After preparing the income statement of an organization, the Balance Sheet is prepared. You have already learnt how to enter figures in a balnce sheet on a step by step basis when studying the accounting equation. The balance sheet is an integral part of the financial statements of a company and will comprise all those account balances that have not been transferred to the trading and profit and loss account i.e. the ones that continue to have balances (Assets, Liabilities, and Capital). A Balance Sheet is prepared to ascertain the financial health of a company at a given point in time. It presents a snap shot of how things were at a given point in time. Although the Balance Sheet gives a snapshot of the condition of the business at a point in time, it should be remembered that this picture could change in the blink of an eye. The Balance Sheet gives an idea of what belongs to the business, what it owes, and what is owed to the business. A Balance Sheet analysed together with a profit and loss/income statement gives an even greater understanding of the business. Preparing a balace sheet is a requirement for public and private companies. Although self employed people and partnerships may not be required to prepare a balance sheet, preparing a balance sheet will still be useful if the business owners wants to raise finance using a bank loan since most banks will want to take a look at the financial statements for the past three years. A Balance sheet will also come handy when if the business owner bids for a contract since the client will want to see it. If nothing else, it gives the business owner the power to keep an eye on the business performance and analyse how things have changed year on year and where things have gone wrong. Continuing with the example of Bourne Brothers, let’s take a look at their trial balance after the trading and profit and loss account has been drawn up.
We will now attempt to draw the Balance Sheet of Bourne Brothers. From your earlier knowledge the following Balance Sheet can be drawn up:
The style of Balance Sheet you have been using so far is known as the “horizontal style”. The style that is being increasingly used by organizations nowadays is known as the “Vertical style”. We will now draw the Balance Sheet of Bourne Brothers using the vertical style. The Balance Sheet will look like this:
Unlike what you learned in earlier study, a Balance Sheet is not re-drawn after each transaction. It is instead prepared at the end of the period with the balances in asset, liabilities, and capital account. In drawing up abalance sheet, we do not actually transfer the balances to the balance sheet. All we do is list the asset, capital and liabilities balance to draw a balance sheet. Therefore unlike the case of preparing a trading and profit and loss account (income statement), the asset, liabilities, and capital accounts are not closed off.
Organizing the Balance Sheet in a meaningful way
How would you feel if you opened your cupboard and things came tumbling down? It would cost you a lot of time to sift through the pile all day to find what you are looking for. Similarly, the user of a balance sheet would have to waste a lot of precious time to find the required information if it was unorganized. They would never find what they set out to find.
Let’s look at how the balance sheet could be presented in a more meaningful way:
Non-Current Assets
These are assets that are not bought to be sold in the normal course of the business and are expected to be of use to the business for a long time. Examples include office premises, production machinery, and furniture. Non-Current assets are listed in descending order, starting with those the business expects to keep the longest. For instance Office premises will be expected to be in use longer than production machinery.
Current Assets
These include items held for resale at a profit, amounts owed by debtors, cash in the bank, and cash in hand. These are listed in increasing order of liquidity, starting with the asset furthest away from being turned into cash, finishing with cash itself. For instance stock will usually take longer to turn into cash than debtors since a sale will first create a debtor and then cash (when the debtor eventually pays). Some people argue that debtors should appear before stock since it is easier to convert stock into cash, for example in a cash sales, the fact is debtors could be turned into cash more readily by factoring. Factoring is the selling of right to receive the amount owed (usually a finance company). The factoring company charges a commission and attains the right to receive the amount owed from the debtor at a later time (the time that had originally been agreed). Nevertheless, it should be kept in mind that it is more logical to place stock before debtors since this is the sequence in which the realisation of current assets takes place.
Liabilities
There are two types of liabilities: Current Liabilities and Long Term Liabilities. Current liabilities are liabilities that fall due within a year, for instance amounts due to creditors for purchase of stock, Bank overdraft, and other short term instruments payable. Long term liabilities are liabilities that have to be paid more than a year after the balance sheet date, for instance money that was borrowed to finance the business.
Illustration
Lets look at the balance sheet of Bourne Brothers after it has been properly arranged:
Note: It is always a better idea to show in the balance sheet the changes in the capital account since the owners will be interested in knowing why their capital has changed. In case there are long term liabilities, it is common practice to add them to the capital.
The balance sheet showing these changes in the capital account will look like this:
