A Balance Sheet in Motion

By popular demand (both of you), I am going to do an elongated article on balance sheets, what they measure, and perhaps more importantly for my readers, how they change. This article will be pretty basic, and isn't likely to solve your specific reporting needs, but hopefully will give you a better understanding of how these crazy financial templates are supposed to work.

The first question I had when I heard the name "Balance Sheet" was, "well, what does it balance?" The answer is that it is a demonstration the accounting equation is in balance, hence the name. This all-important accounting equation is highly important, and is written as:

Assets = Liabilities + Equity

Every transaction that a business does affects this equation. Let me go through a few examples. In each of these cases, the amount of the transaction is not important, and so will be represented by x.

Case 1: You spend money on land

Land is an asset. Cash is an asset. Therefore, the equation changes by

Assets - x + x = Liabilities + Equity

Case 2: You take out a loan to buy land

Land is an asset. A loan is a liability.

Assets + x = Liabilities + x + Equity

Case 3: You sell some stock for cash.

Cash is an asset. Stock is an equity.

Assets + x = Liabilities + Equity + x

You'll notice that in all of these cases, the balance equation doesn't change. The x's always cancel out. This is important, because it keeps the equation in balance. The equation should never be out of balance - it indicates an error. This is one of the fastest ways to show if someone knows what they're doing with a balance sheet - if it doesn't balance, it's clearly wrong.

So, you might ask, if the balance equation never changes, how do I show that my business is growing or (hopefully not) shrinking? The answer comes with Retained Earnings (RE). Retained Earnings is an equity account and is basically equal to Net Income - Dividends Paid. Say, for example, that you make some profits and receive them in cash. Your balance equation changes by

Assets + x = Liabilities + Equity + x

You'll notice that even though the entire equation grew by x, the equation is still in balance.

The balance sheet shows the composition of your company, and RE is the mechanism through which the whole company grows or shrinks. There are other accounts which can do this as well, but RE is by far the most common.

I thought it might be instructive to give a series of examples of how a balance sheet for a fictional company might change over time. Therefore, I've developed a Google Document with different tabs, each tab showing a different step in this company's development. At each step, I will only list non-zero accounts, and will provide a proof that the balance equation is working. As a commentary, I'll also post step-by-step comments here that you can read along.

Spreadsheet Link

The first step is boring. A new company is born! However, this company is nothing more than an idea.

All accounts are zero, and the equation is an exciting 0 = 0 + 0. At least it works.

Step 2: The company issues 1,000,000 shares of stock and gets L$1,000,000 cash.

Equities increase and cash increases. Note that I'm not messing with Par Value for this example.

Step 3: The company buys a small plot of land for L$100,000 and builds a store on it for L$50,000.

Plant, Property, and Equipment is the store, but they had to pay cash for it so this decreases.

Step 4: The company pays a designer L$30,000 cash for the right to sell their designs in the store.

Since the company now has some inventory to sell, the company needs to record the cost of this inventory. Notice that inventory is not equal to the potential revenue from this product, but rather the cost in obtaining it.

Step 5: The company meets another designer and wants to buy their design for L$20,000. However, the company decides to wait and pay this designer at some point later, instead of right now. The designer is OK with this and gives the company the designs.

Now the company has a liability, called "Accounts Payable" because they will at some point have to pay this new designer. However, they also got inventory to sell in exchange for taking on this liability. Notice that this is the first point in this exercise where the company has actually changed value from their original L$1,000,000. This is because they are leveraging themselves using debt, which will eventually need to be paid back with another asset (probably cash). When this happens, the liability will disappear, along with the corresponding amount of cash to go with it.

Step 6: The company spends L$100,000 advertising their wonderful new business.

