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Balance Sheet Explained

What has to balance and why should you care?
By the time you complete this installment you will know what has to balance. You will also know that the Balance Sheet can be a great place to find potential fraud ! or at least be a starting point for valuing a business. So lets get this explained.

The first thing taught in any accounting course is:

Assets = Liabilities + Owners Equity

First let's define the terms in plain English:

Assets are what you own. For example cash, equipment, inventory, deposits. Assets can also be what people owe you, a.k.a. receivables or accounts receivable.

Need help getting the balance sheet explained ? 

Liabilities are what you owe. Examples would be bills form vendors,
credit cards, credit lines or mortgages from a bank.

Owners Equity then is defined by what you own less what you owe. So to The better way to understand the formula above is to reverse it as follows:
Owners Equity = Assets – Liabilities
or Owners Equity = What you got – what you owe

How could we calculate Owners Equity other than backing into the number as we have presented until now? By totaling two things, cash or assets contributed to the to the business and earnings through the operations of the business. If the equity comes from a contribution of the owner it is called Capital if it is through the earnings of the business it is called Retained Earnings.

What is so important about the balance sheet?
The primary purpose is to tell you what the business worth. That is why another name for owners equity is net worth. Is it possible to prepare the balance sheet correctly yet not have the correct worth of the business. This would result from the fact that some assets have a value that exceeds their original cost. Proper accounting treatment will not adjust assets for their fair market value if it is higher than the original cost.

Three large accounting frauds recently were exposed by looking at the balance sheet. If you are interested on how these happened they will be explained at the end. If your time or attention is limited the explanations of these shenanigans are not necessary to understand Financial Statements.

The balance sheet alone only shows a portion of the finances of a business. In fact if an accountant issues financial statements with only a balance sheet then the fact that the standard information is missing must be disclosed in the accountants opinion letter.

In addition to understanding the Financial Statements there are several ration analysis that can be done to help asses the value of your business. As a part of my accounting practice I can produce reports that are written in easy to understand english with clear valuations of the business relative to other companies in the same industry. After evaluating a business for it's strengths and weaknesses a plan can be formulated for improving profitability.

Extra Credit – Fraud and the balance sheet

Enron, Worldcomm & Parmalat

Enron was probably the most involved of all the accounting shenanigans. Enron had investments on its balance sheet in other companies that were controlled by Enron. Although these companies lost the money they invested their accounting was done separately from Enron. The investments were valued as if no money was lost. However things started to unravel when the investments were found to have no more value. We see from this what as with the other large accounting frauds that by properly getting the value of the balance sheet the fraud comes to light.

Worldcomm took items that were normal ongoing expenses of the business and called them Assets. An example of this was maintenance of wiring infrastructure. After you call a plumber to fix your clogged pipe do you have a new Asset? or is just an expense. Worldcomm tried to call a repair bill a whole new sink. This let them hide the underlying losses they were sustaining.

Parmalat
The most unsophisticated of all these frauds was Parmalat. They created a cash account that was verified via fax from their own internal employees. Eventually when a bond payment was due it became obvious that the cash really was not there.

I can be reached via email at cpa@post.com to answer any specific questions you have about financial statements.

Sincerely,

Neil D Rischall CPA