How The BALANCE SHEET Works (Statement of Financial Position / SOFP)

Summary

This video provides an introduction to the balance sheet in accounting, explaining its layout and significance. The host, James from 'Accounting Stuff,' covers how to build a balance sheet using Google Sheets, highlighting its key components: assets, liabilities, and equity. Through example transactions, the video demonstrates the double-entry accounting principle and explains the relationship between the balance sheet and income statement. Whether you're an entrepreneur, investor, or accountant, this tutorial offers valuable insights into understanding and preparing balance sheets, crucial for evaluating a business's financial health.

Takeaways

• 📊 The balance sheet (or statement of financial position) is one of the three main financial statements alongside the income statement and cash flow statement.
• 🏢 A balance sheet provides a snapshot of a business’s assets, liabilities, and equity at a specific point in time.
• ⚖️ The balance sheet must always balance, meaning total assets must equal total liabilities plus equity.
• 📉 Assets are categorized into current assets (convertible to cash within one year) and non-current assets (long-term assets used to generate profit).
• 💰 Liabilities are also divided into current (due within a year) and non-current (long-term obligations like loans).
• 💼 Equity includes owner’s equity and retained earnings, with retained earnings acting as profits held for future use.
• 🔄 Double-entry accounting ensures every transaction affects two accounts, and this principle underpins the balance sheet.
• 🧾 The balance sheet and income statement are linked through retained earnings, where the profit from the income statement flows into equity.
• 📈 Building a balance sheet involves tracking transactions like revenue, expenses, and changes in assets, liabilities, and equity.
• 💻 Accounting software like QuickBooks makes creating balance sheets easier by ensuring all entries balance automatically, reducing human error.

Q & A

What is the purpose of a balance sheet in accounting?

A balance sheet provides a snapshot of a business's financial position at a specific point in time. It shows the company's assets, liabilities, and equity, helping to assess its financial health.

Why is it important for a balance sheet to balance?

A balance sheet must balance because total assets should always equal total liabilities plus equity. This ensures the accounting equation is correct and that the company's finances are accurately represented.

What are the two main categories of assets on a balance sheet?

The two main categories of assets are current assets and non-current assets. Current assets can be converted to cash within one year, while non-current assets are long-term assets that are used to generate profit over a longer period.

What are examples of current and non-current liabilities?

Examples of current liabilities include accounts payable, salaries payable, and accrued expenses. Non-current liabilities include long-term obligations like loans that do not need to be settled within one year.

How does double-entry accounting work in relation to the balance sheet?

In double-entry accounting, every transaction affects two accounts. For example, an increase in an asset may lead to a corresponding increase in equity or liability, ensuring that the accounting equation (Assets = Liabilities + Equity) remains balanced.

What is the relationship between the income statement and the balance sheet?

The profit from the income statement flows into the retained earnings section of the balance sheet. Retained earnings represent the profits that the company holds for future use, linking the two financial statements.

How are assets further classified on the balance sheet?

Assets are classified into current assets, which can be easily converted to cash within a year (like cash, accounts receivable), and non-current assets, which are long-term and not easily liquidated (like property, equipment).

What are retained earnings, and how do they affect the balance sheet?

Retained earnings are the portion of a company's profits that are held for future use rather than distributed as dividends. They appear in the equity section of the balance sheet and show how much profit has been reinvested in the business.

What happens if the balance sheet doesn't balance?

If the balance sheet doesn't balance, there is an error in the accounting entries. This could indicate mistakes in recording transactions, and the discrepancy needs to be investigated and corrected to ensure accurate financial reporting.

How does QuickBooks Online ensure that the balance sheet stays balanced?

QuickBooks Online, a cloud-based accounting platform, automates much of the accounting process and ensures that all transactions are recorded properly. This helps avoid manual errors that can cause imbalances in the balance sheet.

