Balance Sheet: Definition
A balance sheet is a statement of the assets, liabilities, and capital prepared on the last date of the accounting period to show the financial position of the business.
It is prepared with a view to measure the exact financial position of the business on a certain fixed date.
A balance sheet is prepared from the trial balance after the balances of nominal accounts are transferred either to trading or to the profit and loss account. The remaining balances of personal and real accounts represent either assets or liabilities.
These assets and liabilities are shown in the balance sheet in a classified form. The assets are usually shown on the left-hand side and the liabilities on the right-hand side.
Functions of the Balance Sheet
A balance sheet performs several important functions.
1. Summarizes Assets, Liabilities, and Capital
Balance sheets give a summary of various assets provided to the business and the claims on these assets.
These documents show the total value of assets held by the business, debts payable to outsiders by the business, and any capital of the business owners.
2. Measures Business Liquidity
A balance sheet summarizes a firm’s assets, and the claims on these assets indicate the ability of the business to pay its debts. In this way, the balance sheet serves as a measure of the liquidity of the business.
3. Measures Business Solvency
The solvency of a business is measured by ascertaining the relationship of total assets to total liabilities. It indicates the firm’s ability to meet all its short-term and long-term debts. In this way, the balance sheet serves as a measure of solvency.
Limitations of the Balance Sheet
Despite the different functions and uses of balance sheets, they suffer from the following limitations:
- Fixed assets are shown in the balance sheet at their book value (Historical cost — Depreciation to date). A conventional balance sheet does not reflect the original value of assets.
- As fixed assets are shown in the balance sheet at their book value, this does not have any relationship with the market value.
- Sometimes, fictitious assets (e.g., preliminary expenses, discounts, and loss on issue of shares and debentures) are shown as assets on the balance sheet. This inclusion unduly inflates the value of total assets.
- Balance sheets do not reflect the value of certain factors that are like assets (e.g., skill and loyalty of the staff).
- A conventional balance sheet may mislead untrained readers in inflationary situations.
- The value of most current assets depends on some estimates, so it cannot reflect the true financial position of the business.