Financial Accounting (1)

Accounting: A language for business

Balance sheet

Based on: Hervé Stolowy, Michel Lebas and Yuan Ding

Statement of financial position or
Balance sheet

A balance sheet is a snapshot of the status of the financial position

of a business entity at a given point in time
Statement of financial position or
Balance sheet

• The list of obligations and resources can be structured either in

increasing or decreasing order of liquidity.

Assets Shareholders’ equity and liabilities

Land and equipment 200 Shareholders’ equity 400
Inventories 150
Accounts receivable 100
Cash 50 Liabilities 100
Total 500 Total 500

(continental European presentation in thousands of Currency Units [CU])

Emphasis on the long-term potential of the firm

Statement of financial position or
Balance sheet

Assets Liabilities and shareholders’ equity

Cash 50 Liabilities 100
Accounts receivable 100
Inventories 150
Land and equipment 200 Shareholders’ equity 400
Total 500 Total 500

(North American presentation in thousands of CU)

Emphasis on the short-term survival of the firm

The basic business equation or
balance sheet equation

• Assets - Liabilities = Shareholders’ equity

or
• Assets = Liabilities + Shareholders’ equity

• Transactions can take place between assets, between liabilities or can

involve both sides – but the equation always balance
• Give examples
Business equation:
examples for Verdi Co. - Transaction 1
• Initial investment by shareholders at the creation of the company
• Capital contribution of 150; Deposit on the bank account
Business equation:
examples - Transaction 2
• Verdi obtains a 60 currency units loan
• Increase in cash; Liability recorded
Business equation:
examples - Transaction 3
• Purchase of equipment in exchange for liquidity (125)
• Fixed asset recorded; Decrease in cash
Business equation:
examples - Transaction 4
• Services rendered (sold) for 250 on credit
• Revenue recorded; Increase in assets (accounts receivable)
Business equation:
examples - Transaction 5
• Receipt of cash in partial settlement of the account receivable (180)
• Increase in cash; Decrease in accounts receivable
Business equation:
examples - Transaction 6
• Expenses in cash (salaries, 101 and interest, 4) and on account (external
expense, 85)
• Expenses recorded; Decrease in cash; Increase in liabilities
Business equation:
examples - Transaction 7
• Partial settlement of accounts payable (80)
• Decrease in cash; Decrease in liabilities
Business equation:
examples - Transaction 8
• Repayment of a debt (12)
• Decrease in cash; Decrease in liabilities
Business equation:
Summary table
Balance sheet
on 31.Dec.X1

Assets Equity and liabilities

Fixed assets Shareholders’ equity 210
Equipment 125 Capital 150
Earnings (net income) 60

Current assets Liabilities

Accounts receivable 70 Financial debt 48
Cash at bank 68 Accounts payable 5
Total assets 263 Total equity and liabilities 263
Some key points
(1/3)

• Both sides of the business equation must always be balanced with one
another
• Each transaction must be analyzed specifically to identify its possible
impact on shareholders’ equity
• The result of a transaction that creates or consumes value is summarized
in the ‘earnings’ account
Some key points
(2/3)
• What creates income?
• No income (impact on earnings) until transaction 4 (sale of services)
• Transaction 4 is the first operation that affected the shareholders’ equity and
therefore the earnings
• Any transaction that affects either assets and/or liabilities in uneven or
unbalanced ways affects earnings
• Any transaction that only affects the structure of the balance sheet is not
source of value creation
Some key points
(3/3)

• Net income is different from cash

• Net income (+ 60) is different from the cash flow (+ 68)
• Some transactions only have an impact on the bank’s cash balance and not
on earnings (capital, debt, equipment)
• Credit phenomenon (customers and suppliers)
• See table (next)
• The order in which items are listed on the balance sheet is not random
Cash
versus profit

• Sales double each period; Expenses are 80% of revenues;

Customers pay two periods after the sales; Payment to suppliers
one period after the delivery
• Conclusion: business profitable but dangerous cash situation

Period 1 2 3 4 5 6 7
Sales 10 20 40 80 160 320 640
Expenses 8 16 32 64 128 256 512
Profit 2 4 8 16 32 64 128
Openin g cash 0 0 -8 -14 -26 -50 -98
Cash inflow 0 0 10 20 40 80 160
Cash outflow 0 8 16 32 64 128 256
Ending cash 0 -8 -14 -26 -50 -98 -194