Outlines

00:00

📊 Introduction to the Balance Sheet

This paragraph introduces the concept of the balance sheet in accounting, explaining its importance for startups seeking funding, investors assessing financial health, and accountants preparing reports. It emphasizes the relationship between the balance sheet, income statement, and cash flow statement, and mentions that the video will provide a detailed tutorial on building a balance sheet using Google Sheets. The narrator, James, also invites viewers to subscribe for more accounting tutorials.

05:02

📝 Overview of the Balance Sheet Structure

This paragraph explains the basic structure of a balance sheet using an example from QuickBooks Online. It introduces the main components: assets, liabilities, and equity, and emphasizes that a balance sheet must always balance, meaning that total assets must equal total liabilities plus equity. James highlights that modern accounting software like QuickBooks makes creating and balancing a balance sheet easier compared to manual calculations.

10:03

💸 Categories of Assets, Liabilities, and Equity

The third paragraph dives into the different categories of assets, liabilities, and equity. It defines current and non-current assets, explaining that current assets can be converted to cash within a year, whereas non-current assets are long-term investments. It also describes current and non-current liabilities and distinguishes between owner's equity and retained earnings. James introduces the accounting equation and the principle of double-entry accounting, and shows how every financial transaction affects this equation.

Keywords

💡Balance Sheet

A balance sheet, also known as the 'statement of financial position,' provides a snapshot of a company's financial condition at a specific point in time, detailing its assets, liabilities, and equity. In the video, the balance sheet is presented as one of the three core financial statements that is essential for evaluating a business’s financial health.

💡Assets

Assets represent the resources a business owns, which can include cash, property, and inventory. The video explains that assets are divided into current assets, like cash and supplies, and non-current assets, like property and equipment, and are fundamental to the balance sheet equation.

💡Liabilities

Liabilities are obligations the business owes to third parties, such as suppliers and lenders. They are categorized as current (settled within a year) and non-current (longer-term obligations). The video highlights the importance of understanding liabilities to assess how much a business owes and its financial risk.

💡Equity

Equity represents the owners' claims on the business after all liabilities have been deducted from assets. In the video, equity is shown as a crucial component of the balance sheet equation, where assets equal liabilities plus equity. It includes components like retained earnings, which link the income statement and balance sheet.

💡Double-Entry Accounting

Double-entry accounting is a system where every financial transaction has two corresponding entries, one debit and one credit, affecting at least two accounts. The video emphasizes that this principle keeps the balance sheet balanced, ensuring that assets always equal liabilities plus equity.

💡Current Assets

Current assets are short-term assets that can be converted into cash within one year, such as cash, accounts receivable, and inventory. The video explains their role in the balance sheet and how they are distinguished from non-current assets, which are long-term resources.

💡Non-Current Assets

Non-current assets are long-term resources used in business operations, such as property, plant, and equipment. Unlike current assets, these cannot easily be converted into cash within a year. The video introduces non-current assets when building the balance sheet and shows how they contribute to generating profit.

💡Current Liabilities

Current liabilities are short-term obligations that a business must settle within a year, such as accounts payable and taxes payable. The video discusses their role in the balance sheet and how they contrast with non-current liabilities, which have a longer time horizon for repayment.

💡Retained Earnings

Retained earnings represent the profits a business holds for future use, which haven’t been distributed to owners as dividends. The video highlights retained earnings as a key component of equity and explains how they link the balance sheet to the income statement, reflecting accumulated profit.

💡Income Statement

An income statement is a financial document summarizing a company’s revenues and expenses over a period of time, which results in profit or loss. The video introduces the income statement as a companion to the balance sheet, showing how retained earnings connect the two by reflecting profits.

Highlights

Introduction to the balance sheet, one of the three major financial statements in accounting.

The balance sheet provides a snapshot of a business's assets, liabilities, and equity at a single point in time.

The balance sheet always has to balance: total assets must equal total liabilities plus equity.

QuickBooks Online is used as an example for demonstrating how a balance sheet is structured.

