Although the income statement is created with the best intentions, it is still ultimately an estimate. Several of the items that show up on an income statement are estimated or arguably arbitrary, such as the value of goodwill and depreciation. This statement examines the profitability of a firm, so it is important not only as a snapshot, but also when examined over time. This statement can lead to a common size statement analysis that will allow a reviewer to critically examine how a firm’s revenues and expenses have changed over time and how they relate to revenues.
Balance Sheet The balance sheet consists of three sections — assets, liabilities, and stockholders’ equity . Both the assets and liabilities are categorized in descending order of liquidity. The term balance sheet is significant because the sum of the total assets must equal the sum of both total liabilities and stockholders’ equity. The following formula provides the structure of the balance sheet: Assets = Liabilities + Equity The structure of this statement provides a snapshot of how the organization has made decisions related to the allocation of debt and equity, with reference to supporting the assets in a way that keeps the organization in line with meeting the financial objectives set forth by the leadership. The balance sheet reflects the position at a single point in time and the changes throughout the year, as the organization or regulatory bodies deem necessary for reporting this information (Internally, it is prepared monthly; externally, it is prepared quarterly and annually.) In the context of a balance sheet , liquidity refers to the length of time it would take to convert accounts into cash. For example, the most liquid current asset would show up on the top, and inventory would appear toward the bottom of current assets. If one was to make his or her way further down the balance sheet, the fixed assets would be toward the bottom because these are the most illiquid of assets. Similarly, liabilities are categorized in descending order, with accounts payable showing up first because this account is expected to be paid with cash within the next year. The last line item of liabilities would be long-term debt. The third and final section of the balance sheet is the stockholders’ equity. This is the last line item on the balance sheet because stockholders’ equity does not mature. Several common categories found in each of the three sections are discussed further. Assets An organization's assets are the tangible possessions that it owns. These are possessions that can be sold or used by the organization to make products or provide services that can be sold for profit. These assets can also include physical property, such as plants, trucks, equipment, or inventory.
The simplest way to classify assets is to make a distinction between assets that are short-lived and will be converted into cash in less than a year ( current assets ) and those that are expected to have a relatively long life (fixed assets).
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