For the last month or so, it’s been annual audit season at work. Preparing for the audit, sending materials to the auditors, actually going through the audit and so on. Now that the audit part of the audit is finally pretty much done, I’m turning to the next stage: writing up the financial statements. I’ll be obsessed with those for the next week or so, which makes this the perfect opportunity to explain them to you. That way, when your accountant hands you your financial statements to sign off on, you will know what you are signing.
So….let’s start with the…
Balance Sheet (Statements of Financial Position)
Many years ago, back when I was a freshman at the University of Delaware, enrolled in my first accounting course, probably on one of the first days, we learned the “basic accounting equation”:
Assets = Liabilities + Owners Equity
Or, for short:
Or, in plain, non-accountants English:
- What valuable stuff the Company has
- Who owns that valuable stuff
Let’s break this down
An asset is something that a company owns, which has monetary value and which is expected to help bring in future income. Assets take various forms such as:
- Physical items (e.g. cash, computers, inventory)
- Rights to something (e.g. an account receivable means you have the right to money from a third party and a prepaid expense means you paid upfront for a service and have the right to receive it)
- Intangible assets (e.g. trademarks or copyrights)
You will note that the balance sheet doesn’t include EVERYTHING of value. For example, perhaps you put a lot of time and trouble into training your employees and fostering a supportive and cooperative work environment. As a result, now you have a great team that sells like blazes and produces fantastic products and services. Now your team is clearly something of value that is going to generate revenue…but you cannot record them as an asset in your balance sheet.
What does and does not get recorded and the valuation of assets are entire subjects unto themselves and can be a bit complicated. Suffice it to say that your accountant will have spent some time reviewing your assets to see if they are still worth at least as much as they appear in the books. Sometimes, this means that an asset will be “written down” (reduced), if the value of the item has dropped for some reason.
Liabilities are your debts or obligations to third parties, such as employees, suppliers, banks or even your customers. Examples of liabilities are:
- Accounts payable to suppliers
- Employee-related liabilities (e.g. salary, tax withholdings, amounts to be submitted to pension funds and so on)
- Obligations (e.g. deferred revenues or how much you expect to pay on customer warranties and the like)
Here as well, your accountant will spend some time making sure that the list of liabilities is complete and values of your various liabilities are correct. In some instances, the amount recorded will be an estimate based on accounting rules, the company’s past experience or other factors. For example, suppose you sell computers and your policy is to provide customers with free repairs for a year after their purchase. That means you have warranty obligations. Your accountant will estimate this based on how much this has cost you in the past.
Owner’s Equity (or Shareholders’ Equity)
If you own the company yourself, it’s Owner’s Equity. If the company is owned by shareholders, it’s Shareholders’ Equity. While this section will often include hairy-looking terms (e.g. preferred shares, additional paid-in capital, retained earnings), overall, owner’s equity is what is left over when you take all the assets and deduct the liabilities. It is the owner’s share of the assets of the company. Note that if the liabilities are greater than the assets, it can be negative. ☹
Back to A=L+OE
Now, let’s see how this works. To go back to the original equation, let’s say you were able to take all of the assets, and sell them for cash. The “L+OE” part of the equation tells you how to divide the cash. So, if your assets netted you $25,000 and you have liabilities of $20,000, you would take $20,000 of the pile, pay everyone off and voila! The remaining $5,000 belongs to you and/or your shareholders.
As a simple graph, it would look something like this:
Or as an even simpler graph….
If you are interested in learning more about assets, liabilities, equity and balance sheets, I found the explanations on Accounting Basics For Students and Accounting Coach to be particularly layman-friendly.