What Is a Balance Sheet in Accounting?
What Is a Balance Sheet?
A balance sheet is a financial statement that reports company assets, liabilities, and shareholder equity for a specific period. Balance sheets serve as the basis for calculating returns on investment and evaluating the financial health and structure of a business. Put simply, these are financial statements that give a snapshot of everything a business owns and owes and how much money investors have put into the business.
Why Prepare a Balance Sheet?
Look at a balance sheet example, and you’ll see what makes them important. These documents are essential for investors, executives, regulators, and analysts. They help these people understand the financial health of a business. Balance sheets are typically used with the cash flow statement and income statement.
Balance sheets give readers an overview of the assets and liabilities briefly. The sheet helps understand whether the company is making money, has a positive net worth, has enough assets to cover obligations, and how much debt a company holds compared to others.
What is Included in a Balance Sheet?
Accounts in the assets section are listed from top to bottom in order of liquidity. Liquidity refers to how easily they can be converted to cash. The assets are split into current assets that are ready to convert in under a year and long-term assets that can’t.
Liabilities are money a company owes to outside parties. Liabilities include things such as bills to suppliers and contractors to interest on loans and other lines of credit. It also includes utilities, salaries, and rent. Current liabilities are due within one year and listed by order of due date. Long-term liabilities are due in over one year.
- Shareholder Equity
Shareholder equity refers to the money attributable to business owners and shareholders. This is also called the net assets because it is the equivalent of the total assets minus liabilities and debts owed to non-shareholders.
Retained earnings refer to the earnings a company invests back into itself or uses to pay off debt. Any money left over is shared among shareholders as dividends. Treasury stock refers to the stock a company purchase. This stock can be used to prevent hostile takeovers or sold to make money in the future.
Some companies issue preferred stock. This stock is listed separately from the common stock. Preferred stock is given an arbitrary par value that doesn’t affect the market value of shares. Common stock and preferred stock accounts are calculated using the par value, multiplied by the number of issued shares.
Extra capital surplus represents how much money investors have put in outside of common and preferred stock, which are based on the par value instead of the market price. Shareholder equity isn’t directly related to the company market capitalization. Market capitalization is based on stock price, while the paid-in capital is the equity purchased at any price.
Types of Liabilities on the Balance Sheet
The balance sheet lists current and long-term liabilities. Current liabilities can include:
- Current long-term debt;
- Interest payable;
- Bank debts;
- Wages payable;
- Customer prepayments;
- Earned and unearned premiums;
- Dividends payable;
- Accounts payable.
Long-term liabilities can include:
- Principal and interest for bonds;
- Pension fund liability – the money paid into employee retirement accounts;
- Deferred tax liability – the money on taxes accrued to be paid next year.
Some short-term liabilities don’t show up on a balance sheet because they are considered off-the-balance.
What is the Order of Items on the Balance Sheet?
As mentioned before, assets are ordered by liquidity, while liabilities are ordered by the due date. Here’s how assets are ordered on a balance sheet:
- Cash and cash equivalent – these are the most liquid assets and include things such as certificates of deposits, Treasury bills, and hard currency;
- Marketable security is a debt and equity security with a liquid market;
- Accounts receivable (AR) – referring to the money customers owe to a company, including an allowance on doubtful accounts because not every customer pays their due on time;
- Inventory – refers to the cost of goods for sale which are valued at the lower end of market value;
- Prepaid expenses – covers everything that has been paid for, such as advertising costs and insurance.
Why Does a Balance Sheet Balance?
The reason that a balance sheet balances is because of the accounting equation. The equation has assets on one side and liabilities and shareholder equity on the other. The result always balances out, at least it does if everything is entered correctly.
The full equation to balance an accounting balance sheet example is:
Assets = Liability + Shareholder’s Equity
The equation is intuitive because companies must pay for everything they own (assets) by borrowing money (a liability) or taking it from investors (shareholder equity). If it doesn’t balance out, then something has gone wrong. Double-check the numbers and see if you made any mistakes along the way.
Let’s look at a basic balance sheet example. Say Company A borrows $4,000 in a five-year loan. The assets (specifically the cash account) go up by $4,000. The liabilities (specifically long-term debts) also go up by $4,000, balancing the books on both ends of the equation. If that company takes on $8,000 from investors, then the assets and shareholder equity both increase by that amount. Once again, it balances out.
Any revenue a company makes more than assets go into the shareholder equity account. The revenue is balanced by the assets side, appearing as inventory, investments, cash, or anything else the money was used for. The company takes on an $8,000 liability but gains $8,000 in assets to balance the equation.
Who Prepares a Balance Sheet?
Who prepares the balance sheet depends on the company. For a small privately-owned business, the balance sheet is prepared by either the business owner or a bookkeeper hired by them. A mid-size private firm might prepare the sheet internally and then double-checked by an external accountant.
Public companies are required to get an external audit performed by a public accountant. Public companies are also required to keep their books to a higher standard than private ones. Financial statements such as balance sheets must be created and prepared in accordance with the Generally Accepted Accounting Principles (GAAP) and must be filed with the Security and Exchange Commission (SEC).
You don’t need to be an accountant or a math wizard to understand the balance sheet format example and create your own balance sheets. There’s a good chance that your accounting software, if you use one, can prepare one for you automatically. If not, then any accountant can get the job done. There are plenty of great templates out there to help you create the perfect balance sheet to understand your business and make informed fiscal decisions.