All balance sheets are normally classified: that is, different financial elements on a balance sheet are grouped into categories and presented under a common caption. This is a general practice that helps to compare balance sheets of different companies. You can see an example below. For instance, if there are two companies within different industries, they may have different items (components) going into the Current Assets category. However, due to thisclassification rule, it may sometimes not be as relevant to compare components of current assets. Instead, you may just compare the total current assets of the two companies, and that may be all you need in your analysis.
How to prepare a classified balance sheet
Illustration 1: Example of classifications on the balance sheet (horizontal)
|Current Assets||Current liabilities|
|Other Non-current Assets||Common Stock|
The example above shows a balance sheet in a horizontal format: Assets are on the left side, and Liabilities and Equity are on the right side. It is also possible to present a balance sheet in a single column format (vertically) as follows:
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Illustration 2: Example of classifications on the balance sheet (vertical)
|Other Non-current Assets|
It is a matter of preference, but normally balance sheets are presented vertically as shown in Illustration 2.
Important term to remember, as we discuss balance sheet classifications further, is a balance sheet date. A balance sheet date is the date as of which the balance sheet is prepared. For example, most businesses prepare their balance sheets at least once a year as of December 31. However, the balance sheet date is not the date when a balance sheet is actually prepared and becomes available.
As you may have noticed in Illustration 1, assets are on the left side, and liabilities and equity are on the right side. There is a reason why they are presented liked that. Total assets equal the sum of total liabilities and total equity. This is a fundamental accounting equation that results in this equality:
|Assets = Liabilities + Equity|
This equation must hold true in any balance sheet, and if it doesn’t, then it is due to an error somewhere in the balance sheet. You can use this rule in situations where your assets don’t equal your liabilities and equity.
The reason the equation must hold true is because assets are economic resources of a business used to accomplish its main goal, i.e. increase owners’ wealth. Liabilities and equity are the sources of such assets. In other words, liabilities and equity show where assets were obtained from. Liabilities are claims of third parties for resources provided to the business (e.g. creditors). Equity is claims of business owners for resources they invested in the business. Equity, therefore, is an indicator of how many assets the owners can claim in the business after all liabilities are settled. The difference between assets and liabilities (i.e. equity) is sometimes called net worth.
Any trial balance account (trial balances are a starting point in preparing a balance sheet – see further) has a balance. An account may have a debit or credit balance. The normal account balance also indicates whether the account is increased or decreased when it’s debited or credited. There are rules stating which account has a debit or credit balance. The illustration below shows accepted conventions about such balances:
Illustration 3: Normal balances, increases and decreases for balance sheet accounts
Balance Sheet Category
|Contra Asset Accounts|
|Contra Liability Accounts|
For example, an asset account called Cash increases when it’s debited and decreases when it’s credited. The Cash account normally has a debit balance.
Note that there are “contra” accounts. Such accounts are opposite to their related accounts and thus have a different normal balance. Contra accounts are presented as a reduction to their related accounts on the balance sheet. An example of such accounts is Accumulated Depreciation. This account has a credit balance and is related to the Fixed Assets account. On the balance sheet, Accumulated Depreciation (credit balance) is shown under Fixed Assets (debit balance) and reduces the balance of Fixed Assets creating Net Fixed Assets.
Going back to the accounting equation, note that assets normally have debit balances, and liabilities and equity have credit balances:
Let’s review each balance sheet classification in more detail
Current assets are cash and other assets that are expected to be converted to cash or sold or used up usually within one year or the company’s operating cycle, whichever is longer, through the normal operations of the business.
An operating cycle, for a manufacturing company, represents time it takes to invest cash by buying raw materials, produce a product, and receive cash back after selling the product. An operating cycle may be more or less than a year depending on the industry.
Current assets are usually listed in the order of liquidity starting with cash and cash equivalents.
Examples of current assets are cash and cash equivalents, marketable securities, accounts receivable, inventories, and prepaid expenses.
Cash and cash equivalents represent coins, currency, checks, money orders, money on deposit and short-term, highly liquid investments that are usually reported with cash on the balance sheet. Normally, highly liquid means that the investments can be converted to cash within 90 day and with a minimal loss in their value due to changes in interest rates.