Double-entry accounting is the key principle used to build the balance sheet: every transaction has an opposite, corresponding entry.

Explanation of current assets (convertible to cash within one year) and non-current assets (held for longer than one year).

The difference between current liabilities (settled within one year) and non-current liabilities (obligations extending beyond one year).

Equity consists of owner's equity and retained earnings (profits held for future use).

The income statement links to the balance sheet through retained earnings.

A balance checker ensures that the balance sheet stays balanced, with total assets equal to total liabilities and equity.

Transaction examples: recording a $100 capital contribution, a $200 loan, and spending $30 on equipment using double-entry accounting.

Revenue recognition through a $150 window cleaning transaction, showing the flow between the income statement and balance sheet.

The role of debits and credits in adjusting accounts like cash, equipment, supplies, and accounts payable.

Explanation of retained earnings and how they are linked to profit from the income statement.

Final balance sheet check showing how $455 in total assets equals total liabilities and equity.

Transcripts

This video is going to give you a solid introduction to the

balance sheet in accounting. I'm going to explain what it is,

how it's all laid out and then we're going to build ourselves

a balance sheet from scratch using Google sheets and

six example transactions.

[Music]

Hello there, welcome back to the channel!

I’m James this is Accounting Stuff

and in this tutorial we're going to cover the

balance sheet in accounting. The ‘balance sheet’ or

‘statement of financial position’ is one of the three major financial statements

along with the ‘income statement’ and ‘cash flow statement’.

So this is a big big topic. If you run a startup then you

absolutely must be able to prepare one of these in order to have a hope of

getting funding, and on the flip side

if you're ever planning on lending money too or investing in a business,

then it's critical that you know how to read and understand the balance sheet

because the balance sheet will give you an impression of the

business's financial health. And that will determine how risky

the opportunity is for you. And finally

if you're an accountant then chances are you'll be helping

prepare one of these at the end of every accounting period.

Over the past few months I've been posting weekly videos teaching

accounting basics for beginners that you can find up here.

This video is going to link a bunch of these ideas together so if you find any

parts of this explanation confusing then I recommend you check those out

to cement your understanding and come back to this one if you need to.

There will be links in the description below to all of the relevant ones so feel free

to check those out. As I mentioned I'll be

releasing new videos each week and I aim to cover all of the major parts of

the balance sheet. So hit the subscribe button

and click on the bell to be notified when those come out.

Don't know about you, but I'm itching to get cracking

I mean what is the balance sheet? Let's find out.

The balance sheet looks like this. The way it's presented can vary but

there are some key elements at the core of the balance sheet

that the rest of it's built around. Here we have a balance sheet

for a business called Craig's Design and Landscaping Services.

That's because I took this one from the sample company

in QuickBooks Online. QuickBooks Online is the

biggest cloud accounting platform in the world and they specialise

in small to medium sized businesses. So I thought this one would

make a good example. If you're thinking this all looks a bit crazy

then no worries. I'm only showing you the finished product.

We will piece together a simpler one of these for ourselves in a moment.

Right I think it's time for a definition… A Balance Sheet is a snapshot of a

business's Assets, Liabilities and Equity at a single point in time.

And that's exactly what we're looking at. We have Assets over here on the left,

and on the right hand side we have Liabilities and Equity.

Beneath both of the headers we have all of the detail.

All of the individual groups of accounts summarised with their closing balances

at the bottom of the balance sheet. We have our total assets and

total liabilities plus equity. You'll notice that both of these numbers

are exactly the same. That's what we want to see.

It’s the aim of the game here because the balance sheet as

suggested by its name always has to balance.

So your total assets must be equal to your total liabilities

plus equity. If they don't match each other exactly

then we've got a problem. In the past people used to make

their balance sheets manually and this was a pain in *beep*

You could easily waste hours, or even days trying to figure out

where the errors were in your workings. But thankfully,

nowadays accounting platforms like QuickBooks Online exist.

They ensure that your balance sheet always stays balanced.

