The balance sheet and equity

In depth

Current or noncurrent: the rules

F01 introduced the test: an item is current if it will be realised, sold, used up or settled within one year or the operating cycle, whichever is longer. Three details matter when a balance sheet is prepared. Under US GAAP the operating cycle replaces the year only when it is longer than twelve months, and when there is no clearly defined cycle the one-year rule applies (ASC 210-10-45-3); Lantern, like most businesses, uses one year. Under IFRS, trade payables and accrued operating costs are current even if some are due after more than twelve months, because they belong to the operating cycle (IAS 1, paragraph 70). And a liability is current whenever the entity has no right, at the end of the reporting period, to defer its settlement for at least twelve months (IAS 1, paragraph 69(d), as amended from 2024; IFRS 18, which replaces IAS 1 for annual periods beginning on or after 1 January 2027, carries these requirements forward unchanged).

Some businesses, such as banks, have no clearly identifiable operating cycle, and IAS 1 lets them present assets and liabilities in order of liquidity without a current and noncurrent split when that is more relevant (paragraph 60). IAS 1 also doesn’t prescribe the order or format of the statement (paragraph 57), so some IFRS reporters list noncurrent assets first and show equity before liabilities. The facts are the same; only the layout differs.

Lantern’s classified balance sheet

Current assets of $56,476 are dominated by cash ($42,940). Receivables are shown at the gross $7,380 with the allowance of $584 deducted on the face of the statement, so the reader sees both what customers owe and what Lantern expects to collect. Prepaid insurance of $300 is the cover for January and February 2027, the last two months of the policy. Property and equipment appear at cost less accumulated depreciation, $12,000 − $2,000 and $30,000 − $2,800, for a net $37,200. Total assets are $93,676.

On the other side, current liabilities of $26,289 are the six items built up in the receivables and payables lesson. Noncurrent liabilities of $25,000 are notes payable: Coastline’s $10,000, due in one sum on 1 March 2028, fourteen months after the balance sheet date, and the $15,000 of the van note due after 31 December 2027. Equity is $42,387: $20,000 of common stock and $22,387 of retained earnings. Liabilities plus equity, $51{,}289 + 42{,}387$, equal total assets of $93,676. The form shown, with assets above and liabilities and equity below, is the report form; the account form sets assets on the left and liabilities and equity on the right, like the two sides of an account.

The current portion of long-term debt

Lantern’s van note was $20,000, repayable in four yearly instalments of $5,000 from 1 June 2027. At 31 December 2026 the first instalment is due within twelve months and will be paid from current assets, so it is a current liability; the other $15,000 is not due until 2028 and later. The ledger keeps the note in one account, so at the year end the accountant moves the current part with a reclassification entry, adjustment e8. The entry changes no total and involves no cash: it moves $5,000 from one liability line to another.

The split is redone at every balance sheet date. By 31 December 2027 Lantern will have paid the first instalment, and two amounts will be due within the following year: the van’s second instalment on 1 June 2028 and the whole of Coastline’s note on 1 March 2028. The current portion will rise to $10{,}000 + 5{,}000 = 15{,}000$ and only $10,000 of van instalments, those due in 2029 and 2030, will stay noncurrent. A loan that is comfortably long-term this year can become a large current liability next year just because time passes, which is why lenders and borrowers plan refinancing well before that happens.

Two complications are left to intermediate accounting. If a borrower breaches a loan condition (a covenant) on or before the balance sheet date and the loan becomes repayable on demand, IFRS classifies the whole loan as current even if the lender agrees after the year end not to demand repayment (IAS 1, paragraph 74). And a short-term loan the company intends to refinance on long-term terms may in some circumstances be shown as noncurrent; US GAAP (ASC 470-10) and IFRS draw that line in different places.

