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The balance sheet shown in Exhibit 2.2 follows the standardized format regarding the classification and ordering of assets, liabilities, and ownership interests in the business. Financial institutions, public utilities, railroads, and other specialized businesses use somewhat different balance sheet layouts. However, manufacturers and retailers, as well as the large majority of various types of businesses, follow the format presented in Exhibit 2.2.

The left side of the balance sheet lists assets. The right side of the balance sheet first lists the liabilities of the business, which have a higher-order claim on the assets. The sources of ownership (equity) capital in the business are presented below the liabilities. This is to emphasize that the owners or equity holders in a business (the stockholders of a business corporation) have a secondary and lower-order claim on the assets—after its liabilities are satisfied.

Roughly speaking, a balance sheet lists assets in their order of nearness to cash. Cash is listed first at the top of the assets. Next, receivables that will be collected in the short run are listed, and so on down the line. (In later chapters, we say much more about the cash characteristics of different assets.) Liabilities are presented in the sequence of their nearness to payment. (We discuss this point as we go along in later chapters.)

Each separate asset, liability, and stockholders’ equity reported in a balance sheet is called an account. Every account has a name (title) and a dollar amount, which is called its balance. For instance, from Exhibit 2.2 at the end of the most recent year we can determine:

Name of Account	Amount (Balance) of Account
Inventory	$8,450,000

The other dollar amounts in the balance sheet are either subtotals or totals of account balances. For example, the $17,675,000 amount for “Current Assets” at the end of this year does not represent a single account but rather the subtotal of the four accounts making up this group of accounts. A line is drawn above a subtotal or total, indicating account balances are being added.

A double underline (such as for “Total Assets”) indicates the last amount in a column. Notice also the double underline below “Net Income” in the income statement (Exhibit 2.1), indicating it is the last number in the column.

A balance sheet is prepared at the close of business on the last day of the income statement period. For example, if the income statement is for the year ending June 30, 2020, the balance sheet is prepared at midnight June 30, 2020. The amounts reported in the balance sheet are the balances of the accounts at that precise moment in time. The financial condition of the business is frozen for one split second. A business should be careful to make a precise and accurate cutoff to separate transactions between the period just ended and next period.

A balance sheet does not report the flows of activities in the company’s assets, liabilities, and shareowners’ equity accounts during the period. Only the ending balances at the moment the balance sheet is prepared are reported for the accounts. For example, the company reports an ending cash balance of $3,265,000 at the end of its most recent year (see again Exhibit 2.2). Can you tell the total cash inflows and outflows for the year? No, not from the balance sheet; you can’t even get a clue from the balance sheet alone.

A balance sheet can be presented in the landscape (horizontal) layout mode as shown in Exhibit 2.2, or in the portrait (vertical) layout. The accounts reported in the balance sheet are not thrown together haphazardly in no particular order. According to long-standing rules, balance sheet accounts are subdivided into the following classes, or basic groups, in the following order of presentation:

Left Side (or Top Section)	Right Side (or Bottom Section)
Current assets	Current liabilities
Long-term operating assets	Long-term liabilities
Other assets	Owners’ equity

Current assets are cash and other assets that will be converted into cash during one operating cycle. The operating cycle refers to the sequence of buying or manufacturing products, holding the products until sale, selling the products, waiting to collect the receivables from the sales, and finally receiving cash from customers. This sequence is the most basic rhythm of a company’s operations; it is repeated over and over. The operating cycle may be short, 60 days or less, or it may be relatively long, taking 180 days or more.

Assets not directly required in the operating cycle, such as marketable securities held as temporary investments or short-term loans made to employees, are included in the current assets class if they will be converted into cash during the coming year. A business pays in advance for some costs of operations that will not be charged to expense until next period. These prepaid expenses are included in current assets, as you see in Exhibit 2.2.

The second group of assets is labeled “Long-Term Operating Assets” in the balance sheet. These assets are not held for sale to customers; rather, they are used in the operations of the business. Broadly speaking, these assets fall into two groups: tangible and intangible assets. Tangible assets have physical existence, such as machines and buildings. Intangible assets do not have physical existence, but they are legally protected rights (such as patents and trademarks), or they are such things as secret processes and well-known favorable reputations that give businesses important competitive advantages. Generally intangible assets are recorded only when the assets are purchased from a source outside the business.

