The balance sheet (also referred to as the statement of financial position) is one of the major financial statements used by accountants and business owners. (The other major financial statements are the Profit and Loss report and the cash flow statement) A balance sheet is a financial statement that presents a company’s financial position at a specific point in time. It is a snapshot of a company’s assets, liabilities, and equity. The balance sheet is also known as the statement of financial position.
The two sides of the balance sheet #
The balance sheet is divided into two sections: assets and liabilities + equity. The assets section lists the resources a company owns or controls, and the liabilities and equity section lists the claims against those resources.
The assets section is divided into current assets and non-current assets. Current assets are assets that can be converted into cash within one year, such as cash, accounts receivable, and inventory. Non-current assets are assets that cannot be converted into cash within one year, such as property, plant, and equipment.
The liabilities and equity section is divided into current liabilities and non-current liabilities. Current liabilities are obligations that must be paid within one year, such as accounts payable and short-term loans. Non-current liabilities are obligations that must be paid after one year, such as long-term loans and bonds. Equity represents the residual interest in the assets of an entity after deducting liabilities and represents the amount that the shareholders have invested in the company.
The balance sheet must balance, meaning that the total of assets must equal the sum of liabilities and equity. This equation is represented as:
Assets = Liabilities + Equity.
Overall, a balance sheet provides an overview of a company’s financial position, showing what it owns and owes, as well as the amount invested by shareholders. It helps in identifying the liquidity and solvency of the company.
Balance sheet date #
The balance sheet presents a company’s financial position at a specific point in time. It is reasonable to describe the balance sheet as a “snapshot” of the company’s financial position. For example, the amounts reported on a balance sheet dated August 31, 2018 show the position at the end of that day – they tell you nothing at all about what happened on the 1st September 2018 but they contain the combined effects of all business that the company has done from founding up to that day.
What is the point of the balance sheet? #
The balance sheet allows a business manager or an external person such as a supplier or a bank to see what assets a company owns and what it owes to other parties at the balance sheet date. This is valuable information to a bank deciding to offer the company a loan or not or to suppliers who want to know if the business can afford to pay them.
In addition to the assets and liabilities of a business the balance sheet shows how the business is funded, whether by shareholders investment, loans or retained profits.
The three main parts of a Balance sheet are shown on separate sections of the report, they are – Assets, Liabilities, Share owner’s Equity.
How are assets represented on the balance sheet? #
Usually asset accounts are shown with debit balances in the balance sheet, however some items are shown in the assets section of the balance sheet with credit balances, these are usually referred to as ‘contra accounts’ and they often show allowances for reductions in the value of assets or contingencies for assets which may not have the face value expected.
Some examples of contra assets include:
Allowance for Customers who may not pay their debts to the business in full for any reason (Often referred to as ‘Bad Debt Provision’ or ‘doubtful account provision’
Accumulated Depreciation accounts for assets like machinery or buildings which show how the value of those assets has declined over time as they were used and became worn.
The balance sheet is always shown in the companies reporting currency, items with values in other currencies such as bank accounts in foreign currency are translated into the reporting currency at the exchange rate set at the balance sheet date.
The values of assets shown on the balance sheet always reflect actual costs as recorded at the time that the asset was purchased. The rule is that assets are shown at the lower of cost or net realisable value.
As an example, let’s say a company buys a warehouse building of 40,000 square feet in 2001 at a cost of £500,000, then in 2011 they buy an identical unit next door for £800,000 the value of the buildings on the balance sheet will be reported as £1,300,000 (the total cost paid for the buildings) even though it would be reasonable to assume that the real value of the two buildings is now £1,600,000.
All Balance Sheets are designed to be conservative, remember the rule, assets are shown at the lower of cost or net realisable value. So if you buy stock for £1,000, but the market for that kind of item falls and you can only sell them for £900 you must show them on the balance sheet at £1,000 minus a stock value provision of £100 to reduce the total value to the net realisable value of £900. The £100 provision for the value of stock will appear on the balance sheet and on the P&L where it will appear as a cost..
The cost of buildings and equipment will normally be depreciated over their useful lives. This means that over time the cost of these assets will be moved from the balance sheet to Depreciation Expense on the P&L. As time goes on, the amounts reported on the balance sheet for these long-term assets will be reduced.
How are liabilities represented on the balance sheet? #
Usually, liability accounts are shown with credit balances in the balance sheet. Liabilities are obligations of the company; they can also be thought of as a ‘negative asset’.
Most Liabilities are amounts owed to creditors such as suppliers or banks. Along with share owner’s equity.
Liabilities can be thought of as the way that the company funds its operation. For example, a company’s balance sheet reports assets of £100,000 and Accounts Payable of £40,000 and shareholders’ equity of £60,000. The source of the company’s assets are creditors/suppliers for £40,000 and the owners for £60,000. The suppliers have a claim against the company’s assets and the owner can claim what remains after the debts to suppliers have been paid.
Liabilities also include amounts received in advance for products that have not yet been supplied. The cash received will be recorded as a cash asset, but it has not yet been earned, so the company defers the reporting of this revenue by showing a liability to supply the goods of the same value as the cash received.
Examples of liability accounts reported on a company’s balance sheet include:
Debts to Banks such as overdrafts
Accounts Payable to suppliers
Salaries Payable to staff
Income Taxes Payable
Customer Deposits and pre-payments
Liability accounts will normally have credit balances.
In the same way that assets have contra accounts to modify their values, liabilities can sometimes have contra accounts to modify their value. Contra accounts on liabilities will have a debit balance.
A good example of a contra account on a balance sheet is an account to show a discount issued by a supplier against a debt payable.
It is normal to split liabilities up into groups based on how soon they will need to be paid
Current Liabilities is the term used for debts that need to be paid within 12 months of the balance sheet date.
Long Term Liabilities is the term used for loans and other debts that are paid over more than a year.
So if you borrow £10,000 to be paid back over 2 years on the balance sheet date, £5,000 would show in Current Liabilities and £5,000 in Long Term Liabilities
It should be noted that there are a number of assets in most businesses that do not show on the balance sheet because they were not purchased and cannot be valued in money. A good example is the skills of the company’s employees, even the company with the very best sales force in the world cannot value them on their balance sheet for this reason. Similarly brands that are developed in house are not shown on the balance sheet – but brands purchased in a business acquisition are shown on the balance sheet.
Similarly, some liabilities will not be shown, a contract signed on the balance sheet date will have no effect on the balance sheet unless transactions take place at the same time, its normal to disclose these items in the notes on the balance sheet.
Notes are normally added the Balance Sheet to help explain the state of the business, they often reveal important information.
How is Shareholders Equity represented on the balance sheet? #
At the bottom of a balance sheet, you will find the value of Shareholders Equity.
Shareholders Equity is a source of the company’s assets. Owner’s equity is sometimes referred to as the book value of the company, because owner’s equity is equal to the reported asset amounts minus the reported liability amounts.
Owner’s equity may also be calculated as assets minus liabilities.
Shareholders equity is made up of the value put into the business to buy shares plus the companies retained earnings since it was started.
Both owner’s equity and stockholders’ equity accounts will normally have credit balances.
Notes To Financial Statements #
The notes to the balance sheet and to the other financial statements are an integral part of the financial statements. The notes inform the readers about such things as significant accounting policies, commitments made by the company, and potential liabilities and potential losses. The notes contain information that is critical to properly understanding and analyzing a company’s financial statements.
It is common for the notes to the financial statements to be 10-20 pages in length to properly explain the business details to readers.