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Set out the elements that make up a balance sheet

CFA® Level I · Financial Statement Analysis · Analyzing Balance Sheets · FSA.3.a

The idea

The balance sheet reports financial position at a single instant, and the accounting equation holds by construction: assets equal liabilities plus equity. Assets are resources controlled by the firm from past events and expected to produce benefit; liabilities are present obligations; equity is the residue, not an independent quantity. Items are split into current and non-current on a one-year-or-operating-cycle test, which is what makes liquidity readable at a glance. The measurement basis matters as much as the classification: much of the sheet is historical cost, so book equity is not market value, and internally generated intangibles are largely absent from it altogether.

Formulas

The accounting equation

assets = liabilities + equity

assets
resources the company controls and expects benefit from
liabilities
what it owes to others
equity
what is left for the owners, the residual

It holds after every transaction, which is what double entry enforces. Equity is defined as the residual rather than measured, so any error in assets or liabilities lands there.

A practice question

From the question bank, with the reason each wrong option is wrong.

The accounting equation states that assets equal liabilities plus:

  1. equity — correct
  2. revenueWhy not: Revenue is an income statement figure covering a period. The balance sheet equation holds at a point in time, and revenue reaches it only through retained earnings.
  3. expensesWhy not: Also an income statement figure, and one that *reduces* equity rather than adding to it.

Equity is the residual claim, so the equation holds by construction rather than by coincidence.

A harder one

A firm has assets of $800 and liabilities of $500. Its equity is:

  1. $1,300Why not: 800 + 500 — the two added. That double-counts, since the $500 of liabilities is one of the ways the $800 of assets was funded.
  2. $500Why not: The liabilities figure quoted back. Equity is what is left after they are deducted.
  3. $300 — correct

Equity is the residual: 800 minus 500, and it moves with every change in either of the other two.

The hardest tier

A firm reports a large current ratio driven by slow-moving inventory. Its true short-term position is:

  1. better than the ratio suggestsWhy not: The wrong direction. Stock that will not sell cannot pay a supplier, so the ratio flatters the position rather than understating it.
  2. exactly as the ratio suggestsWhy not: The ratio counts every current asset equally. Inventory that turns slowly is not equivalent to cash, which is why the quick ratio excludes it.
  3. weaker than the ratio suggests — correct

Inventory nobody wants cannot settle a payable, which is precisely why the quick ratio excludes it.

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