Financial Statements – Balance Sheet

The Balance Sheet is the financial statement that summarizes the value of an entity’s resources and the claims on those resources at any given time.  Balance Sheet accounts start accumulating their balances from the beginning of the entity and continue until the end.  This contrasts with the Income Statement whose accounts are reset to zero at the end of each fiscal (business) year.

The Accounting Types reported on the Balance Sheet are:

Assets – Assets are items of value that are owned by the business and their value is expected to last beyond the current fiscal (business) year.

Liabilities are essentially debts, they are agreements to delay payments and so, are sources of funds because they provide a way to acquire or pay for goods and services without a direct transfer of cash at the time of the exchange.

Equity (Owners Equity) is a source of funds through direct owner investment (stock or owners capital accounts  or owner “re-investment” (retained earnings) when some or all of the income from the previous year is retained by the business rather than distributing it to the owners.

The Balance sheet Equity Section refers to Total Equity which is Owners Equity + Net Income.  The Net Income portion is easily calculated because since the total debits and total credits of all financial accounts must be equal, and the Balance Sheet and Income Statement split the Accounts between them.  The difference between the Balance Sheet Accounts will equal the difference between the Income Statement Accounts – which is Net Income.

Since Owners Equity is only part of Total Equity, Net Income can also be calculated using a rewrite of the Accounting Equation to Assets – Liabilities = Total Equity (Owners Equity + Net Income)  so move Owners Equity to the other side of the equation as well and the equation becomes Assets – Liabilities – Owners Equity = Net Income.

Also, given the Accounting Equation: Assets = Liabilities + Equity.  The value of any one of the three elements can be determined given any two of the three.

Important financial ratios can be calculated directly from the numbers on the Balance Sheet.  Among these ratios is current ratio and quick ratio each of these help to determine if the business is able to fulfill its short term debt obligations.

• Current Ratio = Current Assets/Current Liabilities
  • A Current Ratio of at least 1:1 (or >= 1) indicate that there is at least one dollar of current assets for each dollar of debt.
• Quick Ratio = Current Assets – Inventory/Current Liabilities
  • A Quick Ratio of at least 1:1 indicates that there is at least one dollar of cash or cash equivalent (including accounts receivable) for each dollar of debt.

Balance Sheet Example:

At the end of each year when the Income Statement accounts are reset to zero, the difference between their debit and credit balances (Net Income/(Loss)) is posted to a Balance Sheet Equity account called Retained Earnings (for corporations or Owners’ Capital for other types of organizations).  An example of this entry can be found at the end of the Income Statement post.

The Balance Sheet does not contain any of the same accounts as the Income Statement, but it does summarize the Income Statement on one line called “Net Income” that is inserted (without an account #) at the end of the Equity Section of each Balance Sheet.  The Net Income entry completes the Accounting Equation for the Balance Sheet:  Assets = Liabilities + (Total) Equity (Owners Equity + Net Income)

So, the listing of balance sheet accounts from the Income Statement post gives us a start in creating a Balance Sheet prior to year end closing entries.

The Balance Sheet has a section for each of the elements of the Accounting Equation, Assets, Liabilities and Equity.  The the first thing I check when I read a Balance Sheet is whether it is “in balance”/the accounting equation is true.  Once I know it balances, I can focus on the substance of the report.

To convert the account listing above to a Balance Sheet format, I’ll add some section headings and a line for the Net Income from the previous Income Statement post.

Assets = Liabilities + Equity

Notice that the Net Income entry doesn’t have an account number beside it. Net Income does not have an account, it is the difference between the Balance Sheet Accounts.  It is also the difference between the Income Statement Accounts.

Each item on the Balance Sheet is stated at its original value or cost.  Since the accounts accumulate their balances from “the beginning of time”, each balance sheet item also stays there at its original value until it is sold, written off or satisfied (debts paid off or equity repurchased).

Items that are listed on the Balance Sheet do lose their value over time so instead of reducing their original account values, contra accounts are used to write down, depreciate or amortize them. Contra Accounts are the same Accounting Type as their counterparts but if their counterpart is a debit account, the contra account is a credit account. The Net Value of the Original Account and the Contra Account together reflects the decrease in book value without losing the historical value. Contra Accounts like Accumulated Depreciation prevent items from “falling off” the Balance Sheet while they are still owned by the entity because when the item’s value eventually depreciates to zero, it is still part of the original account balance.

Depreciation is determined by type of fixed asset. Depreciation methods, classes of assets and examples are listed in IRS Publication 946. Sometimes entities use different depreciation methods for book/tax purposes. Always ask a tax professional for guidance in making decisions that have tax implications.

The purpose of this entry is to demonstrate basic depreciation entries rather than depreciation calculations. I will use straight-line depreciation and assume that the assets were put into service on January 1st. Publication 946 (pg 31) indicates that office equipment is depreciated over 5 years and office furniture is depreciated over 7 years. For the depreciation entry I will add a contra asset account and a depreciation expense account.

After the depreciation entry above, expenses were increased and net income was decreased by $496.  After the depreciation entry and closing entries to the Income Statement, our Balance Sheet looks like this.  Note the change from Net Income with no account number to Retained Earnings with the account number 3500.  The entry to account 3500 is is part of the year end income statement accounts closing entry.

Next up: >> Financial Statements – Statement of Cash Flows

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**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.