The Balance Sheet

Before establishing the accuracy of the balance sheet as a valuation tool it is important to understand that to produce a document that shows the exact value of a company is virtually impossible. The combination of all assets, liabilities, owners equity and many other factors must be calculated in order to reach a final value. However, the methods used when valuing, and the constant changes in the economy and inflation make the value of the company itself a constantly changing figure. Therefore should an accurate value of the company be produced it would only be accurate at the time it is produced. Throughout this essay I will discuss the different aspects of the balance sheet and how the way they are presented affects the figures on the balance sheet. But firstly it is important to understand what the balance sheet comprises of and the role it is intended to carry out.

The balance sheet is a financial document which identifies the company’s assets and liabilities of a company. By deducting the assets from the liabilities the net worth is calculated, this is a key indicator of the value of the company to its owners.

It shows the financial of the company on a particular date, “it is a snapshot of the business and is the best measure that we have for looking at financial health” . However, the fact that it is a snapshot means that it is only valid at the time it is produced thus it may not represent a true and fair view. It is possible that a firm may pick a certain day which benefits.

The balance sheet can be used to determine how much credit a company will get or whether or not they should be invested in, it is therefore a very important document and managers are aware of this. It is therefore possible that companies will try to format information and calculate figures using methods that present a better financial picture. The opportunity to adopt creative accounting occurs when choices are made about the basis of deprecation, stock and cost of goods sold. The methods used to calculate these figures can make a vital difference to the balance sheet.

The accuracy of valuation within the balance is a vital point to consider as the various methods used to calculate lead to dramatically different results. The capitalisation of costs is when a cost is treated as an asset as opposed to an expense, thus increasing total assets. It is hard to challenge this as we are unaware whether money spent on an asset is done so to repair, maintain or improve it, thus the decision is left to the managers judgement.

There are also a variety of ways to calculate the depreciation of an asset. “By using the straight-line method the cost is spread evenly over the life of the asset…..accelerated depreciation basis the depreciation charges are greater in the early years” . Again the chosen method is left to the judgement of the manager and therefore may not be the most appropriate method of valuation.

The basis of deprecation can also be changed or the anticipated life of the asset retrieved in order to alter figures, such alterations may go unnoticed in published accounts.

There are also advantages and disadvantages to the different ways stock and cost of goods sold are established. The two main conventional methods are First In First Out (FIFO), and Average Cost (AVCO). By there being a variety of valuation methods it is not always very accurate and can be hard to adopt.

There is also the issue of valuing assets using historic cost accounting. This is a useful method of accounting as it is good as “it permits accounts to be produced by collecting information about business transactions….amounts are determined by the transaction as opposed to by individuals” . This therefore means that there is no opportunity for figures to be based on judgments or the possible abuse of individuals, thus making it more reliable in that aspect.

This is one of the reasons why historic cost is still a main basis for accounting. However, large problems can occur when using the historic cost method. Increasingly the cost of assets change over time, whether it be due to inflation or advancing technology. This results in a value being presented on the balance sheet that is out dated and unrealistic.

These are several ways in which the figures that appear on the balance sheet can alter the results of important figures. It could therefore be argued that the balance sheet, when read without studying the underlining notes and accounts, does not clearly represent the value of a company. In order for a document to be useful it must be “relevant, reliable, valid and comparable to other similar figures” . There are ways in which the balance sheet does fall into this category and ways in which it does not. For example although it is easy to compare the figures on the