Balance Sheet | Reviewing the Common Financial Statements

Balance Sheet

The second most important financial statement that an accounting system produces is a balance sheet. A balance sheet reports on a business's assets, liabilities, and owner contributions of capital at a particular point in time.

• The assets shown on a balance sheet are those items that are owned by the business, which have value and for which money was paid.

• The liabilities shown on a balance sheet are those amounts that a business owes to other people, businesses, and government agencies.

• The owner's contributions of capital are the amounts that owners, partners, or shareholders have paid into the business in the form of investment or have reinvested in the business by leaving profits inside the company.

As long as you understand what assets and liabilities are, a balance sheet is easy to understand and interpret. Table 1, for example, shows a simple balance sheet. Pretend that this balance sheet shows the condition of the hot dog stand at the beginning of the day, before any hot dogs have been sold. The first portion of the balance sheet shows and totals the two assets of the hot dog stand business: the $1,000 cash in the cash register in a box under the counter and the $3,000 worth of hot dogs and buns that you've purchased to sell during the day.

Table 1: A Simple Balance Sheet

Assets
Cash	$1,000
Inventory	3,000
Total assets	$4,000
Liabilities
Accounts payable	$2,000
Loan payable	1,000
Owner's equity
S. Nelson, capital	1,000
Total liabilities and owner's equity	$4,000

Tip

Balance sheets can use several other categories to report assets: accounts receivable (these are amounts that customers owe), investments, fixtures, equipment, and long-term investments. In the case of a small owner-operated business, not all these asset categories show up. But if you look at the balance sheet of a very large business — say, one of the 100 largest businesses in the United States — you see these other categories.

The liabilities section of the balance sheet shows the amounts that the firm owes to other people and businesses. For example, the balance sheet in Table 1 shows $2,000 of accounts payable and a $1,000 loan payable. Presumably, the $2,000 of accounts payable is the money that you owe to the vendors who have supplied your hot dogs and buns. The $1,000 loan payable represents some loan you've taken out — perhaps from some well-meaning and naive relative.

The owner's equity section shows the amount that the owner, the partners, or shareholders have contributed to the business in the form of original funds invested or profits reinvested. One important point about the balance sheet shown in Table 1: This balance sheet shows how owner's equity looks when the business is a sole proprietorship. In the case of a sole proprietor, only one line is reported in the owner's equity section of the balance sheet. This line combines all contributions made by the proprietor — both amounts originally invested and amounts reinvested.

I talk a bit more about owner's equity accounting later in this chapter because the owner's equity sections look different for partnerships and corporations. Before I get into that, however, let me make two important observations about the balance sheet shown in Table 1. A balance sheet needs to balance. This means that the total assets must equal the total liabilities and owner's equity. In the balance sheet shown in Table 1, for example, total assets show as $4,000. Total liabilities and owner's equity also show as $4,000. This equality is no coincidence. If an accounting system works right and the accountants and bookkeepers entering information into this system do their jobs right, the balance sheet balances.

A balance sheet provides a snapshot of a business's financial condition at a particular point in time. For example, I mention in the introductory remarks related to that the balance sheet in this table shows the financial condition of the hot dog stand business immediately before beginning the day's business activities.

Remember

You can prepare a balance sheet for any point in time. It's key that you understand that a balance sheet is prepared for a particular point in time.

By convention, businesses prepare balance sheets to show the financial condition at the end of the period of time for which an income statement is prepared. For example, a business typically prepares an income statement on an annual basis. In this orthodox situation, a firm also prepares a balance sheet at the very end of the year.

At this point, I return to something that I alluded to previously in the chapter — the fact that the owner's equity section of a balance sheet looks different for different types of businesses.

Table 2 shows how the owner's equity section of a balance sheet looks for a partnership. In Table 1-5, I show how the owner's equity section of the hot dog stand business appears if, instead of having a sole proprietor named S. Nelson running the hot dog stand, the business is actually owned and operated by three partners named Tom, Dick, and Harry. In this case, the partners' equity section shows the amounts originally invested and any amounts reinvested by the partners. As is the case with sole proprietorships, each partner's contributions and reinvested profits appear on a single line.

Table 2: Owner's Equity for a Partnership

Partners' equity
Tom, capital	$500
Dick, capital	250
Harry, capital	250
Total partner capital	$1,000

Go ahead and take a look at Table 3. It shows how the owner's equity section looks for a corporation.

Table 3: Owner's Equity for a Corporation

Shareholders' equity
Capital stock, 100 shares at $1 par	$100
Contributed capital in excess of par	400
Retained earnings	500
Total shareholder's equity	$1,000

This next part is a little bit weird. For a corporation, the amounts that show in the owner's equity or shareholder's equity section actually fall into two major categories: retained earnings and contributed capital. Retained earnings represent profits that the shareholders have left in the business. Contributed capital is the money originally contributed by the shareholders to the corporation.

The retained earnings thing makes sense, right? That's just the money — the profits — that investors have reinvested in the business.

The contributed capital thing is more complicated. Here's how it works: If you buy a share of stock in some new corporation — for, say, $5 — typically some portion of that price per share is for par value. Now don't ask me to justify par value. It really stems from business practices that were common a century or more ago. Just trust that typically, if you pay some amount — again, say $5 — for a share, some portion of the amount that you pay — maybe 10 cents a share or $1 a share — is for par value.

In the owner's equity section of a corporation's balance sheet, capital that's contributed by original investors is broken down into the amounts paid for this mysterious par value and the amounts paid in excess of this par value. For example, in Table 3, you can see that $100 of shareholder's equity or owner's equity represents amounts paid for par value. Another $400 of the amounts contributed by the original investors represents amounts paid in excess of par value. The total shareholder's equity, or total corporate owner's equity, equals the sum of the capital stock par value, the contributed capital and excess of par value, and any retained earnings. So in Table 3, the total shareholder's equity equals $1,000.