What is a Balance Sheet Anyway?
The balance sheet is essentially a financial document that outlines the entire financial position of a business. For this exact reason, the balance sheet is often referred to as the ‘statement of financial position’. It displays how much it owes, how much it is owed, and the assets vs the liabilities. The formula for the balance sheet is:
|Assets = Liabilities + Shareholders Equity|
The balance sheet is necessary so that investors and potential associates can get a clear and accurate picture of the financial situation of a business. While it may not be the most in-depth, it is the first port of call for all potential lenders and investors to get a picture of where the company is and where it is going.
The balance sheet is easier to prepare than you might think. The 5 simple steps are given below for further clarification.
#1 – Prepare the Balance Sheet
Before you start the balance sheet calculations, you must pinpoint the reporting period, acquire supplementary documentation, and create your header.
The reporting date is the final date on which the report is prepared. The majority of companies (especially public companies) will issue quarterly reports on the following dates/quarters:
- Q1 – March 31st
- Q2 – June 30th
- Q3 – September 30th
- Q4 – December 31st
For those companies that opt to use an annual reporting period, December 31st is the date most commonly chosen. Annual balance sheets will have a yearly reporting period and quarterly balance sheets will report on the past 3 months’ activity.
In most cases, the reports will be published a couple of weeks after the end date, so that all of the activity can be monitored and the balance sheet accurately prepared. In this step, you will also need to:
- Gather all relevant information for the creation of the document
- Prepare the heading
Many guides will have these as standalone steps. While any document with updated metrics can be used to prepare the balance sheet, the adjusted trial balance would be the best one to use.
The heading will consist of three lines. The first line will be the name of your business. The second line will be either ‘Balance Sheet’ or ‘Statement of Financial Position’. The third line will be the date of the report.
Do not use terms such as ‘For the Year Ended’, ‘For the Month Ended’, ‘For the Quarter Ended’, as the balance sheet reporting date. This is because we are reporting the financial position at a particular time, not over a given period. An example heading would be:
Boston Best Restaurant
31 December 2022
#2 – Calculate Assets
You now have your date, documentation, and header. It is time to calculate your assets. Remember, that you are calculating all of your assets as of a given date. So you need to calculate your assets as of that date (sometimes, the header date can state ‘As of 31 December 2020’). All assets will be recorded on the spreadsheet under the heading ‘Assets’, and the assets are divided into two broad categories. These categories are:
Using the trial balance, take the assets and record them on your balance sheet. Each entry on the ledger will be under current or non-current assets. Calculate both of these asset classes individually so you are left with total current assets and total non-current-assets.
In accounting, a line is drawn whenever a calculation is made. Add total current assets and total non-current assets together and you are left with total assets, which should have a double line underneath it. This is all you need to do in terms of reporting assets.
#3 – Calculate Liabilities
The process for the calculation of liabilities is similar to that of assets. All assets will be recorded on the spreadsheet under the heading ‘Liabilities’, directly underneath the ‘Assets’ section.
Again, liabilities will be divided into current and non-current liabilities. Sum up each category so that you are left with total liabilities, with a double line underneath. The typical categories for liabilities are given below:
#4 – Calculate Shareholder/Owners Equity
The complexity of this step will largely be a function of how large your business is. For the vast majority of business owners, who are the sole owners of the business, the calculation will be quite straightforward. It gets tricky for publicly listed companies with lots of shareholders. If the business does issue different types of stock, the calculation will include:
You can calculate all of the types of stock as ‘Total Shareholders Equity’ with a double line underneath. This section should go underneath the Current Liabilities section on your balance sheet.
For a Sole Proprietorship, this will be replaced with ‘Owners Equity’. For a partnership, it will be replaced with ‘Capital Accounts’. Bear in mind that the shareholder and owner’s equity both mean the same thing. It is largely the name that is different, but the method of calculating it is the same.
#5 – Balance the Balance Sheet
You now have everything you need to balance the balance sheet! The balance sheet is a single page with a list of assets, liabilities, and shareholder/owner equity. Once you have the totals, it is merely a matter of comparing them. In most balance sheets, the shareholders’ equity will go in the same section as the liabilities, not in its own section. This is because the shareholders’ equity will be added to the liabilities. To restate the formula at the start (but in a different way):
|Liabilities + Shareholders Equity = Assets|
So the sum of Total Liabilities + Shareholder Equity must be equal to the Total Assets. If not, then your balance sheet is not balancing, and you have a problem. Remember that you can have the liabilities/shareholders equity section next to the assets section, instead of underneath. As long as you calculate the two figures and the balance, you are good to go.
How to Calculate Owners/Shareholders Equity on a Balance Sheet
While most people can get their heads around the concepts of balancing the assets with the liabilities, the concept of owners and shareholder’s equity is a little more nuanced. It is made even more complex by the fact that it will often depend on the legal entity type.
Equity consists of contributed capital (money invested) and retained earnings (historical sum of profits and losses). Here, make a list of all the equity accounts like common stock, treasury stock, and retained earningsearningsll the equity accounts are listed, sum them and add the heading ‘Total Owner’s Equity’.
