Balance Sheet Accounts

Why This Matters

The balance sheet is the foundation of financial statement analysis—and you're being tested on more than just definitions. Understanding how accounts relate to each other reveals a company's liquidity, leverage, and operational capacity. Exam questions frequently ask you to classify accounts correctly, explain how transactions affect multiple accounts simultaneously, and analyze what account balances reveal about financial health.

Don't just memorize that inventory is a current asset. Know why it's classified that way, how it differs from prepaid expenses, and what happens when it's sold. The fundamental accounting equation—$Assets = Liabilities + Equity$—governs every transaction you'll encounter. Master the conceptual categories below, and you'll be ready for any multiple-choice question or FRQ that tests balance sheet relationships.

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Current Assets: Short-Term Resources

Current assets represent resources a company expects to convert to cash or consume within one year (or one operating cycle, whichever is longer). The key principle here is liquidity—how quickly can the asset become cash?

Cash and Cash Equivalents

• Most liquid asset on the balance sheet—serves as the baseline for measuring liquidity of all other accounts
• Cash equivalents include short-term investments with original maturities of three months or less, such as Treasury bills and money market funds
• Critical for solvency analysis—insufficient cash means a company can't meet obligations regardless of profitability

Accounts Receivable

• Credit sales not yet collected—represents a legally enforceable claim against customers for goods or services delivered
• Reported net of allowance for doubtful accounts—this contra-asset reflects estimated uncollectible amounts using the matching principle
• Turnover ratio measures collection efficiency—high A/R relative to sales may signal collection problems or overly lenient credit policies

Inventory

• Goods held for resale or production inputs—includes raw materials, work-in-progress, and finished goods for manufacturers
• Valued at lower of cost or net realizable value—write-downs flow through to cost of goods sold, reducing both assets and income
• Cost flow assumptions matter—FIFO, LIFO, and weighted-average produce different balance sheet values and COGS figures

Prepaid Expenses

• Advance payments for future benefits—common examples include insurance premiums, rent, and advertising paid in advance
• Expensed as benefit is consumed—the adjusting entry debits an expense account and credits the prepaid asset (systematic allocation)
• Distinguishes cash-basis from accrual accounting—payment timing differs from expense recognition

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Non-Current Assets: Long-Term Investments

Non-current assets provide economic benefits extending beyond one year. These accounts reflect a company's investment in productive capacity and long-term growth.

Property, Plant, and Equipment (PP&E)

• Tangible long-term assets used in operations—includes land, buildings, machinery, vehicles, and equipment
• Depreciation allocates cost over useful life—accumulated depreciation (a contra-asset) reduces the carrying value on the balance sheet
• Land is never depreciated—it has an indefinite useful life, making it unique among PP&E components

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Current Liabilities: Short-Term Obligations

Current liabilities are obligations due within one year. These accounts represent claims against the company's current assets and directly impact working capital calculations.

Accounts Payable

• Amounts owed to suppliers for credit purchases—the mirror image of accounts receivable from the supplier's perspective
• Trade payables vs. other payables—trade payables specifically relate to inventory purchases; other payables cover utilities, services, etc.
• Extending payment terms improves cash flow—but may damage supplier relationships or forfeit early-payment discounts

Accrued Liabilities

• Expenses incurred but not yet paid—includes wages payable, interest payable, and taxes payable
• Required by accrual accounting—expenses must be recognized when incurred, not when cash changes hands (matching principle)
• Adjusting entries create these accounts—debit the expense, credit the accrued liability at period-end

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Non-Current Liabilities: Long-Term Financing

Non-current liabilities represent obligations due beyond one year. These accounts reflect a company's capital structure decisions and long-term financial commitments.

Long-Term Debt

• Borrowings due beyond one year—includes bonds payable, mortgages, term loans, and notes payable
• Current portion reclassified annually—the amount due within 12 months moves to current liabilities on the balance sheet
• Leverage ratios assess financial risk—debt-to-equity and times-interest-earned measure a company's ability to service obligations

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Stockholders' Equity: Ownership Claims

Equity represents the residual interest in assets after deducting liabilities. Think of it as what shareholders would receive if all assets were sold and all liabilities paid—though book value rarely equals market value.

Common Stock

• Par value of shares issued—recorded at par (a nominal legal value) with excess going to additional paid-in capital
• Represents permanent capital—unlike debt, equity has no maturity date or required repayment
• Shareholders bear residual risk—they're paid last in liquidation but have unlimited upside potential

Retained Earnings

• Cumulative net income minus cumulative dividends—represents profits reinvested in the business since inception
• Connects income statement to balance sheet—net income increases retained earnings; net loss and dividends decrease it
• Not a cash account—a company can have high retained earnings and low cash if profits were invested in inventory or equipment

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Quick Reference Table

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Self-Check Questions

1. Classification challenge: If a company pays $12,000 for a one-year insurance policy, which two accounts are affected at the time of payment, and how does the balance sheet change six months later?

2. Compare and contrast: How do accounts receivable and accrued liabilities both demonstrate the accrual basis of accounting, and what's fundamentally different about what they represent?

3. Conceptual application: A company has $500,000 in retained earnings but only $50,000 in cash. Explain how this situation is possible and what it reveals about where profits were invested.

4. Account relationships: When a company collects cash from a customer who previously purchased on credit, which accounts change and what happens to total assets?

5. FRQ-style analysis: Describe how purchasing equipment with a combination of cash and a five-year bank loan affects the accounting equation. Identify all accounts impacted and whether each increases or decreases.