What is the balance sheet equation?

Balance sheet formula

Assets = Liabilities + Stockholdersu2019 Equity,Note Stockholdersu2019 Equity is commonly referred to as Owneru2019s Equity or just Equity too.

Balance sheet vs income statement

Research and development is a rather uncertain thing.

The research may not find the sought after solution and development may not yield a product that is appealing, feasible, etc.

So how to handle it on the books?,If it is capitalized, the balance sheet grows, but wages and materials have to be paid for today.

With all of the R&D on the balance sheet, there is no offset to any income, which results in taxes and the appearance that the firm is doing well, despite pouring money into R&D that is unproven.

,Reverse the situation by expensing R&D, the income statement wipes away all of that R&D expense and net income looks more reasonable.

Taxes are also lower as a result.

But the financial analysis is more in line with reality.

Balance sheet items

Iu2019ve been an accountant since 1989, and if I had to define off-balance sheet items to save my life, Iu2019d be in a heap of trouble.

There would be hope if I could give an example instead.

,Forget business financials for a minute.

Letu2019s talk about you, me, us.

,Have you ever created a personal balance sheet? If not, do it once even if itu2019s brutally tortuous.

Seriously, you should do this annually.

,Most of you by the age of 30 will or should have a high 5-digit 401k balance (or SEP balance if self-employed).

If you are wise with funds you may have surpassed six figures by the time you hit 30.

,So your deferred compensation plan is an asset.

But Iu2019m betting youu2019ll leave off a major liability.

Do you know what it is? Need some more time?,Calculating the number with a high degree of certainty is difficult, especially 30 years out.

The liability you are missing is an off-balance sheet liability called Projected Income Tax Liability on Deferred Compensation (I made up that name, you call the liability whatever you want).

,Think again if you believe taxes will be lower in your 70s than in your 30s.

Thatu2019s because youu2019ll be missing out on deductions later in life that you could take at a younger age.

,Now letu2019s look at the other side of the balance sheet.

,Does Uncle Sam (as in the U.

S.

) have an off-balance sheet asset? You bet they do.

,When all the baby boomers start living off their 401k plans and IRAs, theyu2019ll be paying income taxes on those dollars that were never taxed.

Imagine the drunken stupor an actuary could work him/herself into by just trying to estimate Americau2019s off-balance sheet asset for taxes not paid on these funds owned by taxpayers.

,So anytime I think of your question (a good one by the way), I think of this scenario as it makes off-balance sheet assets and liabilities more concrete to me.

Donu2019t make me define, let me give you an example.

And I hope this one provides some clarity.

,How Are These Reported In Financial Statements?If you are reading audited financial statements, look carefully at the disclosures.

Most of these items will fall under the umbrella of contingent liabilities.

Do not ignore these notes.

,If private-company reporting, then reader beware.

You need to get really good at asking questions.

Personally, I put my Risk Management hat on and start thinking of relationships or contracts that could go wrong.

Those are my potential off-balance sheet liabilities.

Balance sheet example PDF

Finance numericals were entirely new to me last year and Iu2019ll just share my experience on how I tackled these.

To better structure my preparation for this part, I categorized numerical based problems as follows -,Those based on time value of money, bond yields, price of bonds etcI understood these numericals as simple Geometric Progression (GP) problems that we used to study in Math in school.

All formulae are derived based on GP.

For example, sum of n terms of GP, sum of infinite terms of GP etc.

,The book Corporate Finance by Ross Westerfield that I have recommended on the blog derives these formulae from the scratch and explains stuff in very simple language (in chapters 3,4,5).

This book is available for free on the net.

,Once I understood the derivation and practiced a few problems, remembering the formulae became easy.

,Understanding the derivation also helps understand the actual meaning of each of the terms like yield to maturity, other yields, interest rate, face value etc.

Otherwise these terms can be quite confusing for those who have had no prior exposure to Finance.

,I focused more on understanding the derivations and less on time required to solve the problem because while giving mocks I felt that I was lacking conceptual clarity and hence was unable to solve problems.

Time is not an issue because there are not going to be many numericals to solve.

,Those based on balance sheet and accounting ratiosIt is very important to first understand all the terms mentioned in a typical Balance Sheet.

I referred to the chapter on Balance Sheets in the freely available pdf of u201cFinance and Management by Prasanna Chandra 7th editionu201d for this.

I did not refer to any other chapter in this book and hence the free pdf sufficed.

,NOTE: Only after understanding all the terms in a Balance Sheet can one understand Accounting Ratios.

