| Purpose of a Balance Sheet | | | | rule of thumb that works 90% of the time without |
| The balance sheet boldly declares where a business | | | | you having to leave this article, and that is exactly |
| stands at a given moment in time. From the balance | | | | what you will get. The key here is conservatism, we |
| sheet, a financially sophisticated reader can learn an | | | | are much more worried about overvaluing an asset |
| immense amount of valuable information about a | | | | then we are at undervaluing. Therefore, the rule of |
| business and its viability. That is why potential | | | | thumb is that assets are valued at the lessor of cost |
| investors and lenders will almost always ask you for | | | | (what you paid for it) or fair market value (what you |
| a copy of your financial statements, including the | | | | could get if you sold it right now). Now, there are |
| balance sheet, income statement, statement of | | | | additional considerations, like depreciation for buildings, |
| retained earnings, and statement of cash flows. This | | | | machinery, and equipment, and the value of |
| is also why you, as a savvy entrepreneur, need to | | | | receivables and other moneys owed to you, but that |
| understand the information presented on them. | | | | is the general rule. |
| Why It Is Important | | | | How Liabilities Are Valued |
| The principal reason your business's balance sheet is | | | | The next step is to make a list of items that your |
| so important to you and to any potential investors or | | | | business owes or obligations that it has. This could be |
| lenders is that it is like a photograph of your business. | | | | money that you owe to your suppliers for products |
| It tells how the business is put together, what its | | | | and services or money that you owe to your |
| principal resources are and where any potential | | | | employees for services performed or money that |
| dangers lie. Like any portrait it is incomplete, in that it | | | | you owe to the government for taxes or or money |
| only shows one fleeting moment in time, and | | | | that you owe to the bank or another lender. It could |
| therefore is most useful in conjunction with the | | | | even be money that the business owes to you, as |
| income statement and by comparing several balance | | | | an owner. |
| sheets over a period of time. Ahh, this is where the | | | | Remember what I said before about conservatism? |
| real story begins to unfold! The clever entrepreneur | | | | Well, this counts for liabilities as well, only in this case |
| becomes the Sherlock Holmes of the balance sheet | | | | the concern is that liabilities are undervalued or, even |
| and astutely looks for trends over time and checks | | | | worse, unrecognized and unrecorded. The general rule |
| ratios and balances to see which direction the | | | | of liabilities is that they are included at amortized cost |
| company is headed in and to look for any potential | | | | which should be equal to the amount owed on them |
| to cut costs or perform more efficiently. | | | | at that moment in time. This usually presents less of |
| Why Small Businesses Are Different | | | | a challenge than the valuation of assets because |
| If you are a small business owner or entrepreneur | | | | most long term assets, like loans, have explicit terms |
| then you need to be able to read and understand | | | | that spell out exactly how much you owe on them |
| your balance sheet because, first, it is through your | | | | at any given moment in time. |
| financial statements and other numerical data that | | | | How Equity Is Valued |
| you collect that you really get to know your | | | | Depending upon the type on entity (Corporation, |
| business. Michael Gerber, the best selling author of | | | | S-Corp, LLC. etc.) that you use the equity portion of |
| the E-Myth Revisited, says it much better than I | | | | the balance sheet can use different terms, but really |
| ever could as "because without the numbers you | | | | there are two kinds of equity: capital that you put |
| can't possibly know where you are, let alone where | | | | into the company (stock, contributed capital, etc.) |
| you're going. With the numbers, your business will | | | | and the earnings of the company (retained earnings). |
| take on a totally new meaning. It will come alive with | | | | The capital that you contribute is usually pretty |
| possibility." The very first step you will ever take | | | | straightforward. If you contributed something other |
| down that road to really knowing your business is | | | | than cash, such as real estate, machinery, or your |
| through examining and understanding your own | | | | interest in another business then use the rules for |
| balance sheet. | | | | the valuation of assets, the lessor of cost or fair |
| Second, your balance sheet is how anyone that you | | | | market value. |
| will ever want to do business with will understand | | | | Retained earnings is a whole different ball game. |
| your business. Think about getting a loan, the first | | | | Remember what I said back in the beginning about |
| thing your banker wants to see are your financial | | | | the formula for the balance sheet? That Assets = |
| statements and the first page of your financial | | | | Liabilites + Equity? Well, if you've filled everything else |
| statements is your balance sheet. Why is it first? | | | | out you only have retained earnings left, and, using a |
| Perhaps because it is the most important. Now think | | | | little bit of algebra and adding some detail to the |
| about your situation; you're applying for a loan or a | | | | preceding formula, retained earnings absolutely must |
| grant or you want to do business with the federal | | | | equal Assets - Liabilities - Contributed Capital. |
| government or an investor is thinking about either | | | | Now, it's fine to do the math and plug the number to |
| coming on board or buying you out and you present | | | | get started, but as you go forward your retained |
| your financial statements to them. They open them | | | | earnings will develop a new relationship, with the |
