The balance sheet is constructed on the basis of formal rules and may
not necessarily represent the market value of the firm as a growing con-
cern, or its liquidation value if the component parts were sold off one by
one. The balance sheet represents the financial position exactly at the close
of trading on the date of the balance sheet. The assets and liabilities shown
are those the accountants have ascertained to exist at that point in time.
The accountant’s prime functions are to keep legal claims straight, present
the data as consistently as possible, and stay as close as possible to objec-
tively determined costs.
We might note at this point an insight provided by the balance sheet
equation. The equation states: Total assets must equal total liabilities plus
ownership capital. Therefore, if the firm increases its total assets, it follows
that the liability and/or ownership accounts must also increase to balance
the rise in assets. The firm may increase the amount it owes its suppliers,
borrow from the banks, float a new bond issue, increase its net worth by
floating additional common stock, or retain additional earnings in the
business. The problem of whether to acquire additional assets and the re-
lated question of choosing the best source out of which to finance the addi-
tional assets are a central area of financial decision making.
Let us describe the various major accounts presented in the balance
sheet. In order that the reader may follow the discussion more readily, we
present the balance sheet of Johnson & Johnson. The reader can find com-
pany balance sheets on many online sources, such as America Online
(AOL) Personal Finance Research for five years, or for 10 years in the Stan-
dard & Poor’s (S&P) Stock Guideor company annual reports. We also
show balance sheet variables for Johnson & Johnson in Table 2.1 for the
1999–2003 period, drawing data from the AOL Personal Finance Research
web site. We could find reported balance sheets for 10 years in the Johnson
& Johnson annual report for 2003. A longer history of balance sheet vari-
ables, covering the 1950–2003 period, can be found on the Wharton Re-
search Data Services (WRDS) Compustat database.
Assets
The assets that the nonfinancial firm may acquire or own are usually broken
down into two major categories: current assets and fixed assets. The current
assets and the fixed assets are usually much larger than the other assets.
Current Assets The current assets consist of cash, accounts receivable, and
inventory, as well as items that in the normal course of business will be turned
into cash within one year. One generally assumes that accounts receivable, in-
ventory, and prepaid items will be used up, or converted into cash, within one