The general objective of the balance sheet is to describe the firm’s economic condition at a point in time. In its broadest theoretical sense, economic condition is the firm’s ability to continue operating and thus is based upon both earning power and solvency. Due to the practical difficulties of assessing this theoretical ability, accountants apply a limited definition of the economic condition known as financial position. This concept restricts the balance sheet to disclosures about the firm’s assets, liabilities, owners ‘ equity, and other financial matters. Accounting practice developed this simplified approach because the broader concept is too abstract to be useful. To explain this abstract concept further and to show why it is not used by accountants, it is helpful to show how a firm’s economic condition is similar to a person’s physical condition.
Both physical and economic conditions are affected by a large number of factors. Some of the factors can be described and measured by objective methods; however, many of them are not capable of being precisely measured and thus are evaluated only subjectively. For example, physical factors like heartbeat and respiration rates or blood chemistry levels can be measured precisely, but the patient’s mental attitude can be assessed only subjectively. Similarly, the firm’s cash, receivables, and notes payable can be measured fairly precisely; however, such important factors as management’s ability and the strength of demand for its product cannot be measured with sufficient reliability. Consequently, accounting practice does not attempt to deal with these kinds of variables despite their obvious impact on the firm’s economic condition.
Apart from these problems of assessing physical and economic conditions, it is helpful to identify the roles of the parties that perform the assessments. Typically, nurses, physician’s aides, or other paraprofessional staff carry out routine examinations and other procedures to gather data to be studied by the physician in developing an opinion as to the patient’s physical condition and a strategy for future treatment. Similarly, private accountants and auditors work together to gather data about a firm and present it to the users of the reports. It is the users that perform the evaluation and plan future actions. It would be inconsistent with their role (and expertise) if accountants were to engage in the extensive analysis required to report economic condition in the broader sense described in the first paragraph of this section.
For all these reasons, the balance sheet describes financial position in terms of the firm’s assets, liabilities, and owners’ equity, as well as by other disclosures that have been identified as useful.