| up, turn to page one, and there is your company laid | | | | income statement (also commonly called the profit |
| bare, open to them. And they ask you questions; | | | | and loss statement). Basically, the relationship is net |
| "why is this line a negative number, how did you | | | | income + any contributions to capital - any |
| arrive at the valuation of that line, what are the | | | | distributions of capital (dividends) = the change in |
| terms of this liability." Don't you want to be able to | | | | retained earnings for the period. So retained earnings |
| confidently look them in the eye and answer those | | | | becomes the bridge between the balance sheet over |
| questions? | | | | two consecutive time periods (usually a year). For |
| What Makes Up a Balance Sheet | | | | more information on calculating retained earnings see |
| Hopefully, you have been exposed to some basic | | | | the link to my blog below. |
| accounting and understand the concepts that some | | | | What the CPA or Auditor Does |
| numbers in accounting are recorded as debits and | | | | You've done a fantastic job getting your balance |
| some numbers as credits. These numbers are often | | | | sheet set up and keeping it going, but at some point |
| represented as positive and negative numbers and | | | | you're going to show it to someone, a banker, a |
| the balance sheet, as its name suggests, must | | | | supplier, a potential business partner, and they are |
| balance, i.e. the negative and the positive numbers | | | | going to take one look at the work that you have |
| must total zero. In addition, the basic formula for | | | | so proudly and lovingly put your heart into and they |
| accounting is Assets = Liabilities + Equity, and any US | | | | will say, "what the Hell is this crap?" Don't take it |
| balance sheet will be organized into exactly three | | | | personally (you need their money, after all) just |
| sections with at least two subtotals, for assets and | | | | understand that there are standard ways to present |
| for liabilities and equity. Using the basic algebra that | | | | present financial statements and set rules to follow. |
| we learned in Ms. Arithmatic's 6th grade class, we can | | | | In order to make your statements comply with |
| shrewdly deduce that the two subtotals must be | | | | these rules and to give them an air of authority you |
| exactly equal. So far no problem, because if your | | | | will have to hire a Certified Public Accountant, or |
| balance sheet doesn't balance then you have much | | | | C.P.A., and have them compile, review, or audit your |
| bigger problems then simply worrying about | | | | financial statements. What this means is that the |
| understanding your financial records. | | | | C.P.A. takes your statements and then makes some |
| How Assets Are Valued | | | | cosmetic changes in order to present them in the |
| Great! you're thinking, let's start with the assets! Well, | | | | form proscribed by US Generally Accepted |
| I love an enthusiastic learner and so I will oblige. To | | | | Accounting Principles or, if appropriate, one of a |
| put it very briefly, assets are the total of everything | | | | number of alternate forms, and then issues an |
| your business has that has some sort of value to the | | | | opinion on them. The opinion will vary depending upon |
| business. This could be cash or real estate or stocks | | | | the type of engagement you hired them to do. The |
| and bonds or machinery and equipment or accounts | | | | standard opinion for a compilation is "we took this pile |
| receivable or other moneys due to you. It could also | | | | of crap and made it pretty, but we're not saying that |
| include inventory, which is product that you have | | | | it makes any sense" while the standard opinion for an |
| produced but not yet sold. So to summarize assets | | | | audit is "sure, we took a look and everything seems |
| are usually either cash, something that you have | | | | OK, but please don't sue us if we're wrong!" while a |
| bought, something that you have made and that you | | | | review falls between the two. |
| expect to sell, or something that is owed to you. | | | | Shenanigans |
| Clearly then, if you want to make your balance sheet | | | | If you've watched the news at all over the past five |
| you must have a list of your assets and how much | | | | years then you are aware that not all balance sheets |
| each is worth. The rub lies in the worth, or valuation | | | | are what they are painted to be. Enron and |
| of the assets. "Hmm, you think, I bought this asset | | | | WorldCom are the biggest examples of out-and-out |
| ten years ago at 10 grand, I added 5 grand in | | | | fraud, but more recently the big Wall Street firms, |
| improvements to it, it would cost me 20 grand to | | | | like Lehman Brothers, have come under fire for |
| replace it and I could get about 18 grand on the open | | | | inadequate or questionable accounting practices. How |
| market for it, so what value should I put down for | | | | does this all happen? Well, let's go back and revisit |
| it?" Clever question, my dear reader! Well, as you | | | | the assets and liabilities sections of this article and |
| may have assumed, we accountants have put a | | | | rethink what I said about conservatism. If assets are |
| great deal of thought into these issues and we | | | | valued at higher than they should be, or liabilities |
| continue to think about and tweak the ways we | | | | lower, the difference must come through retained |
| value things to this very day. If you want the exact | | | | earnings in the form of income. So, most accounting |
| answer to just about every accounting question then | | | | frauds are a resulting of overstating assets, usually |
| it is there for you, for free but in techno-accountant | | | | inventory for industrial firms or investments for |
| babble, at asc.fasb.org. However, most of you don't | | | | banking and Wall Street firms, or by not including |
| want to do all that work, you want a quick and easy | | | | certain liabilities on the balance sheet. |