What is a Balance Sheet?

In lessons 1 and 2 we learned about a fictional business owner named Carl. Carl wants to set up a little shop outside his house that sells clocks. He’s named this shop Carl’s Clockworks. Carl needs capital to get his business going so he tried to obtain it through local creditors and investors. He soon learned that creditors and investors require financial statements (the balance sheet, the income statement, and the statement of cash flows) before they are willing to invest money. Carl had a “thrilling” conversation with his accountant friend Peter where he learned that there are rules that govern these financial statements. These rules are known as generally accepted accounting principles or simply GAAP. Carl learned more than he wanted to about the organizations in charge of accounting standards in the United States, but he’s a better man because of it.

In lesson 3 Carl will be re-introduced to the three main financial statements. Carl will then learn, in some depth, about how the balance sheet works using the accounting equation.

Summary of Major Financial Statements (From Carl’s Boring Conversation with Peter)

What is a Balance Sheet? – The balance sheet lists all of the resources or assets of a business. It also lists how these resources were provided to the company. Can you see how it would be useful for a bank or an investor to know what type of resources a company has? Would you be more willing to lend money to someone who has a lot of resources (cash, land, buildings, etc.) or to someone who has no resources? This isn’t the only criteria, but it’s an important one for creditors and investors.

Income Statement – The income statement shows how profitable a company is. It shows all the sales and expenses of a company. It is designed to reflect whether or not a company is making money.

Statement of Cash Flows – You’ve probably heard the statement, “Cash is King!” Well it turns out that creditors and investors want to know where a business’s cash is coming from and where it is going. The statement of cash flows shows where a business’s cash is going and where it is coming from.

Carl is ready to get cooking on his balance sheet and he decides to call up Peter (his accounting friend). Peter wants to meet in person, but Carl, afraid of being distracted by Peter’s abnormally large chin, persuades Peter to hold this conversation over the phone.

The Balance Sheet

Assets   =    Liabilities  +    Owners Equity

Carl	“I hate to say it Peter, but you’ve lost me with that equation. The words sound somewhat familiar but I’m honestly not sure what they mean.”
Peter	“Ha Ha Ha. I bet you wish you had an accounting degree now old friend. Don’t you worry, old Peter will help you.”  “We’ll now go through and define the individual parts of this equation and then we’ll give an example of a balance sheet using your business, Carl’s Clockworks.” Assets “The word asset can be intimidating, but the truth is you probably already have a good, intuitive feel for what the word means. An asset is simply a resource or something that you can use to your advantage. Common examples of assets include cash, buildings, land, inventory, equipment, and office supplies. You can find out more by reading this definition of assets.” “Carl, your little clock shop has a few assets. You have your clocks (inventory), the table you place your clocks on (office supplies), and hopefully you have a little cash.”
Carl	“I’ve never thought of those things as assets before, but I guess you are right Peter. My business does have some assets. I’m feeling fairly official right about now.”  “So I understand assets, what are liabilities?”
Peter	Liabilities  “If an asset is a probable future benefit, then a liability is a probable future obligation. I’m getting too technical with you here. You probably already have a good feel for what liabilities are. Have you ever owed somebody money? Then you had a liability towards that person. You can read here if you want to learn more about the definition of a liability. However, for now and for simplicity’s sake just think of it as owing money to someone. Some common business liabilities include accounts payable, wages payable, utilities payable, and notes payable.” “Carl, your business probably doesn’t have any liabilities yet, but you will soon.”
Carl	Okay, so basically a liability is like a loan. I have to eventually pay back the amount of money I’ve borrowed.  What’s this part of the equation about owners’ equity? I’ve never heard of that before.
Peter	Owners’ Equity  “While most people already have an idea what an asset is and what a liability is, they usually haven’t ever heard of owners’ equity before. This is a difficult topic to understand for those new to accounting. Perhaps the easiest way to understand it is to look at how businesses obtain their assets.” “Remember our equation above: The amount of assets a business has (Assets) is equal (=) to the amount of money borrowed from creditors (Liabilities) and the amount of money given from owners or investors (Owners’ Equity).” “In other words owners’ equity is simply the amount of capital obtained from the owners or investors.”
Carl	“Thanks for the chat Peter. I’m going to go implement what I’ve learned.”  Carl hangs up before Peter can start on one of his extremely long lectures.

In the next lesson Carl will look at how to prepare a balance sheet.

Next Lesson: Lesson 3.1 – Understanding the Balance Sheet