Financial Statements - Balance Sheet

An introduction to the financial statements

The purpose of the three main financial statements is to report the business’s financial performance and position to external users of accounting information. It is important that they only reflect the transactions of the business, and not the transactions of its owner(s).

Although the business is accounted for separately to the owner’s personal belongings and transactions, sole traders and partnerships are not regarded as being legally separate from their owners. Companies are different because the business is treated as being legally separate from its owner(s) (who in this case are called shareholders). This means that there are more rules about the preparation of financial statements for companies, and there are also some items (such as ‘share capital’) that only appear in company financial statements.

The three main financial statements are the balance sheet (BS), profit and loss account (P&L), and cash flow statement (CFS). The most common financial statement to be prepared is the BS. This shows the financial position of the business at a single point in time. However, this only tells part of the story about the business considering the other

financial statemants like P&L(profit and lose account) and the CFS(cash flow statement)

Both of these financial statements, the BS and P&L, are prepared on the accruals basis and are closely linked to each other. The CFS is the least common financial statement and is usually only prepared by companies. However, there is no reason why a sole trader or a partnership could not prepare a CFS, and without one, it is difficult to understand the position and performance of the business in terms of the availability and generation of cash. The CFS is prepared on a ‘cash basis’. Here we can discuss about the most common and the most important financial statement Balance sheet (BS).

Balance sheet (BS)

The BS shows:

• the net worth of a business at a single point in time

• the owners’ equity.

Net worth is the difference between a business’s assets and its liabilities.

Therefore, another name for net worth is net assets. Owners’ equity is the claim on the business by the owner(s). It consists of the original capital invested in the business by the owner(s), and any profits (or other changes in value) that the business has made in the past which have been retained, or reinvested, in the business. These retained profits (or other changes in value) are known as reserves.

Because the BS ‘balances’, the net worth and the owners’ equity should be equal. This is known as the balance sheet equation:

Net Worth = Owners’ Equity

We can use the definitions of net worth and owners’ equity to rewrite this

equation as follows:

Assets – Liabilities = Capital + Reserves

There are many possible definitions of an asset but the usual definition is something which the business owns or controls and which will provide cash or other benefits in the future. Examples of assets are pieces of machinery, computer equipment, goods for resale (stock), cash and customers which owe the business money (debtors). Assets which are

expected to be held for more than one year are called fixed assets, whereas cash or other assets which are expected to become cash within one year are called current assets.

Liabilities are, at their simplest, amounts that a business owes. Generally, at some point in the future it is probable that the business will have to pay out cash or other benefits as a result of a past transaction or event. Examples of liabilities are loans from the bank, and money owed to suppliers (creditors). Similarly to assets, liabilities which will not be paid for at least one year are called long term, whereas those that will be paid in less than one year are called current. You may also find items called provisions in a balance sheet. These are either used to make reductions in the value of an asset, or for liabilities where the amount or timing of the payment is uncertain. You will see some examples of provisions later in the subject guide.

We can rewrite the balance sheet equation again:

Fixed Assets + Current Assets – (Long-Term Liabilites + Current Liabilities) = Capital + Reserves

We can also rearrange this equation to show the sources from which the

business has obtained finance, and the uses of that finance:

Fixed Assets + Current Assets = Capital + Reserves + Long-Term Liabilities + Current Liabilities

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