My Learnings: Accounting - Balance Sheets, Depreciation, and Amortization

Today, I want to talk about Balance Sheets, Assets, Liabilities and their changing natures.

A balance sheets is one of the key financial documents of a company - it describes what a company owns and what it owes. If you scan a company's balance sheet over the years, you get a glimpse of the changing nature of the company - its prosperity, its focus, its history...

A balance sheet has two sides: Assets (what it owns) and Liabilities+Equity (what it owes), and these two sides must always perfectly balance each other out (thus, 'balance' sheet). It is a surprisingly simple document, with some high-level views that are nevertheless insightful to its investors.

Let's have a quick glance on the parts of the balance sheet.

Asset list:

An asset list contains a high-level view of all the key assets of a company. Typically, it will contain:

• Cash account - shows the liquidity of the company
• Accounts receivable (Trade receivables) - shows how much money is due to the company for stuff already delivered.
• Inventory - what the company has, as part of its production. Raw materials, work in progress, finished goods ready to be sold.
• Property, Plant and Equipment - the assets needed by the company to transform raw material into finished products. Depreciates each year.

Liabilities

A list of list contains a high-level view of all the money owed by a company to various people. Typically, it will contain:

• Accounts Payable - what the company owes to its suppliers. My company, Assertion, works out of a co-working space and they bill us on the first of every month, with payment to be made within 15 days. For those 15 days, accounts payable is where the money we owe to our landlords is recorded.
• Financial Liability - appears when external financing is received - usually a bank loan, a VC debt financing, or other such models. Again, looking at my company, Assertion. We have an overdraft facility from our bank. If we ever take out money from the overdraft facility, we will add the amount withdrawn into the Financial Liability section of our balance sheet.
• Equity - the paid up capital.?When Assertion started up, the founders of the company, brought shares of the company, which is the starting capital of Assertion. This is the paid up capital. If the company were to ever disband itself, the last thing it would do is to pay back the paid up capital to the shareholders. The company will probably never pay back the paid up capital, but it may give dividends to the shareholders.

Tangible and Intangible Assets

A company buys laptops, cars, machinery, software, brands and so on. Assets like laptops, cars, machinery are 'hard', tangible assets.

Assume that you bought some software, or acquired a brand. These assets are not tangible - they are 'invisible' and are referred to as intangible assets. Now assume you have been working in the industry for some time and have a collection of loyal customers that you can upsell or cross-sell to - this reduces the cost of customer acquisition. These customers get you new customers through word-of-mouth. The value of this kind of brand, customer loyalty, and reputation is non-trivial and is accounted for in a company's books as goodwill. This too is an intangible asset.

Depreciation

A company buys assets - and the assets are used, directly or indirectly, to convert raw materials into sales. But as time goes on, the assets get used up (the computer gets old and slow, the car becomes run-down…) The loss of value is designated as depreciation.

Depreciation rates vary from asset to asset. Computers are expected to become zero value in 3 year or 4, cars in 5 years or 6, plant machinery may depreciate to zero in 10 years or 30. The rate of depreciation is decided by a company based on the guidelines of that country.

So, you buy a widget and you pay $5000 for it. In your balance sheet, you reduce your cash balance by that amount, and add the widget to your Property, Plant and Equipment list in the assets. In the first year, you price it at $5000. But how much do you reduce its price over the years? Great question!

Depreciation can be calculated via two methods:

• Straight-line depreciation
• Activity-based depreciation?

Straight-line depreciation

Consider the initial cost of an asset (USD 5000). Consider its salvage value (USD 200). The difference is USD 4800. Assume that the lifetime of asset as per guidelines is 5 years

So the annual depreciation will be: 4800/5= USD 960 per year

Activity-based depreciation

Consider that the company buys a battery worth USD 5000. Assume that the battery has a rating of 3000 charges. Assume that its salvage value is USD 200. The difference is USD 4800. Value per charge is 4800/3000: USD 1.6

In Year 1, the company charges the battery 365 times: so it is depreciated in value by 1.6*365=USD 584

Activity-based depreciation may be useful, but it requires us to track carefully the usage of an asset.

Amortization

Some intangible assets have a finite life - in the sense that they too, like tangible assets, lose value. For example, software goes out of date and is no longer useful or functional, and has to be replaced with alternatives. Like depreciation, the cost of the software is broken down and distributed over time - this process is called amortization. Another example is copyright. Yet another is patents.

For example, you brought a database system for 1 million dollars - the company selling this has promised support for 5 years - in the accounts, the million dollars expense is now spread over 5 years (amortized). Amortization is nearly always done in a straight-line model.

Historical versus Fair value accounting

Assume that, as a company, you brought shares in Berkshire Hathway 35 years ago, for which you spent USD 10 million. Today, those shares may be worth 100 million. In the books, when we want to write the asset's value, should we write:10 million (the historical cost) OR 100 million (the fair value)?

Which answer is correct? There are no solid answers, so you can pick one! But whatever you have, you need to stick with it!

You have to apply the same method to all assets that you possess in any given category - for example, if you choose fair value for the shares you own, you have to stick to it even if the stock market crashes and the value goes down - destroying the value of your asset.

Now, certain categories of assets are required to use only historical cost as a method of recording their value - for example, if you brought bricks to build a building - it is practical and sensible to record the inventory of bricks using their historical cost.

Real Estate, Shares, Debts, Pensions, Brand Value, Trademarks and so on are usually recorded on a fair value basis.?

Next time, let's take some practical examples of Balance Sheets, see what they say and understand what they mean. Thanks for reading!