Accounting theory and practice, Volume 1 (of 3)

by Roy B. Kester

The balance sheet, accordingly, should be so arranged that the condition of the business as related to its ability to pay its debts will be apparent. This requires a classification or marshaling of the assets which are concerned in the trading cycle on the one side, and the liabilities which must be assumed in conducting the business during the trading cycle, on the other.

At the head of the list of assets is the item Cash, the most liquid of all, as it can be used directly for the payment of debts. Following Cash come in order Notes Receivable, which, with proper indorsement, can be sold to the banker and converted into cash almost immediately; Accounts Receivable, which represent the claims against customers for merchandise sold and which are collectible within the term of credit extended to the customer; and finally, the Merchandise on Hand, which must be sold either for cash or on credit and then converted into cash by the collection of the outstanding accounts. Sometimes, also, there is included in this group the asset Investments, representing stocks and bonds of other companies which can be converted into cash by sale on a stock exchange. On such securities, and also on the notes receivable, there is usually at the date of the balance sheet some interest which has accrued and may not yet be collectible. It is customary to include the amount of this interest receivable in the same group with the assets from which it arises.

This group of assets, comprising Cash, Notes and Accounts Receivable, Merchandise, and so forth, is called the group of Current Assets. Asset items are classified as current if conversion into cash is expected within three to six months. These are the assets to which the current creditors of the business will have to look for the payment of their claims.

The claims of current creditors are usually included under the titles Notes Payable, Accounts Payable, and Accrued or Unpaid Expenses. The classification of a creditor in the current liability group is usually determined on a time basis. Thus, all debts that will have to be met within six months’ or one year’s time from the date of the balance sheet are usually classed as Current Liabilities.

The excess of current assets over current liabilities is called the working capital of the business; that is, an amount of the current assets equal to the current liabilities will have to be used for the payment of these debts, leaving the excess or difference free for use within the business. While it is not possible to determine, without considering all the circumstances in a given case, how large this working capital should be, the standard rule-of-thumb is that it should equal the amount of the current liabilities. It will thus be seen that the standard ratio of current assets to current liabilities is two to one. The solvency of a given business is always judged by a comparison of the current asset group with the current liability group.

The next main group of assets is given the title Deferred Charges. The content of this item was explained on [page 12]. Thus, if a management has paid some of its expense bills in advance—rent for January paid during December, for example—when showing its financial condition as at the end of December it is proper and necessary, in order to make an accurate showing, that all such prepaid expenses be listed as assets; for, had the payment not been made until the service which it purchased had been used up, the asset cash would have been larger by the amount of the prepaid expenses.

Similarly, with regard to the Accrued Expenses mentioned on [page 14], whatever expenses have been incurred that properly belong to the past period, such as wages due but unpaid, are liabilities; for the cash would be smaller by the amount of such postponed or accrued items had the claims been met during the period. The close relationship of both deferred charges and accrued expenses to cash is thus apparent—the one as an indirect addition to the cash, the other as an indirect deduction from or claim against cash. Accordingly, deferred charges are shown on the balance sheet immediately following the group of current assets, whereas accrued expenses are listed with the current liabilities as noted above.

The next group of assets is called Fixed Assets. Under this title are listed those assets which are used for carrying on the business but are not bought for the purpose of being resold. A certain amount of capital must be invested in the physical business plant. Furniture and fixtures, delivery equipment, buildings, land, machinery and tools, and so forth, must be purchased before the business can commence operating. It is assets of this type that comprise the class of fixed assets. There is a corresponding group among the liabilities which are known as Fixed or Long-Term Liabilities. All debts maturing a year or more after the date of the balance sheet are classed as fixed liabilities. As examples of this class, we have long-term notes payable, mortgages payable, bonds payable, and so forth.

The difference between the fixed assets and the fixed liabilities indicates the amount of owner’s capital which has been invested in the business plant.

The final group of assets is called simply Other Assets, and includes all assets which cannot be classified in any other groups, such as good-will, patents, trade-marks, accounts and notes receivable having a credit term longer than six months, and other similar items. If there are any liabilities not capable of classification in the two groups of liabilities given above, they may be put in a group called Other Liabilities.