I am going to attempt to get a little more academic, yet keep it interesting enough that people don’t fall asleep.
In very simple terms, the balance sheet provides a summary of the assets, liabilities, and equity of a business at a given point in time.
Why is this important? The balance sheet conveys the financial health of an organization. It shows what the company owns and also what it owes (who it borrowed from to acquire goods). To compare it to a personal level, you may “own” a house for $500,000, but if your mortgage is $300,000, your equity is only $200,000. If the house declined in value to $250,000, but the mortgage was still $300,000, the mortgage company would really be considered the owner.
By definition, a balance sheet should balance, although I have seen clients with a balance sheet that does not balance (even when using Quickbooks – I have no idea how these things happen), this is the result of an error.
The common items on a balance sheet include:
- Accounts Receivable
- Fixed Assets
- Accounts Payable
- Bank loans
While these categories seem pretty basic, they can easily get more nuanced. In Part 1, we will only cover the assets, below are some examples and explanations of more unique situations.
You may have also noticed that the first section of the balance sheet is for Current Assets (expected to convert to cash within 12 months), this is the standard structure per US accounting regulations (GAAP). Assets are listed in the order of how liquid they are, with the easiest to convert to cash at the top. In the UK, the order is the opposite.
Negative Cash – Besides having an overdrawn back account, it is possible to show negative cash for other reasons. Simply put, the cash balance on the company’s statements reflects all cash in the bank, and outstanding, but not necessarily, issued checks. Why do companies do this? There are a host of reasons, most of them are not good. In other instances, some businesses could use a revolving line of credit, where the cash is swept out of the account at the end of every day. Therefore, the company views their “cash” as the amount that can be borrowed on the line of credit.
Accounts Receivable (commonly referred to as AR) – Typically, the AR balance is equal to the total of all customer accounts on the AR Aging. The detailed aging provides a listing of each outstanding invoice for every customer. A company may realize that some of their accounts may end up being uncollectible, without knowing which specific ones.
If an organization wants to take into account the risk, without losing any of the detail from the aging, it can take a reserve and put it in allowance for doubtful accounts. This account acts as an offset to AR, and it allows the company to recognize bad debts prior to a full write off and avoiding a big shock to the income statement down the road.
Inventory follows a similar pattern to AR. The total should equal the sum of the individual components at their cost (I will spare you explanation of the various inventory costing methods today). If a company knows that some products will go bad, or some will get “lost” throughout the year, it can take a reserve. For instance, if a company conducts a physical inventory at the end of every year and always faces a write-down for a certain dollar amount, instead of absorbing the lost profit at once, it can smooth it out throughout the year. This is done by assuming an expense every month (the other side of the expense is the reserve account). When the next physical inventory is conducted, any write-downs are taken against the reserve. If the reserve is too big, then the company can enjoy a gain instead.
Remember how current assets should turn into cash in less than one year? If you have more than one year of a given item in inventory, there should probably be a reserve against it, barring a really good explanation.
Prepaid Expenses – This is a favorite for accounting magicians. The possibilities with this account are truly endless. I once saw a company keep two years of catalog expenses (despite producing one catalog per year) in order to help prop up their net income (as expected, that trick eventually caught up with them).
With that being said, most uses of prepaid expenses are legitimate, but without good supporting schedules, the math can be fuzzy. One of the more common ways to use this account is for insurance expenses. If a company has a general liability policy that calls for less than 12 equal payments (virtually all do), your insurance will always be paid up more than your true expenses. If the payments are booked as expenses, it can create a lumpiness in your financial statements that cause confusion when reviewing the results. In the example below, a company pays $48,000 per year, which is a $4,000 expense per month (on average). But if the company marks the payments as expenses, then the $10,000 payment would make January look much worse. By using a prepaid expense account, the variations in payments do not impact expenses.
Fixed Assets – This encompasses all the “hard assets”, such as land, buildings, equipment, vehicles. office furniture, leasehold improvements, and computer equipment. Fixed assets are usually the first section after Current Assets. A good practice should be to maintain a list of all these items so you know exactly what you have and can save headaches later (getting bank financing, selling the business, IRS audits, etc.)
Other assets – This can include intangible assets (patents, goodwill, trademarks, etc), investments in other businesses, loans to other organizations, country club memberships, etc. Other assets are usually ignored by even most accountants.
In Part II, we’ll review liabilities and some of the issues and pitfalls that can await.