Under the IAS 1 of IFRS(International Financial Reporting Standard), every business entity must comply with reporting and representation of financial data.
Five financial statements are the most crucial and mandatory for reporting. A balance Sheet is one of the most important financial statements among all financial statements.
The other four statements include the income statement, statement of change in equity, retained earnings, cash flow, and notes to financial statements. The significant accounting policies are part of the notes to financial statements.
A balance sheet is a snapshot of a company’s financial position. It summarizes the accounting information for a specific period.
A balance sheet tells:
- What does a company own?
- What are the outstanding obligations of a company?
- What is the capital structure of a company?
- Liquidity of The company?
- The net worth of a company
Creditors use a company’s balance sheet to analyze the company’s ability to pay back the debt. Investor assesses the profitability of a company for investment purposes.
Regulators and government authorities analyze a company’s statements for valuation and tax purposes.
With so many users of the balance sheet, a business owner must know how to prepare a balance sheet and understand every item on the balance sheet. In this article, we will walk through step by step process of preparing a balance sheet.
What Is Formula For Preparing Balance Sheets?
The preparation of a financial statement is based on the accounting equation.
The accounting equation suggests that a company’s assets equal the sum of its liabilities and shareholder’s equity. Thus, it is considered the foundation of the double-entry accounting system.
It is one of the fundamental accounting principles. The accounting equation is constructed to justify that every business transaction affects accounts’ debit and credit sides by an equal amount. As a result, the balance of assets and liabilities is maintained.
The accounting equation is often expressed as,
Assets = Liabilities + Shareholder’s Equity
Let’s comprehend the concept with the help of an example.
Suppose company ABC has purchased new machinery in cash amounting to $50,000. What will be the impact on the accounting equation?
Assets = Liabilities + Shareholder’s Equity
+50,000 (machinery asset) -50,000 (cash paid) = No change in liabilities or Shareholder’s Equity
The balance sheet balance will remain the same as the amount equal to the machine’s value has been paid.
If a company, ABC, pays its loan of $100,000 through cash, what will change the accounting equation?
Assets = Liabilities + Shareholder’s Equity
-100,000 (CASH PAID) = -100,000 (liabilities written off) + No change in shareholder’s equity.
Benefits Of Preparing a Balance Sheet
Why should a business prepare a balance sheet?
We have already discussed the balance sheet’s benefits for outside users. What are the balance sheet’s benefits to the company in preparing its financial statements?
Risk Assessment
A business operating in any industry is exposed to many risks. A balance sheet represents the financial data summary by classifying it under assets, liabilities, and shareholder’s equity.
By looking at the company’s balance sheet, management can assess different figures and data’s long-term and short-term effects.
The current ratio of a company tells about the short-term debt-paying ability of the company. If a business organization maintains its balance sheet, management can assess and mitigate the risks on time.
Liquidity
Again, you can assess the company’s liquidity using the balance sheet. Ideally, a company should have positive worth, which implies more assets than liabilities.
A company’s ability to pay its short-term obligations and long-term loans can be assessed using current, acid-test, acid-test, and net assets ratios.
A company can assess if the debt levels are unsustainable or any other financial problems to save the business from future crises.
Efficiency
How does a balance sheet measures the efficiency of financial matters and business?
When a balance sheet is read and the income statement, it can give useful insights into how efficiently the organization employs its current assets.
The asset turnover ratio measures efficiency and tells how much revenue is generated by using fixed and current assets.
Helpful In Financial Ratios
All the financial ratios are calculated by taking input from the company’s balance sheet. Management can calculate helpful ratios related to financial leverage, liquidity, productivity, profitability, and solvency by using the balance sheet and income statement data.
These financial ratios enable the management to take timely action to mitigate uncertain risks a business faces every moment.
Rate Of Return
Investors, as well as the management, can find the rates of returns for future planning. The use of information is different for both users. An investor is looking for ROI to find a profitable investment.
In contrast, management is looking for opportunities to invest more rigorously by leveraging a good return rate and equity.
If a company has a good rate of return on assets, it is easy to get qualified for a bank loan. Besides, if a financial statement is updated, a company can always take timely actions to improve the rate of return.
When Is the Balance Sheet Prepared?
A general misconception prevails that balance sheets are prepared at the end of a financial year. Is it true?
The balance sheet is prepared at the end of a financial year! But it doesn’t mean that a balance sheet has to be prepared only then.
The year-end balance sheet is used for a lot of external purposes. It is prepared for public disclosure, but many companies prepare quarterly financial statements too. Even monthly balance sheets are also prepared.
The frequency of preparation depends on the volume of business and financial reporting patterns of any business. However, one thing is clear that
Balance sheets are mostly prepared at the end of an accounting period. It can be a month-end, quarter-end, or year-end.
Preparing Balance Sheet Step By Step
Let’s dive into the step-by-step preparation of a company’s balance sheet!
