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The Balance Sheet, Part 1
The Balance Sheet is a statement of the business financial situation. It is a statement of what the company owns and what the company owes right now. It is not an Income Statement or Profit and Loss Statement (P&L), which is a statement which shows income and expenses over a year.
The Balance Sheet is Assets (money or property owned by the company or owed to the company), Liabilities (what the company owes) and Equity (difference between assets and liabilities). Equity includes Retained Earnings, which is the total profits the company has made over the company’s lifetime, less money paid to the owner(s) in the in dividends or withdrawals.
Master Builder uses Accrual Accounting. This gives a correct picture of the company’s financial state. What this means is that income appears on the Income Statement when it is earned, not when it is received. Expenses are shown when they are incurred, not when they are paid. This provides financial statements that accurately reflect the company’s business
activity and stability.
What is the Balance Sheet?
The Balance Sheet is one of the most important financial documents that any accounting system can produce. While the Income Statement details net profit for a specific time period, usually a year, the Balance
Sheet is a sample of the company’s financial situation at a specific time.
When looking at the company’s financial statements, you’ll see the Income Statement has a title like “for 6 Months ending June 30, 2008”. The Balance Sheet for the same time period is probably titled “as of June 30, 2008”. So the Balance Sheet is based on a point in time: what the company owns and owes as of a specific date. The Income Statement shows a period of time: what the company earned and spent over a specific period of time.
The Balance Sheet has three sections: Assets, Liabilities, and Equity.
Assets are money or property owned by the company or owed to the company.
Examples include:
• Cash in the bank
• Money the company is owed (Accounts Receivables and Notes Receivables)
• Inventory
• Value of vehicles and equipment (less depreciation)
Liabilities are monies the company owes to others, both short- and long-term. The net difference between Assets and Liabilities may be called any of several names, including Owner’s Equity, Retained Earnings, Net Worth, or Capital.
Another way to look at Owner’s Equity is the total amount the company has earned during its life, less money paid to the owner(s) as dividends or draws.
Sometimes it’s hard to know when an item should appear on the Balance Sheet or the Income Statement. When the company incurs an expense, the company has a choice: the company can capitalize it or expense it. If the item will be completely used up in the current year, the company should declare it as an expense. The costs will appear on the Income
Statement. It will reduce the company’s profit for the current year.
If the item will provide value for more than one year, the company should capitalize it by indicating an asset account; these costs will appear on
the Balance Sheet and then be expensed over several Income Statements.
Another way to look at it is: if the company purchases a truck which should last three years, the company will capitalize the cost of the truck by indicating a fixed asset account. Then the company will depreciate the truck as a depreciation expense one year at a time.
Understanding this important distinction between capitalizing and expensing
costs will help the company verify the company financial data. There are two important reasons to conduct a Balance Sheet audit: 1) the effect of errors over time, and 2) the justification of the company net profit.
The Balance Sheet consists of permanent accounts. The accounts balances are carried forward year after year. Except for the Retained Earnings account, the ending balance at the end of the company fiscal year is the same as the beginning balance at the start of the next fiscal year.
On the other hand, the Income Statement, hand, shows profit and loss for a particular period of time; at the end of the fiscal year, each Income
Statement account balance is zeroed out and rolled into the company’s Retained Earnings account on the company Balance Sheet. Since Balance Sheet balances carry over from year to year, any errors also will continue year to year.
Errors on the Balance Sheet:
1) can affect the profit of a different year, and
2) will require attention sooner or later.
Also, every account on the company’s Balance Sheet can be verified to an outside document. It’s much easier to review each Balance Sheet account than to verify every item on the company’s Income Statement. The company’s net profit is the final number on both the Balance Sheet and the Income Statement. If the company can justify every number on the company’s Balance Sheet, then the company has proved that the net profit shown is correct.
Because Balance Sheet accounts continue each year and can be verified more easily, it’s important to review and justify each account balance for accuracy. Only with an accurate Balance Sheet can the company truly determine the company’s financial health.
Balance Sheet Elements
The following elements make up the Balance Sheet:Assets (owned by the company or owed to the company)
Cash:
The cash accounts will be listed first on the company’s Balance Sheet. This includes all checking accounts, such as the company operating account and the company payroll account. Also included in this section are savings accounts, money market accounts, short-term Certificates of Deposit, and petty cash.
Receivables:
Invoices that the company has billed to the company’s clients are totaled on the company’s Balance Sheet and listed as receivables. The company will
often be asked to produce an Aged Receivable report, which lists all invoices in a category based on the age of the due date:
Current
1-30 days
30-60 days
Older than 60 days
Many company owners do not know that when a bank or bonding company reviews the company’s receivables aging report, they will often ignore any receivables more than 60 days past due (they assume that these are uncollectible.)
Retention:
When clients hold back a portion of payment on an invoice, this is called retention. They will ultimately pay this amount, but are holding the payment until the satisfactory completion of the job. The retention may be shown in a separate account on the company’s Balance Sheet. Remember, retention is never aged; it is always considered part of the company’s current receivables until after the job is completed. When the job is finished, the retention should be released and then becomes due. If retention is not kept in a separate account, it should be shown in a separate column in the company’s receivable aging, as again it should never be considered past due.
Other Receivables:
Besides the company’s clients, other companies and individuals can owe the company money. This section includes loans made to employees, friends, vendors (or any other individual or company not a client).
Prepaid Accounts:
On an accrual accounting system, the company recognizes (or records in the company’s accounting program) expenses when they are incurred, not when paid. Therefore, accounts in this section represent monies the company have spent but not yet received value for. For example, does the company prepay a year’s worth of insurance? Or a month’s worth? Anytime the company pays money for an item and receives the benefit in a later month, it should be considered a prepaid expense. These accounts are included in the company’s current assets.