If you run a small business and you'd like to give

QuickBooks Online a try then you'd be doing me a massive favour

if you follow my link down in the description. It's an affiliate link.

So you'll get access to a free 30-day trial and the chance to

support me making more accounting videos just like this one.

Check out the video I made up here if you're interested.

But if cloud accounting isn't for you, that's ok you can also

support the channel by giving this video a like and sharing it

with someone if you think they'd find it useful. But anyway,

I promised you that we'd build ourselves a balance sheet from scratch

and I meant it. So here we are.

We have a clean slate. We're going to build this balance sheet

from the ground up using one key principle…

Double-Entry Accounting. In double-entry accounting

every accounting entry has an opposite, corresponding entry in a different account.

Or put simply… Stuff the business owns

is equal to the stuff the business owes.

We accountants call stuff that the business owns ‘Assets’.

But the stuff that the business owes is a little bit more complicated.

We use two different words to describe it depending on

who the business owes stuff to. When a business owes stuff to

third parties like lenders, suppliers and employees

we call them ‘Liabilities’. However when a business owes stuff to

its owners we call it ‘Equity’. So we have

Assets are equal to Liabilities plus Equity.

This is the basic accounting equation and it always balances.

Total assets must be equal to total liabilities plus equity.

Now every financial transaction that a business is involved in affects

this accounting equation. So the values of our

assets, liabilities and equity are constantly changing.

But it's possible for us to take a snapshot and freeze

their values at a single point in time. When we do that

we're looking at a balance sheet. The thing is though that

these three buckets are far too broad. There are many types of

assets liabilities and equity, and it would be helpful if we could

distinguish between them. It's time for us to hop into

Google Sheets and flesh out this balance sheet. We'll begin with assets.

And FYI I'm going to move through this next section fairly quickly because

I've made a video covering assets and a lot more detail

that you can find linked up here and down below in the description.

The same goes for liabilities and equity. So check those out if you'd like

some fuller explanations. Assets are broken down broadly

into two main categories. Current assets and non current assets.

Current assets are short-term assets that can be converted into cash

within one year. Some of the most common types of

current assets are cash, accounts receivable,

supplies, inventory and prepaid expenses.

On the other hand, non current assets are

long-term assets that are used in operations to generate profit.

They can't easily be converted into cash. So we expect to hold on to them

for more than one year. Two common types of non current asset

are long-term investments and property, plant and equipment.

It's a similar situation for liabilities. We have current liabilities.

Which are our businesses obligations that need to be settled within

one year from now. These include accounts payable,

salaries payable, taxes payable and accrued expenses.

And we also have non current liabilities. Obligations that aren't expected

to be settled within one year. Stuff like long term loans.

And that leaves us with equity. The final piece of the puzzle.

This section works a bit differently to assets and liabilities.

We have two broad categories to consider. Owner's equity

and retained earnings. You can think of retained earnings

as profits held for future use and this is key because it’s the profit

in retained earnings that forms the link between the balance sheet

and the income statement. Keep that in mind.

I’ll demonstrate how it works in this next example.

But before we get stuck in. Let's do some housekeeping

and tidy up this balance sheet by adding some totals.

On the left. We have total assets

and on the right we have total liabilities and equity.

These have to match each other exactly because the balance sheet always has to balance.

To emphasise this I'm going to add a little ‘balance checker’

that'll take the difference between these two cells.

This should always be equal to zero. Now that we've built a template

for our balance sheet it's time for some numbers.

Let's go back to the scenario of the window cleaning business

that we covered in the videos on T Accounts,

Journal Entries, and the Trial Balance.

I'll drop links to all of these down in the description.

We're going to use these transactions again so that you can see

how all of these concepts fit together. In the interest of saving you time.

I'm going to move through these transactions fairly quickly.

So if you find yourself getting stuck and wanting some deeper explanations

of the debits and credits, then go back and watch those videos

on T Accounts and Journal Entries. By the way,

on a side note… The Trial Balance is not

the same thing as the balance sheet. If you'd like to see me make a video

explaining the differences let me know in the comments.