Marketing is not an asset. It is temporary, and thus is recorded on the income statement. However, we lost cash, and so we still have to make the balance equation work. In order to do this, imagine an income statement with just one entry on it: marketing expense of L$100,000. This would carry down through to net income, where it would then go to Retained Earnings! That's what's happening here. Because I'm doing this step-by-step this may seem a little strange, but this is what happens every day in business. It's just that the reporting periods clump groups of transactions into time periods, which are easier to understand.

Step 7: The company's advertising pays off! They get L$200,000 worth of sales!

Now Retained Earnings will increase by the revenue they received. Cash will also increase to balance this out.

Step 8: The company decides to pay off that second designer, now they they've sold some of his designs. They send him L$20,000.

Now the liability will go away and cash will decrease.

Step 9: The company issues a dividend for L$50,000 to its shareholders.

Dividends come out of Retained Earnings. The formula for RE is actually

Old Retained Earnings + Net Income - Dividends = New Retained Earnings

Cash decreases, and so does RE.

Step 10: The company pays L$10,000 worth of tier payments on their land.

This costs cash, and tier payments are on the income statement, meaning they will come out of retained earnings. Therefore, cash and RE both decrease.

Notice how at every transaction, the balance equation is kept in balance. This is demonstrated on every step throughout this elongated example. If at any point the equation is out of balance, something funny is going on or a transaction hasn't been recorded properly, and so it's time to examine the process.

Now I know it's not practical to keep a running balance sheet for most SL businesses. However, I think that most CEOs should at least be aware of how the transactions they're doing affect the balance sheet.

I also know that there are a myriad of topics and situations I have not covered here. Some of these topics get rather involved and can have different meanings depending on what the management is intending. A great example of this is buying back stock. Although it's easy to see that cash decreases, what happens to balance it? Equities should decrease, but how? That's a tricky topic, one which I don't want to touch here.

And now, a word about my accounting partnership:

SLFR Group does not (in my mind) exist to force people who have the unfortunate circumstance of not understanding financial statements into paying for them. Rather, it is to aid in the preparation of these statements and to serve as a check for those who are unsure of their own abilities. I'm here to help, not harm.

iVentures (my partner in SLFR Group) and I are both familiar with the exchange reporting standards and would be happy to assist you in preparing your company's statements.

Options: Lesson 1

One of my favorite topics in finance is that of options. I've mentioned options in a few previous posts, and I would like to dedicate a few posts to the mechanics of options and option pricing. Coincidentally, this is also the same material that I'm studying for my next RL actuarial exam, exam MFE (Modeling: Financial Economics).

Options are power. There are no markets in Second Life that trade options. Some are afraid investors will use them without understanding them. Others are swamped fixing other bugs so that the thought of including derivatives is nearly impossible at present. Regardless, options exist in real life, and they're useful in real life. Whether they ever exist in SL, these lessons will teach you about what options are, how they operate, and how to price them (at least basically). I'll be using some mathematics for this, and the lessons will build on each other.

For our purposes, we will concentrate on options on an underlying stock. However, you should know that options also exist on futures, currencies, indexes, and even other options. Each of these brings a new caveat to the stage, but for my sanity I'm going to stick to cash and stocks.

There are two broad types of options. I'm going to go over them very slowly:

A call option gives the owner the right, but not the obligation, to buy an underlying stock at a specified strike price (K) by time T.

A put option gives the owner the right, but not the obligation, to sell an underlying stock at a specified strike price (K) by time T.

Read those two sentences again. And again. One more time.

Also know that I'm describing American options in the definitions above. If they were European options, they would have ended with "at time T" instead of "by time T." Some of the pricing models will only value European options, but I'll make sure to warn you ahead of time.

If the price of the underlying stock is denoted as S, then the payoff of the call option is

Call Payoff = Max{0,S-K}

This is because if the stock price (S) is below the strike price (K), then you simply choose not to exercise the option (why buy the stock at K when it's selling at S?). If S > K, though, you can buy at K and then sell at S, netting S-K for yourself. Similarly, the payoff for a put option is

Put Payoff = Max{0,K-S}

If the stock price (S) is below the strike price (K), then you can buy the stock at S and sell it at K, netting you K-S. If S > K, then you would prefer to sell at S, and so it is not advantageous to exercise your put option (and thus the value is zero).

