Once you’ve learned about the balance sheet, it is important to define the elements or components of the balance sheet. The three components discussed in this article are assets, liabilities, and owners’ equity.

Assets

Many definitions of assets have been proposed and used in business and academic research. 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.

For example, if a large company maintains its own fire station on its grounds, the building and the equipment are considered assets by this definition.

On the other hand, if the company relies on publicly provided fire protection, neither the publicly-owned building nor the equipment is considered an asset 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

Liabilities are one of two general categories of claims held against a company. As a definition, liabilities are the non-ownership claims against the firm.

It is also possible to define liabilities as obligations that the entity must satisfy through the sacrifice of some future benefit.

The claim is against the firm, not against any particular asset 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.

Along with the liability agreement, the two parties may execute a collateral agreement (e.g., 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 non-owner claim is clear. In practice, however, the distinction between an owner claim and a non-owner 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. If 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.

Owners’ Equity

The other type of claim that can be held against a firm is owners’ equity. Owners’ equity differs significantly from liabilities in three major respects:

  • Generally, there is no specified maturity date for the claims
  • The claims are not as readily enforceable as are liabilities
  • There is generally no specification of the rate of return to the holder that carries the same strength as interest agreements on debts

Considering these differences, the term “claim” applied to owners’ equity only in a very broad sense, especially compared to the narrower case of liabilities.

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 on 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 distributing assets through dividends and withdrawals, and net income or losses.

Measuring the owners’ equity using either of the two above approaches has no effect on the outcome. They are simply two different approaches to explaining the third component of the balance sheet.

Owners’ equity claims are made 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.

Frequently Asked Questions

What are the main components of a balance sheet?

The primary components of a balance sheet are assets, liabilities, and shareholders' equity. Other line items may be included depending on the nature of the business.

Why is a balance sheet important?

A balance sheet is important because it provides a snapshot of a company's financial condition at a specific point in time. It can be used to measure performance, assess risks, and make decisions about how to allocate resources.

How is a balance sheet prepared?

A balance sheet is prepared by taking the company's assets and liabilities and netting them against each other. This results in the company's shareholders' equity.

What are the most common assets on a balance sheet?

The most common assets on a balance sheet are cash, Accounts Receivable, and inventory.

How can I use a balance sheet to measure performance?

You can use a balance sheet to measure performance by comparing the company's current assets, current liabilities, and shareholders' equity to past periods. This will give you an idea of how the company is performing financially.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.