There are six transactions that we're going to cover

and we'll work through them one by one filling out our balance sheet template as

we go. In transaction number one

The owner of the window cleaning business makes capital contributions of $100.

We're double entry bookkeeping so this transaction is going to affect

two accounts… Cash and owner's equity.

The business's cash is going to be debited to increase it by $100

and owner's equity will be credited to increase that by $100 as well.

Are we in balance? Yes we are.

In transaction number two the business takes out a further $200 loan

to fund this activities. We need to debit cash again by $200

to increase it and credit long-term loans by $200

to increase them too. Transaction 3.

The business spends 30 dollars in cash on window cleaning equipment.

We credit cash by 30 dollars to decrease it and we debit our plant, property and equipment

by 30 dollars to increase our equipment. In transaction four

the business spends a further $50 on cleaning supplies.

The payment is made on account. Paying for something on account

means that you're agreeing to pay the supplier at a later date.

So we debit our supplies by $50 to increase them.

And this time, we don't credit cash.

We credit accounts payable by $50 to increase them instead.

Just a couple more transactions left to go you've got this!

These ones are going to affect our retained earnings account.

Remember that means our profit held for future use

and it links the balance sheet and the income statement together.

I'll show you how this works now. Transaction 5.

The window cleaning business makes a hundred and fifty dollars

cleaning windows and uses up half of its cleaning supplies

in the process. This transaction is a bit more tricky

than the ones we've covered up to this point because there are two parts to it.

Each with their own double entries. The first thing that we need to do is

recognise revenue earned. To do that,

we debit cash to increase it by a hundred and fifty dollars

and we also credit revenue to increase that by a hundred and fifty dollars.

But hold up… where does revenue go?

I can't see it anywhere in our balance sheet?

We're going to need to jot down an income statement

for our window cleaning business. An income statement is a

summary of our revenue earned and expenses incurred

over a period of time. So here we have revenue of

a hundred and fifty dollars. Almost there…

Next we need to record the second part of the transaction.

Half of our cleaning supplies were used up on this job.

So we can't recognise those as an asset anymore.

They now make up our cost of sales.

Which is a kind of expense and belongs in our income statement as well.

In the fourth transaction we spend $50 on cleaning supplies

so if we've used up half of them, then we need to credit supplies

by $25 to decrease them and debit cost of sales

in the income statement to increase our expenses by $25.

But our balance sheet still isn't in balance. How can that be?

We need to build a bridge between the profits in our income statement

and the retained earnings or profits held for future use

in the equity section of our balance sheet. So the hundred and twenty five dollars

of profit in our income statement now flows through the

retained earnings and balances our balance sheet.

One important thing to note… Retained earnings and profit for the year

don't normally match each other exactly like they're doing in this example.

That just happens to be the case because we don't have any

retained earnings from previous years and none of the profits had been

drawn out of the business. That being said,

the simplicity of this example is a great way to demonstrate

this link between the income statement and the balance sheet.

We'll see how that works one more time in transaction 6.

Where our window cleaning business incurs laundry costs of $20.

The payment is made in cash. So we need to credit cash by $20

to decrease it and debit laundry costs by $20

to increase them in the income statement.

Our profit of a hundred and five dollars rolls up into the retained earnings section

of our balance sheet giving us total assets of

four hundred and fifty five dollars and total liabilities plus equity

of four hundred and fifty five dollars as well.

And our balance sheet checker is showing zero.

Good stuff! How did you find that?

I didn't want to skip any steps in this balance sheet tutorial.

If you've got any questions let me know down below in the comments

or send me a direct message on instagram

@accountingstuff Hit this circle to subscribe

and keep up to date with all of the latest videos

and check out the accounting basics playlist over here to explore some of the ideas that

we just touched on in more detail. And good luck with those balance sheets!

[Music]