What information does a balance sheet provide? How do accounting conventions and asset valuation affect measuring and reporting financial position?
"The purpose of the balance sheet is simply to set out the financial position of a business at a particular moment in time" (Atrill & McLaney, 2006). This broad definition can be made more specific by stating that the balance sheet shows the assets of a business on one side and the claims made against a business on the other side, and ensures that the two sides always balance. The assets that it shows are the resources of the business and these must always have some future monetary value, be exclusively owned by the business, exist as a result of a past transaction and be measured in monetary terms. Cash, plant, trademarks and investments are all examples of business assets. Claims do not have the same requirements as assets in terms of their definition, but can be divided into Capital claims - which are the claims of the owner against the business - and Liability claims - which are the claims of everyone else against the business.
The balance sheet essentially shows the result of the 'balance sheet equation' which is defined as Assets = Capital + Liabilities. For example, if a business purchases £5,000 worth of stock on any given day then £5,000 will be added to the assets section of the balance sheet, but this purchase is also now a claim against the business by an external party (the supplier) so £5,000 must also be added to the Liability claims section of the balance sheet. A business will normally use the balance sheet in three ways; "for reporting purposes as part of annual accounts, to help all parties interested in a business to assess the worth of a business and as a tool to help improve the management of a business" (Business Link, 2008).
A number of accounting conventions affect the reporting of financial position. Business Entity convention ensures that the business and its owners will always be treated as seperate bodies regardless of the type of ownership. This means that the two types of claim will always be applied. Money Measurement convention keeps assets and liabilities that cannot be assigned a monetary value off the balance sheet. Historic Cost convention values assets at their acquisition cost, not an adjusted cost for factors such as depreciation. Going Concern convention assumes that the business will continue to operate in the future and has no need to sell non - current assets, and that the financial reports should be prepared on this basis. Dual Aspect convention keeps the balance sheet 'balanced' by recording transactions with two aspects, as explained in the second paragraph of this essay. Prudence convention (now Gordon Brown's nickname as Chancellor of the Exchequer makes more sense) makes financial reports lean towards caution - making any expected bad news clear straight away. Stable Monetary Unit convention assumes that money will not change in value over time, and finally Objectivity convention means that financial reports will be prepared based on objective facts rather than subjective opinion.
Asset valuation is important to the balance sheet because Historic Cost convention isn't really practical in the real world, some allowance has to be made for the fact that assets can appreciate or depreciate in value over time, and this must be recorded to accurately show the true value of a business. In terms of tangible non - current assets such as delivery vans either the net value of the asset after depreciation can be shown on the balance sheet, or a 'fair value' which is usually the market value of the asset. Implementing this latter method of valuation can have a drastic change on how the business looks on paper - especially if the business owns assets that have considerably increased in value.
Atrill, P. and McLaney, E. (2006) Accounting and Finance for Non - Specialists 5th Ed. Harlow, Essex: Pearson Education Ltd.
Business Link (2008) Balance sheets: the basics [Online]
Available from: http://www.businesslink.gov.uk/bdotg/action/layer?topicId=1073889327 (Accessed 13th Jan 2008)