Creating a Balance Sheet
In this lesson, you’re expected to learn:
– the procedure for creating a balance sheet
– the effect that transactions and adjustments have on a company’s balance sheet
– basic accounting principles and assumptions
A balance sheet is created by entering all the transactions the company has ever made up to that date and then making various adjustments:
• A transaction is anything that the company does which affects its financial position. This includes raising money from shareholders, buying materials, paying staff etc.
• Naturally, large companies make thousands of transactions each year, which is why they require accounting departments to oversee these transactions. The accounting principle, however, is exactly the same, regardless of the size of the company.
• Even after entering all the transactions in the balance sheet, various adjustments need to be made if it is to reflect the true financial position of the company.
• Keep in mind that a balance sheet is only a reflection at a particular moment – since transactions are ongoing, it is constantly changing.
Suppose Sarah runs Company X that made over a hundred transactions in its first year. Rather than go through every one of them, these transactions (and adjustments) can be summarized in the following way:
Pay £10,000 cash into Company X’s bank account as starting capital (share capital)
Before this transaction, the company had no assets and therefore no claims. The first thing Sarah did was to put £10,000 of her own money into the account so that the company could commence operations. In return, she received a certificate saying she owned 10,000 £1 shares in the company.
Since the company has no other assets or liabilities yet, the whole £10,000 must be owed to the shareholders. Sarah, as the only shareholder, would claim it all.
Buy £8,000 of stock (cash on delivery)
The first stock of product that Sarah bought had to be paid for at the time of purchase, as the supplier was uncertain about the company’s ability to pay.
Cash goes down by £8,000 but the company has acquired another asset, stock, which is worth £8,000.
This is known as double entry bookkeeping.
Sell £6,000 of stock for £12,000
Company X sold stock for £12,000 which had only cost the company £6,000. The £6,000 profit is not owed to anyone else so it must belong to shareholders.
Thus, the cash box goes up by £12,000 and the stock box goes down by £6,000 (value of the stock sold). Hence, the assets bar goes up by a net £6,000. We also create a new box on the claims bar called retained profit (£6,000).
Shareholders’ equity is therefore the £10,000 share capital Sarah put in plus the £6,000 retained profit from this transaction. Thus, Company X has made their shareholders richer.
Pay £1,000 interest on long-term loan
Recall that Sarah borrowed £10,000 from her parents – which they said they would not ask the company to repay for at least three years. They do, however, want some interest. Sarah agreed that the company would pay them 10% per year. Thus Company Xpaid £1,000 in interest at the end of the year.
This was paid in cash so the cash box goes down and the shareholders suffer as retained profit goes down by £1,000.
Adjust for £3,000 depreciation of fixed assets
When Sarah bought the car, we put it on the balance sheet at the price she paid for it. Since she has been using the car to visit customers during the year, its value will have declined, i.e. it has depreciated.
This means that the shareholders have become poorer because if all the assets were sold off, there would be less cash for them.
We therefore reduce the fixed assets box by this amount. Also, since shareholders have become poorer, we reduce the retained profit by £3,000.
The value of an asset on a balance sheet is known as the net book value, which is the cost of the asset less the total depreciation on the asset to date.
It indicates reduction in value of any fixed assets. Reduction in value of assets depends on the life of assets. Life of assets depends upon the usage of assets.
We can define depreciation as the amount by which the book value of a tangible fixed asset is deemed to have fallen during a particular accounting period. It therefore appears as an expense of that period.
There are many deciding factors that ascertain the life of assets.
• For example, in case of a building, the deciding factor is time.
• In case of leased assets, the deciding factor is the lease period.
• For plant and machinery, the deciding factor should be production as well as time.
There can be many factors, but the life of assets should be ascertained on some reasonable basis.
Assets = claims = liabilities + shareholders’ equity
According to this equation, this is simply the numbers version of our balance sheet chart. We list all the assets and total them up. Below that we list all the claims. This format is used by virtually all American companies.
Assets – Liabilities = Shareholders’ Equity
This equation is the basis of British and many European balance sheets. The advantage of using this format is that it clearly displays the net assets of the company and how those net assets were attained. You can also put the previous year’s balance sheet alongside the current year’s so they can be compared.
• The accruals basis
• The going concern assumption
According to this concept:
• Revenue is recognized when it is earned, not when cash is received.
• Expenses are recognized when they are incurred, not when cash is paid.
In practice, if a company were to stop trading and try to sell its assets, it may not get as much for some of them as their value on the balance sheet. For example, when a company stops trading, it can be very difficult to persuade debtors to pay. Fixed assets may not have the same value to anyone else as they do to the company.
Accounts are therefore drawn up on the basis that the company is a going concern, i.e. that it is not about to cease trading.