Accounting - Explaining The Balance Sheet

One of the fundamental financial statements of a business is called the balance sheet. In laymans terms, what are the different components of the balance sheet?

The nature of the balance sheet is that it is similar to a financial picture of the organization at a certain point of time (as opposed to an income statement which is over a period of time). For example, the balance sheet can be as of December 31, 2006, or whatever is the close of the fiscal year. Balance sheets can be determined monthly or at other intervals as well. Balance sheets contain permanent information, as opposed to temporary information on an income statement. For example, cash is a permanent account, that is, an ongoing part of the business. Revenues (sales) and expenses are temporary accounts, determined for specific fiscal years and then those accounts are closed out to the balance sheet.

The balance sheet equation is assets equal debts plus owners equity. An asset is some type of property you need in your business. Cash, real estate, equipment, vehicles, inventory and the like are required to run a business. There are claims on this property: who owns what and that comprises the debt and owners equity sections. Debt is how much the bank (and other creditors) owns of your assets and owners equity is how much you own. So the grand total of the property (assets) will equal the claims of the bank and the claims of the owner.

Now that weve defined the basic components of the balance sheet, lets look at each section in a little more detail, starting with assets. Weve given some tangible examples of what assets can be, but they can be intangible (not physical) as well. An example of an intangible asset is accounts receivable, that is, amounts your customers owe you but have not yet paid. That is an asset, because some day that cash will be realized. Another type of intangible is a prepaid expense. It may be required for you to take out a 3-year insurance policy, paid upfront. Youve already paid for this service but have not yet received the benefit of insurance coverage for the entire three-year period and in the meantime that is considered an asset.

Debts are also known as liabilities. In addition to owing money to banks, your business could own money to suppliers. This is called accounts payable. A more formalized statement of something owed is called notes payable. Money owed on a mortgage is called mortgage payable. Payables that are due within one year are called current payables; payables that are due longer than one year are called long-term payables.

Owners equity (or capital) can be explained in terms of your home mortgage. Your house is the asset and how much you owe the bank is the liability. What is left is the owners equity. This logic can be applied to your assets in total; subtract what is owed to the bank and the result is owners equity. There are different types of owners, depending on business types. A sole proprietorship is a single owner, as contrasted with a partnership where there is more than one owner. If a business is incorporated, this section is referred to as stockholders equity and common stock will be involved.

In summary weve looked at the balance sheet complete with the goods a business has (the assets). Claims by others on those goods are considered to be liabilities and the net result is owners equity. That is why the balance sheet balances. Assets equal liabilities plus owners equity.

Michael Russell

Your Independent guide to Accounting

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