that a particular asset (or group of assets) will be liquidated to pay the liability if cash is not available to make payment. However, even in this circumstance, the liability holder’s claim is against the firm rather than the asset. Generally, the creditor would prefer not to take possession of the collateralized asset.
Conceptually, the idea of a nonowner claim is clear. In practice, the distinction between an owner claim and a nonowner claim may be hard to draw when one individual holds both types. The interpretation of a particular case will depend upon its circumstances, and it is not possible to state a simple rule that can be followed without exception.
For example, a major stockholder may lend cash to a corporation. In the event the firm goes bankrupt, the court may determine that the transaction created an additional owner’s interest and that the loan does not have the same status as the firm’s other liabilities. This situation may occur if the court determines that the owner, in anticipation of the possibility of liquidation, wanted to invest more in the firm but desired to avoid the risk of ownership. Upon liquidation, creditors are granted a preference over owners to the existing assets of the firm. On the other hand, if a minority stockholder of a large firm acquires some of its bonds on the open market, there could be little cause to treat the bond liability as an owner’s claim. Most liabilities are satisfied by the distribution of cash. Others are cleared by distributing other types of assets or by providing services. Some are eliminated (but not satisfied) by converting them to owner’s claims.
The other type of claim against the firm is the owners’ equity. Owners’ equity differs significantly from liabilities in three major respects: (1) generally, there is no specified maturity date for the claims, (2) the claims are not as readily enforceable as are liabilities, and (3) there is generally no specification of a b to the holder that carries the same strength as interest agreements on debts. Thus, the term claim is being used for owners’ equity in a very broad sense.
Statements of Financial Accounting Concepts (SFAC) 3, although recognizing that owners’ equity represents claims against the entity, defines owners’ equity as a residual remaining after deducting the liabilities from the assets. This approach is based upon the fact that owners’ claims are secondary to creditors’ claims with respect to their satisfaction from the assets of the entity.
Another approach views owners’ equity as the sum of the original contributions by owners and the changes that have occurred since the date the firm came into existence. Typical changes include additional investments, the reduction of owners’ claims by distribution of assets through dividends and withdrawals, and net income or losses.
Measuring the Owners’ equity by either of the two above approaches has no effect on the amount computed. They are simply two different approaches to explaining the third component of the balance sheet.
Owners’ equity claims are against the firm rather than the firm’s assets. The claims can be satisfied by distributing assets to the owners. They also can be reclassified within several internal categories. In many cases, the claims are simply left unsatisfied without any definite plans for settlement. It is important to emphasize that owners’ equity, like liabilities, cannot be distributed. Only assets can be used to satisfy the owners’ claims.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.