The tangible assets of the business are reported in the “Property, Plant, and Equipment” account (see Exhibit 2.2 again). More informally, these assets are called fixed assets, although this term is generally not used in balance sheets. The word fixed is a little strong; these assets are not really fixed or permanent, except for the land owned by a business. More accurately, these assets are the long-term operating resources used over several years—such as buildings, machinery, equipment, trucks, forklifts, furniture, computers, and telephones.

The cost of a fixed asset—with the exception of land—is gradually charged off to expense over its useful life. Each period of use thereby bears its share of the total cost of each fixed asset. This apportionment of the cost of fixed assets over their useful lives is called depreciation. The amount of depreciation for one year is reported as an expense in the income statement (see Exhibit 2.1). The cumulative amount that has been recorded as depreciation expense since the date of acquisition up to the balance sheet date is reported in the accumulated depreciation account in the balance sheet (see Exhibit 2.2). As you see, the balance in the accumulated depreciation account is deducted from the original cost of the fixed assets.

In the example, the business owns various intangible long-term operating assets. These assets report the cost of acquisition. The cost of an intangible asset remains on the books until the business determines that the asset has lost value or no longer has economic benefit. At that time the business writes down (or writes off) the original cost of the intangible asset and charges the amount to an expense, usually amortization expense. At one time the general practice was to allocate the cost of intangible assets over arbitrary time periods. However, many intangible assets have indefinite and indeterminable useful lives. The conventional wisdom now is that it’s better to wait until an intangible asset has lost value, at which time an expense is recorded.

You may see an account called “Other Assets” on a balance sheet, which is a catchall title for assets that don’t fit in the current assets or long-term operating assets classes. The company in Exhibit 2.2 does not have any such other assets.

The accounts reported in the current liabilities class are short-term liabilities that, for the most part, depend on the conversion of current assets into cash for their payment. Also, debts (borrowed money) that will come due within one year from the balance sheet date are put in this group. In our example, there are four accounts in current liabilities. We explain these different types of current liabilities in later chapters.

Long-term liabilities, labeled “Long-Term Notes Payable” in Exhibit 2.2, are those whose maturity dates are more than one year after the balance sheet date. There’s only one such account in our example. Either in the balance sheet or in a footnote, the maturity dates, interest rates, and other relevant provisions of long-term liabilities are disclosed. To simplify, we do not include footnotes with our financial statements example in this chapter. (We discuss footnotes in Chapter 16.)

Liabilities are claims on the assets of a business. Cash or other assets that will be later converted into cash will be used to pay the liabilities. (Also, cash generated by future profit earned by the business will be available to pay the business’s liabilities.) Clearly, all liabilities of a business should be reported in its balance sheet to give a complete picture of the financial condition of a business.

Liabilities are also sources of assets. For example, cash increases when a business borrows money. Inventory increases when a business buys products on credit and incurs a liability that will be paid later. Also, typically a business has liabilities for unpaid expenses and has not yet used cash to pay these liabilities. Another reason for reporting liabilities in the balance sheet is to account for the sources of the company’s assets, to answer the question: Where did the company’s total assets come from?

Some part of the total assets of a business comes not from liabilities but from its owners investing capital in the business and from retaining some or all of the profit the business earns that is not distributed to its owners. In this example the business is organized legally as a corporation. Its stockholders’ equity accounts in the balance sheet reveal the sources of the company’s total assets in excess of its total liabilities. Notice in Exhibit 2.2 the two stockholders’ (owners’) equity sources, which are called capital stock and retained earnings.

When owners (stockholders of a business corporation) invest capital in the business, the capital stock account is increased. Net income earned by a business less the amount distributed to owners increases the retained earnings account. The nature of retained earnings can be confusing; therefore, we explain this account in depth at the appropriate places in the book. Just a quick word of advice here: Retained earnings is not—we repeat, not—an asset. Get such a notion out of your head.