Marketable securities are short-term (temporary) investments in securities and other interest-generating financial assets. Such investments are usually made to earn interest on excess cash which is currently not used in the business.
Accounts receivable are amounts due from customers on credit sales (i.e. sales when customers agree to pay you later).
Accounts receivable sometimes may have a related contra asset account called Allowance for Doubtful Accounts. Such an account represents the amounts that you believe may not be collectable (e.g. a customer is bankrupt). The net amount (Accounts Receivable – Allowance for Doubtful Accounts) is shown on the balance sheet.
Inventories are raw materials, work-in-process (i.e. started but unfinished products), finished goods (i.e. products ready for sale), and sometimes supplies (e.g. spare parts for your machinery and equipment).
Similar to accounts receivable, the Inventories Account may also have a related contra asset account called Excess and Obsolete Reserve (E&O Reserve). This account represents the cost of inventory that you do not anticipate to sell or use in your production any more due to technical obsolescence, etc. The net amount (Inventories – E&O Reserve) is presented on the balance sheet. Note that not all businesses will have an E&O reserve.
Prepaid assets are prepayments you’ve made that will benefit future periods.
For example, if you pay an insurance premium for your business, the coverage you obtain is for a year. Thus, the benefits you will be getting from this asset are extended over a year. Normally, prepaid assets shown in the current assets are the ones expected to be used (expected to expire) within a year after the balance sheet date. If a prepaid asset is expected to provide benefits for longer, then the portion of the prepaid asset related to benefits after one year is shown in the non-current assets (i.e. Other Non-current Assets) on the balance sheet.
All assets not included into current assets are non-current (long-term) assets. They are presented on the balance sheet after the current assets and may include the following classifications: fixed assets, intangible assets, investments, and other non-current assets. Let’s review each classification in greater detail.
Fixed assets may include land, buildings, machinery and equipment, vehicles, and leasehold improvements.
Fixed assets are expected to be utilized by the company (i.e. provide benefits) over a period longer than one year. Note that fixed assets are tangible assets (i.e. have physical substance). Fixed assets, as they provide benefits, use up some of their cost.
The process of allocating this decrease in fixed assets’ cost to multiple years is called depreciation.
A contra asset account called Accumulated Depreciation keeps information about how much of the fixed assets’ cost has been depreciated. The net amount (Fixed Assets – Accumulated Depreciation) is shown on the balance sheet.
Intangible assets may include patents, goodwill, technology, customer lists, value of non-compete agreements, among others.
Intangible assets are similar to fixed assets except that the major value of intangible assets comes with the rights they bring to the owner and not their physical substance. Similar to fixed assets, some intangible assets lose their value with time as they provide benefits (process is called amortization), and this process is reflected in the Accumulated Amortization account. Note, however, that some intangible assets (e.g. trademarks or goodwill) have indefinite lives, and thus, they are not amortized.
Investments are long-term investments in securities of other companies. Such securities may be debt securities (e.g. bonds, notes receivable) or equity securities (e.g. stock).
Other non-current assets may include other long-term assets not included into the investments, fixed, or intangible assets categories. Such other assets may be portions of prepaid expenses that will start expiring in more than a year after the balance sheet date, the cash surrender value of life insurance on officers, and others.
Current liabilities are obligations due to be paid or settled within one year or the company’s operating cycle, whichever is longer.
Usually current liabilities are settled by using current assets. Therefore, sometimes it is useful to compare current assets and current liabilities to understand if your business will be able to pay your current obligations using your current assets (the difference between the two is called working capital). Current liabilities may include accounts payable, accrued expenses, short-term loans, current portion of long-term debt, and income taxes payable. Let’s review current liabilities in greater detail.
Accounts payable are liabilities (obligations) created by buying goods or services on account. In other words, it is your company’s promise (and obligation) to pay for purchased goods or service later.
For example, if you purchased merchandise inventory today, and the credit terms state that you need to pay for the inventory next month, then you need to record this obligation as an account payable in your books.
Accrued expenses represent costs incurred but unpaid as of the period end.