This is quite an important metric outside of the topic of the balance sheet. It denotes how much the business is worth if it was to be liquidated right now. It is what would be returned to the owner/shareholder (in theory). From this figure, many other metrics are derived, including the debt to equity ratio (‘DE’), the book value of equity per share (‘BVPS’), and return on equity (‘ROE’). The easy formula for calculating shareholder equity is:
Essential Concepts in Preparing a Balance Sheet
In order to understand the Balance Sheet, you will need to know the following concepts:
- Assets – These are assets owned by the business with a quantifiable value. Assets are divided into ‘Current Assets’ and ‘Non-Current Assets’. Current assets can be converted to cash within 12 months. They include cash and cash equivalents, prepaid expenses, inventory, marketable securities, and accounts receivable. Non-current assets are long-term investments that cannot be exchanged in a short time frame. This category includes land, equipment, patents, trademarks, goodwill, and intellectual property.
- Liabilities – Liabilities are what is owed by the business to an external agency. Like assets, they are divided into ‘Current’ and ‘Non-Current’ Liabilities. Current liabilities include accounts payable and accrued expenses. Non-current liabilities include leases, bonds payable, and loans.
- Shareholder Equity – This is the total amount that would be left over if all assets were liquidated and all liabilities paid. This, as the name suggests, belongs to the shareholders. The Formula is Shareholders Equity = Assets – Liabilities. Shareholder equity can also be termed owners equity, depending on the type of legal entity structure.
Premium Software to Prepare the Balance Sheet
There is a myriad of software platforms that help you to understand the mechanics of your accountancy systems and how your transactions are accounted for. The simple balance sheet is actually one of the most straightforward computations, as it is typically a single page long, consisting of only additions and subtractions. It is the integration of the trial balance, general ledger, and balance sheets, where the software really shines through.
Once the general ledgers are inputted, the trial balance and balance sheets can be automatically computed. All you have to do is select your reporting date and the software will do the math. Every accountancy software will be able to prepare a balance sheet. However, among the best software providers for ease of use, affordability, integration, reliability, and inter-operability include:
Preparing the Balance Sheet – Things to Watch Out For
One thing to bear in mind in any kind of accounting is that the initial parameters are not correct. All of your data is going to stem from the general ledger, which is derived from various sub-ledgers (accounts payable, accounts receivable, cash management, fixed assets, purchasing, projects, etc).
This is where you might want to get some help. The balance sheet and trial balance can be done with software or even an Excel spreadsheet. But sub-ledgers need to be inputted correctly for everything to work smoothly. The biggest issue with the balance sheet is user error, as is often the case. You might simply forget to record a transaction, such as inventory, supplies, or petty cash. A reminder system might serve to offset this.
Transposition errors are super common, even for seasoned book-keepers. This error occurs when you transfer one set of figures but invert them. $48 might become $84 on a different sheet. This error is often only found out later, but you can cross-reference on other sheets to spot them as they come up. Getting a co-worker or employee to double-check the figures can also help but can be time-consuming. And it is also not the most invigorating of roles to complete.
Other Common Errors
Inventory is another area prone to mins recording. The inventory has to be tallied at the end of every single day, so there are bound to be errors. But of all of these errors, the biggest would be wrongful classification. This will destroy your balance sheet. Obviously, assets go in the assets section and liabilities in the liabilities section. But you also want to ensure that your subcategories under assets and liabilities are correct. This can get confusing, but it may have tax implications. For instance, there are 3 common liability accounts:
- Accrued expenses
- Unearned revenue
- Accounts payable
You want to put each debit and each credit in the correct subcategory. The good news is that once you are familiar with this, you will know what to do each and every time. High-quality accounting software is also something of a pre-requisite in the modern era. It will help you to avoid mistakes while also help you to increase your understanding of financial documents, regulatory requirements, accounting terminology.
Differences in Trial Balance vs Balance Sheet
There are many differences between the trial balance and the balance sheet. The trial balance records all of the balances from general ledger accounts. While the trial balance records credit vs debit, the balance sheet records total assets vs total liabilities. The trial balance can be defined as a statement of debit as well as credit balances, whereas a balance sheet can be defined as a statement of assets, liabilities, and shareholder equity.
The trial balance ignores opening stock and includes closing stock while the balance sheet includes opening stock but excludes closing stock.
The trial balance is more of an internal document used to spot any mathematical errors, while the balance sheet is used to demonstrate the financial positions of a business at a given date, typically to investors and/or shareholders. The trial balance is not a financial statement, while the balance sheet is. For this reason, the balance sheet will need an external audit/regulation, while the trial balance will not. However, despite the many differences, both sheets will contain similar financial metrics, including:
While the two documents might seem similar at first glance, they both serve entirely different purposes than you would think. But it is definitely a good reason to understand both at the same time, where possible. While the trial balance is created from the general ledger accounts, while the balance sheet is created from the trial balance sheet. You should seek to understand all aspects of the business – basic accountancy is not as complex as you would think, at least in terms of the high-level overview.
Preparing a balance sheet is extremely easy to do, provided you have all the (accurate) figures at hand. The 5 steps above are all you need to know.
To further extend your knowledge of accountancy and of your own business functioning, consider investigating General Ledger (‘GL’) and Trial Balance (‘TB’).
Both are intimately connected with the Balance Sheet and provide additional information to make you an all-around better business person.