Underbillings:
As a contractor, the company must adjust the company’s financial statements to reflect the income earned on a job rather than the total amount billed on a job. By creating a Work in Progress (WIP) adjustment, the company will adjust the income statement to show the company’s true earnings. If the company has greater earnings than the company have billed to date on a job, the company can recognize this additional income with an offset to the Underbillings asset account. (NOTE: WIP adjustments will be discussed in greater detail in the next installment.)
Inventory:
Some contractors purchase materials in bulk that will be used on several jobs, not just one. When the company purchases these materials and keep them, the company will recognize the costs of these materials as inventory. The value of the materials will stay in the inventory account until the
materials are actually used on a job. Once used, the costs can then be deducted from inventory and charged on the company’s Income Statement as a job expense.
Fixed Assets:
Large equipment purchases will be listed on the company’s Balance Sheet as Fixed Assets. Examples include vehicles, job equipment, office equipment, and communication equipment. The company’s company can set a limit so that only items above a set price will be booked to the company’s fixed asset account (if the limit was between $2,000, any item less than purchased for less than $2,000 would not be included as a fixed asset, but would be expensed immediately). Be aware that fixed asset values appear on the company’s Balance Sheet at historical cost, or the price the company actually paid for the item, and therefore may not reflect the true market value of the item.
When the company purchases a fixed asset, the company will expect to receive value over a long period of time (definitely longer than one accounting period). To reflect this time range, the company will spread the cost of the asset over its useful life. To do this, the company expenses a portion of the fixed assets cost to the Income Statement in each accounting period the asset is used. This expense shows up on the Income Statement in an account called Depreciation Expense. At the same time, the company must reduce the asset’s value by the amount of the depreciation. However, the company will not directly reduce the asset’s value, but instead accumulate each year’s depreciation in a Balance Sheet account called Accumulated Depreciation. The net difference between the fixed asset and its accumulated depreciation is called the book value (the asset’s remaining value). Remember that this usually does not reflect the actual value of the equipment, but rather the remaining balance that will be expensed in the
future.
Liabilities (monies the company owes to others)
Accounts Payable:
Accounts Payable is the total amount of bills the company received from vendors and suppliers that have not yet been paid. As with Accounts Receivable, the company should create a supporting schedule that will show the aging of these accounts. Any payable carried for more than 60 days may be a problem, and the company might need to justify why it is still owed.
Accounts Payable invoices can also have retention. If a client holds back (retains) a percentage of the invoice balance, the company may hold back the same percentage from the company’s vendors. As with Accounts Receivable, the retention portion of any open bill is always considered
current until released.
Payroll Taxes Payable:
When the company has employees, the company does not have to pay the
full cost of the payroll when the company issues the net paychecks.
However, the company will need to pay the difference as well as the company’s employees’ additional costs soon after. While a payroll service can take all the money out of the company’s account at the time of the payroll checks, if the company prepares the company’s own payroll, there will be a timing difference between when these payments are made.
Workers Compensation Payable:
Similar to Payroll Taxes Payable, the company will most likely not pay the full cost of the company’s workers comp. when issuing paychecks. Different workers compensation policies call for different payment schedules. However, it’s best to include the cost of workers compensation with each
payroll, and hold the amount of this liability in the Workers Comp. Payable account until payment is actually made. This makes job costs more accurate.
Overbillings:
As stated previously, a contractor must adjust the financial statement to reflect the income earned on a job, instead of the total income billed on a job. By creating a WIP adjustment, the company will adjust the company’s Income Statement to show the company’s true earnings. If the company has billed more on a job than the company has earned, the company must recognize this as an Overbilling (also referred to as Billings in Excess). The offset to this will be a reduction of the company’s contract income on the company’s Income Statement. Some financial statements combine the Underbilling and Overbilling accounts into one. (These adjustments will be discussed in greater detail in the next installment.)
Notes Payable:
All payables that are not considered Accounts Payable or Revolving Credit also will appear on the Balance Sheet. If the length of the note is more than one year (such as a vehicle loan), the balances will appear in a section called
Long Term Liabilities.
Equity
The Equity section of the Balance Sheet is presented differently, depending on the type of company.
Corporations (or LLCs): If the company are a corporation, the company’s Equity consists of two sections: Stock and Retained Earnings. The Stock section shows the original money invested by the Owner(s) of the corporation. The balance in this account will usually not change from year to year. The Retained Earnings section shows the beginning balance of the Retained Earnings plus the current year’s net profit, less any dividends. The ending balance of Retained Earnings represents the cumulative balance of
the net profits over the life of the company less all dividends paid.
The Net Profit shown on the Balance Sheet is the same amount as the net profit shown on the Income Statement. This represents the net of income less expenses for the current year only.
Dividends represent payments made directly to the owners. Often small companies do not pay dividends; instead, they pay the owner(s) a bonus
through payroll prior to determining the net profit for the year.
Sole Proprietorships: Sole Proprietorships do not have a Stock account. The
Equity typically has only the Retained Earnings section, often referred to as Owners Equity. The Owners Equity account is similar to the Retained Earnings account for a corporation; this account represents the cumulative balance of the net profits over the life of the company less the draws taken by the owner.
The Draw account shows the amount of money the owner has taken during the current year. It also includes the owner’s personal expenses paid by the company. This is similar to the dividend account in the corporation, except that it has different tax consequences.
The Balance Sheet will also show the net profit, the net of income earned less expenses for the current year.
In the next installment, we’ll see how the Balance sheet is organized, look at ratios within the Balance Sheet, and a few special issues which may occur.
Please contact me if you would like to learn more about instituting a comprehensive training process. Thank you.
Andy King
T: 805-771-8400
service@missiondevelopment.com
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