A VERY DIFFERENT WAY OF LOOKING AT FINANCIAL STATEMENTS…

A VERY DIFFERENT WAY OF LOOKING AT FINANCIAL STATEMENTS…

PART II OF III...

Now let’s define the terms. I am not pulling this out of a book. I remember this from 1965, when I took my first accounting class. It’s something that every CPA can repeat even if you wake him or her up at 4 AM and ask them for the definitions.

An ASSET is something you own that has value, and that can be reduced to monetary terms. If something is “priceless,” it’s not an asset because it cannot be reduced to monetary terms.

A LIABILITY is simply something you owe. And when I say “YOU,” I mean an individual, a business entity, a charity, or any other entity that owes money to someone else.

And CAPITAL is simply the residual amount that is left over after you subtract Liabilities from the Assets.

When you consider the following, you will realize that a balance sheet doesn’t give you a good picture of the entity because you have different values for different items. The equity is only a calculated number after subtracting Liabilities from the Assets, as I wrote before. But, the Balance Sheet, prepared year after year, indicates the entity's progress over a very long period.

Assets are cash, valued at today’s dollars, accounts receivable less an allowance for doubtful accounts, which is a guess of how much is owed to you and how much you will not receive. Inventory may be valued at today’s dollars, but what about old and non-saleable inventory? Buildings and machines, and cars are valued at cost less accumulated depreciation. Now a definition that I love. Depreciation is the systematic allocation of the cost of a fixed or non-monetary asset throughout its use or benefit. I did that from memory!!! That means that the machine that you bought 15 years ago is valued at the dollar from 15 years ago and that the asset has been reduced by a calculation of an estimated number because you really don’t know how long the machine will last. So, in my opinion, the value is meaningless, but if used consistently year after year, it appears on the balance sheet. By the way, the Internal Revenue Service has guidelines on the useful lives of the assets, usually used in depreciation calculation.

Cash is real and can be touched. Accounts receivable are a promise to pay you an amount of money someday in the future, you most likely will not collect all of it, and you may collect some in a very long while, making it a different value than today’s dollars. Inventories can become worthless or lose value under certain circumstances. I explained the buildings to you. Then you have intangible assets like trademarks, patents, and goodwill. They are valued at the cost of research, manufacturing, and legal fees and amortized over a useful life based on the law. Amortization differs from depreciation because it is used only on intangible assets and is always amortized using the straight-line method. So, again everything is an estimate or a number dictated to us by the IRS. So, the asset section of a balance sheet comprises tangible and intangible assets and a lot of estimates.

Liabilities are made up of accounts payable. The money you owe for expenses you bought on credit, the merchandise you will sell (inventory). Short-term debt is like a bank loan. A mortgage is payable on a building or a big piece of machinery. You will pay accounts payable with today’s dollars, but you will pay the mortgage with dollars over the next 30 years if it’s a mortgage on a piece of property. The values are really all different.