I have been working on the fundamentals of accounting for my first MBA exam today. Like most employees or a large organisation, I have not had to deal with balance sheets in my work before, so the practice application of double-entry bookkeeping is new to me.
You may be aware that businesses, companies, and organisations (entities in accounting speak) must follow a set of financial reporting standards called the International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP) in the US. An entities finances are kept separate from its owner’s finances (Entity concept) even when the entity is a proprietorship, where the entity has a sole owner/investor.
The reporting centres around the balance sheet that displays the health and composition of an organisation. The balance sheet has three main elements, assets, liabilities, and equity, all recorded in monetary amounts in a single currency.
Balance Sheet equation: assets = liabilities + equity
Assets are items owned and controlled by the company and acquired at a measurable financial cost and are split into current assets and noncurrent assets. Current assets are short term items that are likely to be used or converted to cash within the financial year; these include cash, accounts receivable (money owed for goods/services), inventory, and prepaid expenses like insurance. Noncurrent assets are long term items that are unlikely to be used or converted to cash within the financial year; these include property, plant and equipment such as factories, equipment and land.
Liabilities are debts owed to creditors in return for goods and services and are similarly slit into current and long-term categories based on the current financial year. Current liabilities include bank loans, accounts payable (money owed for goods and services) and estimated tax liabilities (estimate before filing reports at the end of the year). Equity is the capital supplied by investors (Paid-In Capital) and profits from the business that are then reinvested into the company (Retained Earnings).
The balance sheet displays all assets, liabilities, and equity of a company, with assets on the left and liabilities and equity on the right. The Double-entry bookkeeping principle requires that any transaction, such as a purchase of inventory or equipment, results in two entries, an increase in PP&E or inventory, could mean a reduction in cash or increase in accounts payable if they are purchased on credit, for example.
I hope you enjoyed a brief introduction to accounting and the balance sheet.