In the book we use at my school, chapter 2 continues the discussion of financial statements by showing you the classified balance sheet. The classified balance sheet still contains assets, liabilities, and stockholders equity as we discussed in the previous post. The difference is that the assets and liabilities are grouped in to categories (classifications). Stockholders equity remains the same as it was in chapter 1 (common stock + retained earnings). I will explain the various classifications below. Look at the illustrations in your textbook. In some textbooks this topic is contained in chapter 2. In others the classified balance sheet usually appears in the chapter on inventory and merchandising transactions, probably chapter 4 or 5.
Asset Classifications
The assets can be grouped in to the following classifications:
- Current Assets
- Long-term Investments
- Property, Plant, and Equipment
- Intangible Assets
Current assets are those assets that have a life of one-year or less. These assets include (but are not limited to) cash, short-term investments, accounts receivable, inventory, supplies, and prepaid insurance.
Long-term investments can arise under three circumstances. One, where the business takes its own cash and uses it to buy the stock or bonds of another corporation. Second, where the business buys an asset that it does not intend to use currently. For example, a business buys a piece of land that one day it hopes to build a factory on. Until then, this land cannot be classified as property, plant, and equipment since it is not in use. Third, the business has an asset that was in use but has been taken out of service. For example, a business owns two factories, one in New York and the other in New Jersey. Due to a decline in the economy it decides to temporarily close the factory in New Jersey until the economy improves. That factory can no longer be classified as property, plant, and equipment since it is no longer in use. It must be re-classified as a long-term investment.
Property, Plant, and Equipment are assets that have a service life of more than one year. Property means land. Plant means building. Buildings would include office buildings, factories, stores, and air plane hangers. Equipment means equipment. Equipment is a very broad category and can include such things as factory machinery, office equipment, computers, furniture, and vehicles. The buildings and equipment depreciate while land does not.
Now is probably a good time for a brief discussion on depreciation. Depreciation, as an accounting concept, has nothing to do with market or resale value. Depreciation is a method of allocating the cost of an asset over the period of time in which we expect to use it. In accounting depreciation represents the deterioration or wearing out of an asset over time.
In this section of the balance sheet, we subtract the amount of depreciation that has accumulated on that asset from the day we first acquired it up to the date of that balance sheet. This is why we call it “accumulated depreciation.”
Land does not depreciate because it doesn’t have a finite life. Buildings and equipment will eventually wear out but land does not.
The assets that fall in to this category are currently in use. By use I mean they are helping the company to earn revenue. It is because they are in use that they depreciate.
Intangible assets do not have physical substance but yet they exist. Examples of intangible assets include patents, trademarks, copyrights, franchises, and goodwill. Intangibles usually give their owner the exclusive right to use something. These assets do not depreciate like property, plant, and equipment but they do eventually expire. These assets amortize, rather than depreciate.
Liability Classifications
As was explained in an earlier post, liabilities are debts or obligations that eventually have to be repaid (satisfied). Liabilities are broken down in to two classifications:
- Current liabilities
- Long-term liabilities
Currently liabilities have to be satisfied within one year. Generally, they are satisfied from current assets (i. e. cash).
Long-term liabilities are satisfied more than one year hence.
Some liabilities can be both current and long-term. For example, if you were to take a five year loan to buy a car, the bank would require you to make 60 monthly payments. The first twelve payments would be classified as a current liability while the remaining forty eight months would be classified as long-term.
I think that’s enough for now. The next chapter is one of the most important in the course. Be ready.