What are the limitations of the balance sheet?

Definition of Balance Sheet

The balance sheet is one of the main required financial statements. It is also known as the statement of financial position.

The balance sheet reports a U.S. company's assets, liabilities, and owner's (stockholders' equity) as of the final moment of an accounting period in accordance with generally accepted accounting principles (GAAP, US GAAP).

GAAP's historical cost principle means that some noncurrent assets are reported at amounts less than their current market value. It also means that some valuable assets that were developed internally (not acquired in a transaction) will not be reported on the balance sheet.

Examples of Limitations of Balance Sheet

Assume that a company developed an internet business that now attracts millions of visitors each day and has $10 million in annual revenues and $6 million in net income. Since the internet business was not purchased from another company and its cost to develop was not significant, the company's balance sheet will report only the business's cash, receivables and some related payables. The balance sheet will not report the business as an asset, even though the company received multiple offers to sell the internet business for $30 million.

Similarly, the immensely talented designers and content writers employed at a highly profitable internet marketing firm are not reported as assets on the firm's balance sheet because of the cost principle. This is also true for the firm's brand names that resulted from effective marketing, highly satisfied service, and expertise in specialty services that are in great demand.

Another limitation of the balance sheet involves a company's land and buildings in valuable locations that were acquired many years ago. For instance, the company's land is reported at an amount no greater than its cost. The company's buildings are reported at their cost minus the accumulated depreciation. As a result, the amounts reported on the company's balance sheet for its land and buildings are significantly lower than their current market values.

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