What is a balance sheet, and how do you create one?

In order to determine your company’s profits or losses, and to be able to calculate taxes at the end of the financial year, you need to keep your books. Book­keep­ing records all business trans­ac­tions for a company, and serves as the basis for the profit and loss account and the prepa­ra­tion of the balance sheet. Together with the income statement, the balance sheet is a main component of the annual report. But what exactly is a balance sheet, and how is it created?

The balance sheet is a statement of a company’s assets and li­a­bil­i­ties at a given point in time. It’s divided into two parts, with the assets on the left and the li­a­bil­i­ties on the right. The assets side provides in­for­ma­tion on what the company owns or its resources. The li­a­bil­i­ties side shows the company’s oblig­a­tions. It’s important that the total sum of assets always matches the total li­a­bil­i­ties.

The assets are organized according to their liquidity. The li­a­bil­i­ties are struc­tured according to their maturity, and cover the entire financing of the company.

While the US has no specific re­quire­ments about how you choose to keep your books, every business is required to create a balance sheet. The structure and size of the balance sheet can be flexibly based on the size of the company and the required com­plex­i­ty. Small busi­ness­es, for example, tend to have much simpler balance sheets than large cor­po­ra­tions. Even as an en­tre­pre­neur, though, a balance sheet and profit and loss report are required as part of the annual financial state­ments.

While all merchants are required to turn over these basic com­po­nents, there might be ad­di­tion­al reporting re­quire­ments that you need to pay attention to depending on the size of your business. Here, you can find a full breakdown of balance sheet re­quire­ments for the US.

The goal of a balance sheet is to provide in­for­ma­tion about the financial health of a company at a par­tic­u­lar point in time. It also documents the company’s com­pli­ance with ac­count­ing reg­u­la­tions. The profit and loss report, together with the balance sheet, makes up the annual report, and is carried out before the balance sheet is created.

There are few basic types of balance sheets which you can create to suit different purposes.

The most popular type, a clas­si­fied balance sheet divides in­for­ma­tion by sub­cat­e­gories. These cat­e­gories are then clas­si­fied to make it easy to find the in­for­ma­tion in question. There are no re­quire­ments about which cat­e­gories must be included, but main­tain­ing a con­sis­tent structure sim­pli­fies the process of comparing in­for­ma­tion over multiple periods.

An un­clas­si­fied balance sheet doesn’t employ the cat­e­gories and sub­cat­e­gories of the clas­si­fied version, and instead lists all items at once. Assets are generally ordered first, followed by li­a­bil­i­ties. There are no subtotals as would be included in a clas­si­fied balance sheet, but instead totals are listed for assets, li­a­bil­i­ties, and equities. This type of balance sheet is mostly suitable for small reports with few items to list, or for internal reporting purposes. Assets are listed according to their liquidity, with cash assets at the top and fixed assets at the bottom. Li­a­bil­i­ties are also presented in a similar manner, generally organized by due date.

A com­par­a­tive balance sheet is used to compare account balances at multiple points in time. This is par­tic­u­lar­ly useful for gaining an overview of the company’s general financial position, i.e. the tra­jec­to­ry of its net worth and debts. The subtotals for the various points in time are presented side by side. The SEC requires a com­par­a­tive balance sheet including at least two years for reports from publicly-held companies, though the GAAP does not.

Since balance sheets are composed to encompass an entire fiscal year, the term “interim” does not really apply to them. However, interim financial state­ments can be useful to present periods that cover less than one year. For example, publicly-held companies that are required to issue quarterly reports may make use of interim balance sheets. Since the balance sheet is only used to refer to a specific point in time, not a span of time, the interim balance sheet will differ slightly from the other reports included in an interim financial statement.

The structure of a balance sheet usually follows the clas­si­fied style (see above). The values for the in­di­vid­ual items are taken from data in the ac­count­ing records that were used to record all business trans­ac­tions for the fiscal year. For example, if the purchase of a machine was financed with a loan, then the value of the “property, plant, and equipment” (asset side) increases – and so does the value of the cor­re­spond­ing liability on the other side. De­pre­ci­a­tion for wear and tear, i.e. the de­te­ri­o­ra­tion of the machine, and the interest paid on the loan are recorded in the profit and loss report to adjust profit totals. The cal­cu­lat­ed profit or loss is shown under the balance sheet item “equity” on the li­a­bil­i­ties side of the balance sheet.

On the assets side, a dis­tinc­tion is made between current assets and non-current assets. The dif­fer­ence is based on how long they will be owned for. Here, fixed assets, or non-current assets, are long-term, such as machinery and vehicles. These valuables remain in the company for a longer time. Current assets, on the other hand, are “in cir­cu­la­tion”, i.e. finished products, goods, and items that the company needs for further pro­cess­ing (material), as well as re­ceiv­ables from customers (open invoices), cash, and bank assets.

Property, plant, and equipment includes long-term assets that are acquired for op­er­a­tional use in the company. Ac­qui­si­tion costs for these assets de­pre­ci­ate as they’re used, depending on the asset and annual wear and tear, on a pro rata basis, which reduces the profit. It’s then recorded in the balance sheet at the re­spec­tive carrying value.

Purchases, such as raw materials, are not de­pre­ci­at­ed. The costs for their ac­qui­si­tion are fully deducted from the profit, since they serve the purpose of making the current profit. The value of raw materials reported in the balance sheet comes from the company’s inventory at the balance sheet date, which is de­ter­mined by means of the annual stock count.

The li­a­bil­i­ties side shows the source of the capital. It records equity, pro­vi­sions, li­a­bil­i­ties, and, if ap­plic­a­ble, deferred income as well as deferred tax li­a­bil­i­ties. The li­a­bil­i­ties show where or to whom the company owes something and what the owner is entitled to.

On this side, maturity is important. Stock­hold­ers’ equity is regarded as long-term capital that remains in the company for a long time, with other long-term li­a­bil­i­ties such as mortgages and bank loans listed below. The situation is different for short-term li­a­bil­i­ties, such as supplier invoices – these are usually settled within thirty days and therefore are po­si­tioned before long-term li­a­bil­i­ties.

Pro­vi­sions are li­a­bil­i­ties whose value isn’t yet de­ter­mined: These include taxes, pension payments, and an­tic­i­pat­ed lit­i­ga­tion costs from pending pro­ceed­ings.

Accruals/pre­pay­ments result from payments that occurred at a different time than when the service was used. On the assets side, an example of this would be advance rent payments, say if the rent for January and February was paid in December of the previous year (pre­pay­ment). On the li­a­bil­i­ties side, examples would be services that were invoiced in advance but not rendered until the following financial year, such as advances (accrual).

Generally speaking, the creation of a balance sheet and income state­ments requires a certain amount of expert knowledge. Though you’re certainly not required to, it’s advisable to hire a tax con­sul­tant to prepare your annual financial state­ments – not least because you can avoid any costly cor­rec­tions at a later date, but also because both the tax au­thor­i­ties as well as banks ap­pre­ci­ate prepa­ra­tion by an in­de­pen­dent third party.

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