Accrued expenses are required under the accrual basis of accounting, which is used for financial reporting purposes. An example of accrued expenses may be a cell phone bill with the billing period running from the 16th of the current month to the 15th of the following month. You will not receive the bill until the middle of the next month; however, you have used the cell phone for 15 days in the current month and, therefore, should recognize cell phone expense for 15 days of the current month by posting an accrued expense.
Short-term loans are notes payable expected to be settled within one year after the balance sheet date.
For example, if your company purchased equipment and issued a note payable to be settled in six months after the balance sheet date, then the amount of the note will be recorded under short-term loans.
Current portion of long-term debt represents the amount of long-term debt that will be paid within one year after the balance sheet date.
For example, some long-term debts (i.e. bank loans) are required to be paid in installments quarterly or semiannually, and then, a balloon payment is made at the maturity date for the remaining balance. The installment payments to be paid within one year after the balance sheet date represent short-term obligations and thus are recorded in the current liabilities under the caption “Current Portion of Long-term Debt” (may be shortened to Current Portion of LT Debt).
Income taxes payable are the amounts of income taxes that your company is obligated to pay to local, state, or federal authorities. These obligations are presented in the current liabilities section because it is usually expected that these balances will be paid within a year after the balance sheet date.
Non-current (long-term) liabilities are other liabilities that are not included into the current liabilities section. Therefore, non-current liabilities are obligations that are not expected to be due (paid) within one year after the balance sheet date. Examples of non-current liabilities are long-term lines of credit and term loans.
A line of credit is an agreement, under which a bank provides your business with loans of money (i.e. up to an approved limit) during a predefined period.
You can take out the amount you need (e.g. via check, ATM, etc.), repay it, and then borrow again. At a point in time you can only have an outstanding balance up to a certain limit. This kind of loans is sometimes called revolving loans. If an outstanding amount is to be repaid within more than a year after the balance sheet date, then the amount is shown under the non-current liabilities on the balance sheet date.
Term loans are loans that are to be paid on a certain date (i.e. maturity date). Again, if the payment date is not within one year after the balance sheet date, then the loan is presented under the non-current liabilities.
As mentioned above, when we talked about current liabilities, any portion of long-term debts (whether it’s a line of credit or term loan), which is to be paid within one year after the balance sheet date, must be presented under the current liabilities.
Equity is the owners’ claim on assets. Equity, as noted above, is also the difference between assets and liabilities. Equity may include multiple financial elements. The most common equity elements are capital (common stock), current year earnings, and retained earnings. Let’s review them in more detail.
Capital (common stock for corporations) represents the amounts contributed by owners to the business. Depending on the legal form of a business, capital can be named differently.
Current year earnings are the net income or loss of the business for the current year. This amount is the difference between all revenues and all expenses on the income statement. Current year earnings are presented on the balance sheet only until they are transferred to retained earnings.
Retained earnings are net income (loss) retained (accumulated) by your company.
For a company with relatively simple operations, retaining earnings are cumulative net incomes (losses) less dividends paid out since the company’s origination. Note that when dividends are paid out, they reduce retaining earnings. Also note that retained earnings may be a negative amount in situations when the company is not profitable (i.e. more losses than net incomes).
A balance sheet is a financial statement that has a certain commonly used format.
First of all, a balance sheet has a header. The header needs to include your company name, the title of the financial statement (i.e. balance sheet), and period(s) presented in the financial statement. Note that some balance sheets are presented for one year, while others are presented for two years in a comparable format (e.g. comparable balance sheets of public companies). An example of the header for a single-year balance sheet is presented below:
Your Company Name
Next, the balance sheet with related captions is presented. Major captions (Assets, Liabilities, Equity) are presented first. Then, the next level captions are shown. The next level captions are the categories (classifications) we reviewed earlier (current assets, investments, etc.). Under each caption, components of the caption are presented. An example of the current assets caption is presented below:
Note how the components of current assets are intended to the right so it’s easier to read the balance sheet.
Finally, let’s recall that assets can be shown on the left side while liabilities and equity are shown on the right side (horizontal presentation). Alternatively, assets can be shown first with liabilities and equity presented underneath the assets. If a balance sheet for a single period is shown, it seems to be more readable to show assets on the left and liabilities and equity on the right side. However, if comparable balance sheets (i.e. a balance sheet for two or more periods) are prepared, then it makes more sense to show liabilities and equity under assets