A balance sheet should always balance. The name "balance sheet" is based on the fact that assets will equal liabilities and shareholders' equity every time.
Understanding Balance Sheets
The assets on the balance sheet consist of what a company owns or will receive in the future and which are measurable. Liabilities are what a company owes, such as taxes, payables, salaries, and debt. The shareholders' equity section displays the company's retained earnings and the capital that has been contributed by shareholders. For the balance sheet to balance, total assets should equal the total of liabilities and shareholders' equity.
The balance between assets, liability, and equity makes sense when applied to a more straightforward example, such as buying a car for $10,000. In this case, you might use a $5,000 loan (debt), and $5,000 cash (equity) to purchase it. Your assets are worth $10,000 total, while your debt is $5,000 and equity is $5,000. In this example, assets equal debt plus equity.
Why a Balance Sheet Balances
The major reason that a balance sheet balances is the accounting principle of double entry. This accounting system records all transactions in at least two different accounts, and therefore also acts as a check to make sure the entries are consistent.
Building on the previous example, suppose you decided to sell your car for $10,000. In this case, your asset account will decrease by $10,000 while your cash account, or accounts receivable, will increase by $10,000 so that everything continues to balance.
Assets are the first of three major categories on the balance sheet. Current assets represent the value of all assets that can reasonably expect to be converted into cash within one year and are used to fund ongoing operations and pay current expenses. Some examples of current assets include:
- Cash and cash equivalents
- Accounts receivable
- Prepaid expenses
- Marketable securities
Noncurrent assets are a company’s long-term investments or any asset not classified as current. Both fixed assets, like plant and equipment, and intangible assets, like trademarks, fall under noncurrent assets. Some examples of noncurrent assets are:
- Property, plant, and equipment
- Long-term investments and even goodwill
Current liabilities are short-term liabilities that are due within one year and include:
- Accounts payable are a short-term debt owed to suppliers.
- Accrued expenses are expenses that have yet to be paid, but have a high probability of being paid.
Noncurrent liabilities are also listed on the balance sheet and are included in the calculation of a company's total liabilities. Noncurrent liabilities are long-term debts or obligations and unlike current liabilities, a company does not expect to repay its non-current liabilities within a year. Some examples of noncurrent liabilities include:
- Long-term lease obligations
- Long-term debt like bonds payable
For example, a company's long-term lease that lasts more than one fiscal year is listed on the balance sheet. The rental arrangement is listed as an asset on the balance sheet, and the lease obligation is listed as a liability. Since the lease lasts longer than one fiscal year, it is a noncurrent liability.
'Retained earnings' is money held by a company to either reinvest in the business or pay down debt. 'Retained earnings' are also earnings that have not been paid to shareholders via dividends.
Shareholders' equity is the net of a company's total assets and its total liabilities. Shareholders' equity represents the net worth of a company and helps to determine its financial health. Shareholders' equity is the amount of money that would be left over if the company paid off all liabilities such as debt in the event of a liquidation.
Balance Sheet Example
Below is Apple's balance sheet, as of September 26, 2020, from their annual 10K statement. We can see how the balance sheet balances by the following:
- Total assets were $324 billion.
- Total liabilities were $259 billion.
- Shareholders' equity was $65 billion (highlighted in yellow).
At the bottom of the balance sheet, we can see that total liabilities and shareholders' equity are added together to come up with $324 billion which balances with Apple's total assets.
If the balance sheet you're working on does not balance, it's an indication that there's a problem with one or more of the accounting entries.