Wikipedia has some nice graphs of a call payoff and put payoff, which I encourage you to look at.

That's it for lesson 1. Subsequent lessons will get into the pricing, and then the all-important parity equation and how that functions. More math coming, I promise!

Please, if you have questions, ASK! This material can be very confusing, even for advanced traders. I'm probably going to speed up, not slow down, in the next lesson, so get questions out of the way now. If you're too shy to post them here (even anonymously), then email me at guardian.market@gmail.com.

Distractions

Sorry I've been a little slow on posting this past week. I've been distracted by my RL work and the launching of an accounting firm partnership with iVentures Volitant. You can find that announcement here.

Let the Games Begin!

With the WSE's announcement that it is leaving the Linden Dollar behind and going to trade solely in World Internet Currency units (WICs), the competition has begun for companies to be from the WSE to other exchanges. Already two have jumped ship: MAI and HOT, and one has sworn allegiance: DDE. As for the other side of the coin, to my knowledge two of the exchanges, VSTEX and CapEx are offering incentives for companies to switch. VSTEX is offering 10% off their IPO/relising fees, and CapEx is offering 100% off of them, both for a limited time.

It's an interesting battle, really. DDE's decision to stay surprised me greatly, as I would have thought that a business being conducted in Linden dollars, established in Linden dollars, and (until now) paying dividends until Linden dollars would have wanted to stay away from changing currencies and paying loads of transaction fees in order to bring any kind of value to their shareholders. But Delicious tends to know what she's doing, so maybe she's got something up her sleeve that I don't know about.

The question in my mind is how many of the WSE's 42 companies will jump ship in the next month. I really can't understand any retail or land company wanting to stay on the WSE now. Scripters and investment firms could still survive in WICs, since the scripters can simply request payment in USD and the investment firms should be savvy enough in whatever currency. I had originally thought the flight would be more severe, but so far it seems like companies are proceeding as normal, much to my surprise.

As to WSE 4.0 itself, I can only conclude that Luke Connell is attempting to reach outside the walls of Second Life, probably for at least two reasons. The first is that if he leaves Second Life and keeps the companies with him, he's outside the reach of Linden Lab's mighty ban hammer. The second reason is that he allows himself to list firms from other worlds, perhaps the Entropia Universe or IMVU. If it works, it could be amazing.

However, also I've got to wonder about the profitability of HCL at this point. We know HCL has defaulted twice on its bonds, and has had no income for 50-some days and counting. HCL owns an island with low occupancy, but tier still comes due, as well as a hefy (and ad-free, I believe) web server. According to the HCL income statements, HCL had L$8.3 million in profit (neglecting the L$2.78 million they owe in bond interest currently*) ending January 1, which is about USD$31,300. I'm not saying they're going bankrupt right away, but between all the expenses (who pays for Connell's RL expenses, anyway?) I've got to wonder if this conversion to WICs isn't just all smoke and mirrors to mitigate some deposit liabilities.

With no one demanding Linden dollars, who is to say what's happening to those dollars? While there may be an initial "dump the WICs" session, I imagine the WIC will be fairly illiquid. Some hefty transaction fees could make sure people keep their "game tokens" as WICs and not as Lindens, allowing Connell free use of all the Lindens deposited into the WSE.

But enough of the theories, I have a more important question to the CEOs of the WSE: Which of you will stand by a twice-defaulted exchange moving away from your primary transaction currency? Which of you will remain next to the CEO who has played a major role in the collapse of not one, but two of Second Life's major banking institutions? And how will you justify it to your investors?



*If anyone can explain to me how you can manage to post an L$8.3 million profit and yet not have L$2.8 million to pay your bondholders with, I'd love to hear that reasoning. Please include the mathematics behind it.