Using Balance Sheets in Accounting

The balance sheet is the second-most-important financial statement that an accounting system produces, after an income statement. A balance sheet reports on a business's assets, liabilities, and owner contributions of capital at a particular point in time.

  • The assets shown on a balance sheet are those items that are owned by the business, which have value and for which money was paid.

  • The liabilities shown on a balance sheet are those amounts that a business owes to other people, businesses, and government agencies.

  • The owner's contributions of capital are the amounts that owners, partners, or shareholders have paid into the business in the form of investment or have reinvested in the business by leaving profits inside the company.

As long as you understand what assets and liabilities are, a balance sheet is easy to understand and interpret. The following table shows a simple balance sheet. Pretend that this balance sheet shows the condition of a hot dog stand at the beginning of the day, before any hot dogs have been sold. The first portion of the balance sheet shows and totals the two assets of the hot dog stand business: the $1,000 cash in the cash register in a box under the counter and the $3,000 worth of hot dogs and buns that you've purchased to sell during the day.

A Simple Balance Sheet
Assets
Cash $1,000
Inventory 3,000
Total assets $4,000
Liabilities
Accounts payable $2,000
Loan payable 1,000
Owner's equity
S. Nelson, capital 1,000
Total liabilities and owner's equity $4,000

Balance sheets can use several other categories to report assets: accounts receivable (these are amounts that customers owe), investments, fixtures, equipment, and long-term investments. In the case of a small owner-operated business, not all these asset categories show up. But if you look at the balance sheet of a very large business — say, one of the 100 largest businesses in the United States — you'll see these other categories.

The liabilities section of the balance sheet shows the amounts that the firm owes to other people and businesses. For example, the balance sheet in this table shows $2,000 of accounts payable and a $1,000 loan payable. Presumably, the $2,000 of accounts payable is the money that you owe to the vendors who have supplied your hot dogs and buns. The $1,000 loan payable represents some loan you've taken out — perhaps from some well-meaning and naive relative.

The owner's equity section shows the amount that the owner, partners, or shareholders have contributed to the business in the form of original funds invested or profits reinvested. This balance sheet shows how owner's equity looks when the business is a sole proprietorship. In the case of a sole proprietor, only one line is reported in the owner's equity section of the balance sheet. This line combines all contributions made by the proprietor — both amounts originally invested and amounts reinvested.

A balance sheet needs to balance. This means that the total assets must equal the total liabilities and owner's equity. In this balance sheet, for example, total assets show as $4,000. Total liabilities and owner's equity also show as $4,000. This equality is no coincidence. If an accounting system works right and the accountants and bookkeepers entering information into this system do their jobs right, the balance sheet balances.

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