Functions and Limitations of Balance Sheet
What is a Balance Sheet?
The balance sheet may be defined as a statement of 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 the following main functions:
1. Provides the summary of Assets, Liabilities and Capital
Balance Sheet shows the summary of various assets provided to the business and the claims on these assets. It shows the total value of assets possessed by business, debts payable to outsiders by the business and capital of the owner in the business.
2. Measures the Liquidity of the business
As Balance Sheet shows the summary of various assets provided to the business and the claims on these assets it indicates 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 the solvency of the Business
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
Besides the different functions and uses of Balance Sheet, it suffers 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, therefore, it does not have any relationship with the market value.
- Sometimes “Fictitious Assets” such as preliminary expenses, discount and loss on issue of shares and debentures are shown as assets in Balance Sheet. This inclusion unduly inflates the value of total assets.
- Balance Sheet cannot reflect the value of certain factors which serve like assets, such as skill and loyalty of the staff.
- A conventional Balance Sheet may mislead the untrained readers in inflationary situations.
- The value of the majority of current assets depends upon some estimates, so it cannot reflect the true financial position of the business.