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.