Working capital and the current ratio

Two measures from F00 summarise the current section. Working capital is current assets minus current liabilities; the current ratio divides one by the other. For Lantern, working capital is $56{,}476 - 26{,}289 = 30{,}187$ and the current ratio is $56{,}476 \div 26{,}289 \approx 2.15$: about $2.15 of current assets for every dollar due within the year. Had the accountant forgotten e8, current liabilities would have been $21,289, working capital $35,187 and the ratio 2.65, a flattering picture of the same business.

The current ratio treats every current asset as equally able to pay bills, which is rarely true. Lantern’s cash alone, $42,940, exceeds all its current liabilities, while $6,100 of those liabilities will be settled by delivering events and coffee, not by paying cash. Judging whether 2.15 is comfortable for a coffee business, and comparing it with others, is the work of F03 Financial Statement Analysis; here the point is that the ratio is only as good as the classification behind it.

Contributed capital: par value and additional paid-in capital

A corporation’s charter states how many shares it may issue, its authorised shares, and for many companies a par value for each: a nominal amount, often a cent or less, fixed by the charter and given meaning by state corporate law rather than by accounting standards. In Delaware, for example, shares with a par value may not be issued for less than par (Delaware General Corporation Law, section 153), and the capital a corporation records for them must be at least their total par value (section 154). Because par is usually tiny, it says nothing about what a share is worth.

When shares are issued, US practice splits the proceeds: Common Stock is credited with the par value of the shares issued, and the rest goes to additional paid-in capital (APIC). No-par stock is credited in full to Common Stock, unless the board assigns it a stated value, which is then treated like par. Lantern’s shares have no par value, so all of Ana’s $20,000 went to Common Stock and its Additional Paid-in Capital account is empty. Had the same $20,000 bought 2,000 shares with a $1 par value, the entry would have split it: $2,000 to Common Stock and $18,000 to APIC. Total contributed capital is the same either way.

Shares are sometimes issued for something other than cash, such as equipment or professional services. The issue is then recorded at the fair value of the shares or of what is received, whichever can be measured more reliably, and split between par and APIC in the usual way.

The balance sheet or its notes give, for each class of stock, the par or stated value and the numbers of shares authorised, issued and outstanding. Shares are issued when first sold. Some may later be bought back and held as treasury stock, shown as a deduction from equity; issued shares not held in treasury are the outstanding shares, the ones that vote and receive dividends. Some companies also issue preferred stock, which ranks ahead of common stock for dividends; F04 meets it as a source of fixed payments. Companies reporting under IFRS, and UK companies, usually call common stock share capital and APIC share premium.

Retained earnings and dividends

A cash dividend involves three dates. On the declaration date the board votes the dividend, and it becomes a legal liability: debit Dividends (or Retained Earnings directly; Lantern uses a Dividends account, which is closed to Retained Earnings), credit dividends payable. The date of record fixes who will be paid, the shareholders on the register that day; no entry is made. On the payment date the company pays: debit Dividends Payable, credit Cash. Retained earnings fall when the dividend is declared, not when it is paid.

Lantern’s two dividends were declared and paid on the same day, $300 on 30 March and $4,700 on 15 December, so no dividend was owed at the year end. Suppose instead that the December dividend had been declared on 15 December and paid on 8 January 2027. Retained earnings and total equity would be exactly as reported, but the balance sheet would show $4,700 of dividends payable among current liabilities and $4,700 more cash. Working capital would not change ($61{,}176 - 30{,}989 = 30{,}187$), but the current ratio would fall from 2.15 to about $61{,}176 \div 30{,}989 \approx 1.97$, because the same amount has been added to both sides of a ratio above one.

The statement of changes in equity

The statement of changes in equity explains how each component of equity moved from the start of the period to the end. For Lantern’s first ten months it is short: common stock rose from nothing to $20,000 when Ana’s shares were issued, and retained earnings rose by net income of $27,387 and fell by dividends of $5,000, ending at $22,387. Each closing balance is the figure on the balance sheet, which is the articulation F01 introduced: net income from the income statement enters here, and total equity leaves here for the balance sheet.