Define The Reporting Date And Period Of the Balance Sheet
The balance sheet reports the summary of the company’s financial data. It is important to define the reporting period of a balance sheet according to the financial year followed by a company. The closing of a reporting period is quoted on the balance sheet generally.
If a company reports its data annually, the balance sheet will be prepared annually, and the reporting date will be 31st December.
For quarterly reporting, the reporting dates for each quarter will be:
- Q1: 31st March
- Q2: 30th June
- Q3: 30th September
- Q4: 31st December
For the monthly reporting, the last date of every month will be treated as the reporting date.
A header of an annual balance sheet will look like this:Company ABC, LLC Balance Sheet as of 31st December, 20xx
Find Out The Assets And Add The Balances
The next step is to identify the assets of the company. Assets are the items owned by the business. Assets are classified into:
Current assets: Current assets are the short-term assets of a company that can be liquidated within 12 months. The current asset includes cash, marketable securities, term certificates, stock held for sale, account receivables, and prepaid expenses.
Non-current assets: Non-current assets are long-term assets and are categorized into fixed assets and intangible assets.
Fixed assets are physical assets like buildings, machinery, land, equipment, property, etc. Intangible assets are non-physical assets like goodwill, patents, and copyrights.
Identify The Liabilities And Add The Balances
The next step is to approximate the liabilities. Liabilities are the obligations of a business that have to be paid. Most commonly, the following liabilities may occur in a company.
Current-liabilities
- The current part of the long-term loan
- Unearned revenue for services to be provided
- Account payable due to the creditors
- Other current liabilities
- Outstanding wages, salaries, and expenses
Non-Current Liabilities
- Non-current unearned revenues
- Long-term debt
- Deferred tax liability
- Pension fund
After liabilities, shareholder’s equity is calculated to compare the assets with liabilities. The shareholders’ equity generally includes issued capital, additional paid-up capital, and retained earnings.
Balancing The Totals
The final step is to balance both sides and find the total. One concern of most accountants arises:
Why is the balance sheet balance not equal?
There might be one of the following reasons for the balance of asset and liability being unequal.
- There might be some misplaced or incomplete data from some accounts
- Some transactions have been incorrectly entered
- Currency differences also cause unbalanced totals. If a company has business in different countries or deals with different currencies, the exchange rate fluctuations lead to complications. Incorrect recording of the exchange rate by a few points can create a huge difference in the balance sheet.
- One reason can be a change in inventory because it impacts the cash flow. Therefore, dealing with this reduction in cash balance can be tricky and might end up with unbalanced totals on the balance sheet.
Example of A Balance Sheet
Let’s take an example of a company ABC that prepares its financial statements at the end of the year. According to the adjusted trial balance of the company, the following were the figures.Description Debit(USD) Credit(USD) Cash In-hand 150,000 Cash at bank 175,000 Accounts receivables 15,000 Account Payable 19,000 Shareholder’s equity 1,000,000 Land & Building 400,000 Office Equipment 100,000 Goodwill 200,000 Deferred Tax liability 3,000 Unearned Revenue 6,000 Bank Loans 300,000 Machinery & Equipment 350,000 Patents & Copyrights 90,000 Interest Payable 9,000 Outstanding Wages 8,000 Prepaid Insurance 5,000 Retained earnings 190,000 Profit Transferred from P & L Account 50,000 Marketable Securities 100,000 1,585,000 1,585,000
The balance sheet will be as follows:
| Company ABC, LLC |
| Balance Sheet |
| as of 31st December, 20xx |
| ASSETS | Amount | LIABILITIES AND SHAREHOLDER’S EQUITY | |
| Current Assets | Current liabilities | ||
| Cash In Hand | 150,000 | Account Payable | 19,000 |
| Cash In Bank | 175,000 | Unearned Revenues | 6,000 |
| Marketable Securities | 100,000 | Outstanding Interest | 9,000 |
| Accounts receivable | 15,000 | Outstanding Expenses | 8,000 |
| Pre-paid Insurance | 5,000 | ||
| Total Current Assets | 445,000 | Total Current Liabilities | 42,000 |
| Fixed Assets | Long-Term Liabilities | ||
| Land & Building | 400,000 | Long-term loan | 300,000 |
| Office equipment | 100,000 | Deferred Tax Liability | 3,000 |
| Machinery & equipment | 350,000 | Total Long-Term Liabilities | 303,000 |
| Total Fixed Assets | 850,000 | ||
| Shareholder’s Equity | |||
| Intangible Assets | Paid-up capital | 1,000,000 | |
| Goodwill | 20,0000 | Retained Earnings 190,000 | |
| Patents | 90,000 | +Profit From P & L 50,000 | 240,000 |
| Total Intangible Assets | 290,000 | ||
| TOTAL ASSETS | 1,585,000 | TOTAL CAPITAL AND LIABILITIES | 1,585,000 |
Final Words
We have comprehended the balance sheet topic, the benefits of the balance sheet, and how to prepare a company’s balance sheet.
