Items of Balance Sheet | Financial Statements | Accounting

Balance sheet is a standing position of the company in terms of assets and liabilities at any point of time presented in India every six months and yearly. The net results of the company in the form of profit or loss are carried to the balance sheet. The assets and liabilities of any unit should be equal and balance and hence called balance sheet.

1. Contingent Assets:

An item in Balance Sheet which is subject to liquidity and different interpretations is Contingent Assets. It is a category of assets, which need not be shown in the balance sheet proper. But the usefulness of these assets is a matter of discretion to the analyst and the company claims need not be taken as totally true and realisable.

Some examples of contingent assets which are shown in notes to balance sheet and not balance sheet proper are given below:

1. An option to apply for shares — rights, warrants, coupons, etc.

2. A legal action on infringement of copyright, patent, etc.

3. Possible refund of taxes paid.

4. Possible recovery of written off debt on legal action.

Financial analysts may have to take each item separately and assess the extent of bonafides and usefulness of item for overall credit rating of the company or for proper evaluation of assets vis-a-vis liabilities.

Some miscellaneous assets are reported in balance sheets, the details of which should be looked into carefully by the analysts. These are the non-current assets of duration of life of more than one year. They may be unquoted investments, loans and advances to employees, directors, deferred charges, prepaid expenses etc., and advances made to subsidiaries or investments for housing for employees etc. These non-current expenses are treated as assets and many of them may not be realisable in cash, within a short period of less than one year.

2. Intangible Assets:

Another grey area for financial analysts is the intangible assets. All types of malpractices, window dressing and cover up operations are possible due to intan­gible assets as in the case of contingent liabilities. They are no doubt useful in the business, but the extent of the usefulness is a matter of discretion, unlike in the case of physical assets.

Goodwill, patents and trademarks, designs and copyrights, unwritten off- expenses, deferred revenue expenditure, bad and doubtful debts, carry forward losses, development expenses etc. are examples. Under this category, the following are a few examples which are found in the balance sheets of many companies- Normally appearance of these items is an indication of doubtful nature of the financial position of the company, as sound and growing companies or blue chip companies do not carry such items, as they would write them off from their profits and surpluses. To the extent that they appear, they deem to wipe out the capital of the company and in ascertaining the true net worth of the company, the analyst has to reduce them from the owner’s funds.

3. Contingent Liabilities:

Schedule VI of the Companies Act mentions some items as examples of contingent liabilities. As these are not shown in the Balance Sheet, but in a footnote, many analysts ignore such data, although they are very relevant for a correct analysis of the financial position. If the contingent liabilities in the Balance Sheet exceed the amount of current assets, the company becomes highly risky.

Sometimes guarantees given by a company result in a liability much more than originally estimated. Contingent liabilities are a potential risk for the company, which if not prudently assessed will lead to wrong conclusions about the company.

The liabilities which are mentioned as contingent liabilities in the footnotes are given below as a few examples:

1. Guarantees given by the company.

2. Claims of the government on the company, not acknowledged as due by the company.

3. Uncalled liability on partly paid shares.

4. Arrears of fixed cumulative dividends.

5. Bills discounted but not matured.

6. Estimated amounts of contracts, remaining to be executed on capital account and not provided in the balance sheet.

7. Contested amounts of excise claims.

8. Dues contested in a court, but pending before the final court order.

There can be many more such contingent claims on the company, which might have been underestimated by the accountants, but have to be assessed by the financial analysts, carefully.

4. Depreciation:

Confusion also arises out of the use of the concept of deprecia­tion. Depreciation refers to write off of the values of fixed assets. The Companies Act 1956, in schedule VI, enumerates the following items as fixed assets.

Good will, land, buildings, leaseholds, railway sidings, plant and machinery, furniture and fittings, property development, patents, trademarks and designs, the stock and vehicles. Of the above some like good will, patents, trademarks and designs are intangible assets, but writing off of their values is permitted. Revaluation of assets again lead to fictitious assets, which financial analysts should not take into account, for valuation of shares as they are not free reserves as per the definition of the government.

Obsolescence is also partly similar to depreciation, since technologies may change leading to obsolescence of plant and machineries. All physical assets except land depreciate with time, but some physical assets also lose their value due to obsolescence, which means loss of usefulness of an asset, caused by super-cession of one type of machinery by another and more advanced. Changes in tastes, styles, and fashions bring in new product which are make the old products obsolete and with that machinery producing them also lose their value. New inventions and innova­tions have produced new machinery, which make the old machinery obsolete. The financial analysts have to take due care of such possibilities in valuation and analysis of financial statements for arriving at the net asset value of the company.

Methods of Depreciation:

The following are the factors which are considered for providing depreciation on fixed assets:

1. Projected life period of the assets based on expert opinion and prevailing practice.

2. Estimated salvage and resale value of the asset vis-a-vis the cost of acqui­sition.

3. Method adopted for depreciation.

The methods, usually prevailing for depreciation arc the following:

a. Straight Line Method:

Under this, a constant proportion of the original cost of the assets less the scrap value is provided every year, as a fixed amount.

b. Written Down Value Method or Diminishing Value Method:

Here a fixed percentage say 20%, is Written off every year on the diminished book value of the asset, till the asset is reduced to the scrap. This method is approved by the Income Tax Dept. This will lead to reduced amount of write off year after year, as the book value diminishes from the original cost.

c. Sum of the Years Digits Method:

The depreciation provided under this method also gets reduced year after year. To give an example, if the life of the asset is 5 years, the sum of the digits is 1 + 2 + 3 + 4 +5 = 15, and the first year deduction will be 5/15, followed in later years by 4/15, 3/15, 2/15, and 1/15, leading to total write off in 5 years.

d. Depreciation Fund Method or Redemption Fund Method:

Under this, an equal amount is written off every year, by debiting it to the profit and loss account and crediting it to the depreciation hind account. The yearly installment is calculated in such a manner that, if the amount is invested at compound interest, it will accumulate to an amount equivalent to the cost of the asset minus scrap value over the period. The provisions are not retained in the Business but invested in some securities, with reinvestment facility, so as to get back full value of the original cost of the asset.

e. Annuity Method:

When the funds are to be retained in the business, and book value is written down every year, by provision for depreciation, the installment to be provided periodically is calculated as per the Annuity Table as a fixed amount. Here the presumption is that money invested in an asset earns interest at a fixed rate, which is debited to the asset account at reduced value of principal, each year. This method, generally prevalent in respect of long leases of large capital goods involves a provision at a fixed rate, but the amount provided declines year after year, as the interest charge keeps on decreasing although the principal amount repaid is the same every year.

There are a number of other methods for providing depreciation which are less frequently used. These are based on the concept of endowment for a fixed period, or revaluation of the asset, or based on the value of output each year or machine hour product etc. Sometimes all the assets are grouped together and a flat rate of depreciation is charged every year for the total value. This clubs all the assets together and a fixed life period say 5 to 8 years is decided and depreciation accordingly provided. This method, called global method is not permitted under the Companies Act, in India.

Each method has its own advantages and disadvantages. Most commonly used methods are the straight line method on the original cost, and the written down value method on the book value of the asset. Whatever is the method, accounting standards dictate, that the same method should be continued throughout the life of the asset, while in fact a number of companies change these methods of providing depreciation depending on their profits and management policy.