So please cover Balance Sheets before moving on to Accounting Ratios,For understanding accounting ratios, XII Accountancy Part II NCERT Chapter 5 is the best source in my opinion because of its simple and concise language.

I first tried to understand the rationale behind each of the ratios.

,Given the large number of Ratios, this part requires repeated revisions.

Not revising all the ratios multiple times can lead to huge confusion.

,Other types of numericals that I found out about while solving mocks - These have been uploaded as part of my handwritten notes on Numericals on the blog.

You may want to refer to these once to get an idea of the derivations I am talking about,Note: Last year just one simple numerical was asked.

This fact may tempt some to skip studying for numericals altogether this year.

But I think that the basics should still be covered because simple numericals can be quite scoring.

And in this exam, 2 marks can potentially boost your rank significantly.

Balance sheet and income statement

Both, the balance sheet and the P&L/Income statement display the four most important financial aspects of the firm, which are : Expense, Asset, Income, Liability.

,Every penny that is involved in a financial transaction with the firm can be categorised under the above four categories.

After categorising, Balance sheet and P&L statement are made and conclusions drawn.

,The most important difference between a balance sheet and P&L statement is this:,Balance sheet is valid for a single day.

It always reads , u201cBalance statement as on u2026.

.

u201d .

It may be different the next day or for a previous date.

,P&L statement is made over a certain time period.

It always reads, u201c P&L statement for the periodu2026u2026.

u201d .

Balance sheet of a company

To understand how to read balance sheet, one must understand what is a balance sheet and what it represents.

,The balance sheet, also referred to as the statement of financial position, reports the financial position of a business at a point in time.

Because the information is reported at a point in time, the balance sheet can be compared to a photograph.

It is based upon the accounting equation and reports the assets, liabilities, and equity of the business.

At all times Assets = Liabilities + Equity (A = L + E) on the balance sheet and in the accounting system.

For academic purposes the equation can also be expressed Equity = Assets u2013 Liabilities.

,Assets are the first part of the balance sheet.

Common assets are cash, accounts receivable, and property, plant, and equipment.

Assets are presented on the balance sheet in order of liquidity: how easily assets can be converted to cash, with cash being presented first.

Ending cash is calculated using a bank reconciliation, because there may be outstanding checks and deposits not reflected in the bank balance.

Accounts receivable tracks amounts owed to the business from customers.

Next, inventory is tracked as an asset until sold.

Property, plant, and equipment are also considered assets.

Property, plant, and equipment are expensed over time using the process of depreciation.

,Assets: cash, accounts receivable, equipment, inventory, property, plant, and equipment, intangibles,Liabilities are debts that the business owes.

The order is determined based upon how quickly the liabilities must be repaid.

Common liabilities are accounts payable and notes payable.

Accounts payable tracks amounts owed to providers of goods and services to the business, referred to as vendors.

Notes payable are loans used to finance the business.

,Liabilities: accounts payable, notes payable, accrued expenses, bonds payable,Equity represents amounts invested in the business and prior income statement activity.

Common stock and retained earnings are typical equity accounts.

Common stock is issued to investors in exchange for investment, typically in the form of cash.

The retained earnings account tracks the accumulated activity that has been reported on the income statement.

Retained earnings therefore connects the income statement and the balance sheet.

,Equity: Common stock, retained earnings,The balance sheet provides valuable information to stakeholders and represents the accounting system in the form of Assets = Liabilities + Equity.

Different accounts distinguish whether a transaction affects the balance sheet or income statement.

If a business buys a car for example, it is an asset, not an expense.

Liabilities track amounts owed and the sources of debt financing.

When a business pays back a loan, for example, it is a decrease in liabilities, not an expense.

Equity tracks the sources of equity financing and prior income statement activity.

If a business issues common stock to raise money, it will increase equity, not revenue.

The retained earnings account ties the income statement to the balance sheet, creating a system that balances in the form of the accounting equation.

,The balance sheet allows stakeholders to access critical information that cannot be found on the income statement alone.

A business could be profitable, but have large liabilities.

A different business could also have a loss on the income statement, but have a large amount of valuable property on the balance sheet.

If the investor ignored the balance sheet in either case, he or she might be making an uninformed decision.

The income statement and balance sheet should therefore be viewed together.

nComparable to a picture, because it reports financial activity at a point in time,I highly recommend for you to read more :http://accountingplay.

com/glossary/balance_sheet_example/Further, to better understand, here is a link of my videos regarding Balance Sheet: ,, n, ,