Chapter 2: Balance Sheet

Perspective and Issues

As set forth by the IASB's Framework for the Preparation and Presentation of Financial Statements, the objective of financial reporting is to provide information regarding an entity's financial position, performance, and changes in financial position to a broad spectrum of users, to enable them to make rational and informed economic decisions. According to the Framework, the financial statements are meant to report on the "results of stewardship of the management, or the accountability of management for the resources entrusted to it."

These provisions of the Framework are consistent with IAS 1, Presentation of Financial Statements, which was revised in 1997 and may be further revised as part of the Board's current Improvements Project. This revised standard refers to financial statements as "a structured financial representation of the financial position of and the transactions undertaken by an enterprise," and elaborates that the objective of general-purpose financial statements is to provide information about an enterprise's financial position, its performance, and its cash flows, which is then utilized by a wide spectrum of end users in making economic decisions. This information is communicated through a complete set of financial statements which, according to IAS 1, comprises the following components:

1. The balance sheet

2. An income statement

3. Another statement showing either

   1. All changes in equity, or

   2. Changes in equity other than those arising from capital transactions with owners and distributions to owners

4. A cash flow statement

5. Accounting policies and other explanatory notes

The balance sheet is a statement of financial position that presents assets, liabilities, and shareholders' equity (net worth) at a given point in time. The balance sheet reflects the financial status of an enterprise in conformity with international accounting standards. Alone among the traditional financial statements, it reports the aggregate effect of transactions at a point in time, while the other financial statements—the income statement, the statement of cash flows, and the more recently prescribed statement showing either "all changes in equity" or "changes in equity other than those arising from capital transactions with owners and distributions to owners"—accumulate the totality of transactions over a period of time, such as a year.

Whereas during the early history of financial reporting the emphasis was almost universally on the balance sheet (with often only that statement being made available to those outside the entity), for an extended period beginning in the 1960s, users of financial statements placed increasingly greater emphasis on the income statement, even to the exclusion of the balance sheet. During this period, the more desirable enterprises were those exhibiting the fastest earnings growth, as investors became more interested in short-run maximization of performance, generally expressed in terms of earnings per share.

However, a cycle of worldwide inflation and recession that began during the 1970s, and which saw the demise of once-respected entities having insufficient liquidity to withstand severe "credit crunches," brought about a renewed interest in the balance sheet. By the mid-to late 1980s a more balanced view became dominant, with both balance sheet and income statement (the cash flow statement did not achieve prominence until the very late 1980s and early 1990s) receiving close scrutiny.

This shift of emphasis back toward the balance sheet has signaled a departure from the traditional transaction-based concept of income, toward a capital maintenance concept. This orientation has historically been more popular among economists than with accountants, consistent with the former group's concern with measuring real, not merely nominal, wealth creation. Accounting theory, on the other hand, has been more oriented toward an income measurement approach, with matching of costs and revenues being a key principle. To the extent that periodically recognized costs are the result of an amortization (i.e., a historical cost allocation) process, accounting income will not necessarily correspond to economic change in wealth over that period.

Under the capital maintenance approach to income measurement, income for a period is the change in total productive capacity over that time interval; only to the extent that the entity maintained its net assets (after adjusting for capital transactions), would income be deemed to have been earned. By using a capital maintenance concept, it is argued, investors can better predict the overall profit performance and future potential of the firm. This is consistent with a balance sheet approach to accounting measurement.

Financial statements should provide information that helps users make rational investment, credit, or economic decisions. The balance sheet must be studied to assess a firm's liquidity, its financial flexibility, and its ability to generate profits, pay its debts as they become due, and pay dividends. Liquidity refers to an entity's present cash and near-cash position, as well as to the timing of its future cash flows that are anticipated to occur in the normal course of business. Liquidity thus refers to the enterprise's ability to meet its obligations as they fall due.

The concept of financial flexibility is broader than the concept of liquidity. Financial flexibility is the ability of the entity to take effective actions to alter the amounts and timing of its cash flows so that it can respond to unexpected needs and opportunities. Financial flexibility includes the ability to raise new capital or tap into unused lines of credit.

An important objective of financial reporting is to provide information that is useful in assessing the amounts, timing, and uncertainty of future cash flows. IAS requires that either the balance sheet be classified (into current and noncurrent assets and liabilities) or that assets and liabilities be presented in order of relative liquidity. For most businesses, balance sheets are more meaningful if they are classified into categories. Assets are current if they are used in the entity's operating activities and are reasonably expected to be converted into cash, sold, or consumed either within twelve months of the reporting date, or in the normal course of one operating cycle, if longer. Assets are also classified as current when they are held primarily for trading or short-term investment purposes and are expected to be realized within twelve months of the reporting date.

Liabilities are classified as current if they are expected to be liquidated through the use of current assets or the creation of other current liabilities. The excess of current assets over current liabilities is known as net working capital, and for many entities this is a key indicator of liquidity and financial flexibility. Unless an entity has a positive net working capital, it is insolvent in a technical sense and at great risk of failure in the immediate term.

For some businesses, however, the concept of working capital has little or no relevance and a classified balance sheet is accordingly not presented. Such businesses often include banks, other financial institutions, and insurance enterprises. Personal financial statements (for which there are no specific standards under IAS) are unclassified for the same reason.

Ultimately, each reporting entity must decide whether a classified balance sheet would be meaningful to users. IAS 1 makes it incumbent upon each enterprise to make a determination, based on the nature of its operations, whether or not to present current and noncurrent assets and current and noncurrent liabilities as separate classifications on the face of the balance sheet.

Additionally, the current version of IAS 1 makes it incumbent upon enterprises, whether they choose to present a classified balance sheet or not, to disclose, for each asset and liability item, the amounts expected to be recovered or settled more than twelve months after the balance sheet date. This new requirement somewhat mirrors the information about the maturity dates of financial assets and financial liabilities which is required by IAS 32. IAS 1 builds upon this foundation and emphasizes that additional information concerning the expected dates of recovery and settlement of nonmonetary assets and liabilities, like inventories or provisions, is also useful (whether or not an enterprise presents a classified balance sheet).

Consistency has always been a valued feature of financial reporting, but has not always been given recognition as a fundamental concept or principle. SIC 18 states that when more than one accounting policy is available under an IAS or an SIC, an enterprise should choose and apply consistently one of those policies, unless the standard or interpretation permits categorization of items for which different policies may be appropriate. If a standard or an interpretation permits categorization of items, the most appropriate accounting policy should be selected and applied to each category.

Once an appropriate policy has been selected, then any change in policy should be in accordance with the requirements of IAS 8. Choices among alternative accounting policies, while still abundant, are becoming less so, as the IASB has continued to refine the limits of acceptable accounting. Thus, lack of consistency should become less of an issue over time.

Sources of IAS

IAS 1, 7, 10, 24, 30, 32, 38, 39, 40

SIC 8, 18

IASC's Framework for the Preparation and Presentation of Financial Statements