THE BALANCE SHEET

OBJECTIVES:

1. To know the definition of a balance sheet.

2. To identify and define the four components of the balance sheet.

The Balance Sheet is a statement used to determine the financial strength and weakness of a
business. It lists everything a company owns and everything a company owes at a specific point
in time. For example, an existing business may develop a balance sheet on July 8, 200X in order
to see what it owns and owes on that specific date. The same company may develop another
balance sheet on August 20, 200X to view the items it owns and the money it owes on that date.
The company then can compare the two Balance Sheets (on July 8 and on August 20) to
determine whether their financial position is improving. If, however, you are not an existing
business owner but are planning on establishing a business, you will be required to construct
annual forecasted balance sheets for three years into the future. This will enable you, as a
potential business owner, to estimate the items your business anticipates to own in each of the
three years as well as how much your business anticipates to owe in each of the three years. By
developing a forecasted annual balance sheet for three years into the future, you and investors
will be able to determine if your proposed business provides an opportunity.

FOUR COMPONENTS OF THE BALANCE SHEET:

The balance sheet consists of four main components, namely; the Heading, Assets, Liabilities,
and Equity. The Heading depicts the name of the company, the name of the statement and the
date at which the account balances apply. Assets are items that have economic value to a
company. Liabilities are items that have an economic burden on the company - usually items a
business owes to other businesses. Equity consists of all the investments made into a company
over the years - usually in the form of capital or shareholder's investments and retained earnings.
One very important thing to remember about the Balance Sheet is this:

THE ASSETS OF ANY BUSINESS MUST ALWAYS EQUAL THE SUM OF THE
BUSINESSES' LIABILITIES AND EQUITY.
ASSETS = LIABILITIES + EQUITY

This is how the Balance Sheet received its name. The Assets balance with the Liabilities and
Equity. Lets now separately explain the four major components of the Balance Sheet. To do this
we will use the following balance sheet example.

Balance Sheet Example:

The TOY Company
Balance Sheet
As of December 31, 200X

ASSETS:

Current Assets:

Cash $10,122

Accounts Receivable $ 5,000

Prepaid Fire Insurance $ 1,200

Inventory $12,558

Total Current Assets $28,880

Fixed Assets:

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

Total Fixed Assets $26,500

TOTAL ASSETS $55,380

LIABILITIES:

Current Liabilities:

Accounts Payable $12,254

Income Taxes Payable $ 5,676

Short-Term Loan Payable $ 5,179

Total Current Liabilities $23,109

Long-Term Liabilities:

Mortgage on Building $19,757

TOTAL LIABILITIES $42,866

EQUITY:

Capital - Donald Sutherland $12,514

TOTAL EQUITY $12,514

TOTAL LIABILITIES & EQUITY $55,380

As you can see the Asset = Liabilities + Equity ($55,380 = $42,459 + $12,921). The following
assumptions also are needed for our example. Be sure to read all assumptions since they will be
referred to as we explain the components of the balance sheet.

Assumptions For Our Example:

Donald Sutherland is the sole-proprietor of The Toy Company. He invested his life savings of
$10,000 into his business. The Company buys preassembled wooden toys from a supplier in
Maine and sells them to end consumers (you and I). Donald registered the company on January
1, 200X and has been operating it since then.

Today's date is January 10, 200Y. The above Balance Sheet, however, shows the Toy Company's
financial position on December 31, 200X

On January 1, 200X the company purchased office equipment valued at $12,500. The equipment
consists of two computers, a fax machine, and a mobile photocopier. Donald's accountant
suggested these item be pooled into one asset account called Office Equipment.

On July 1, 200X, The Toy Company received a 10 year, $22,500 loan to purchase a building.
The building will be used to sell the company's preassembled toys.

Donald's accountant suggests the building has a useful life of 5 years and will be depreciated in
equal amounts per year over these 5 years. Therefore, the building will depreciate $4,500 per
year ($22,500 divided by 5 years = $4,500 per year). Lets also assume, the accountant suggests
the office equipment pool of assets has a useful life of two years and will be depreciated in equal
amounts per year over these two years. Therefore, depreciation expense and accumulated
depreciationon the office equipment will be $6,250 per year ($12,500 divided by 2 years =
$6,250 per year). The asset's estimated value, after their useful lives have expired, is assumed to
be zero. Note: The useful lives have been set only for presentational purposes and should not be
used as guidelines.
On July 1, 200X, The Toy Company purchased fire insurance on its building and its inventory of
toys. The insurance company quoted a yearly rate of $2,400. The insurance contract called for a
1 year payment to be made in advance.

The company applied for and received a short-term loan of $7,000 on August 10, 200X from a
local bank.

The company allows its customers to buy products on credit. The credit terms established by the
Toy Company requires customers to pay within 30 days of the purchase date. Those customers,
not paying within the 30 days, will be charge 2 % interest.

The Toy Company has established a credit rating with its supplier which allows them to pay for
each order of preassembled toys within 45 days. Also, Donald has set up charge accounts with
local vendors(merchants) which allows him to pay for the company's general office supplies
within 45 days.

The Net Income before taxes for the Toy Company in 200X (from January 1 to December 31) is
$14,190. Donald's accountant determined a tax rate of 40% would apply to the net income before
tax. Therefore the income taxes to be paid will be $5,676. As of December 31, 200X, the tax
obligation has not been paid and therefore is considered an income tax payable. The company's
200X Net Income After Tax is $8,514 ($14,190 - $5,676 = $8,514).

Donald withdrew $500 cash each month from the business to pay his personal living expenses.
Therefore, during the year, the total amount he withdrew was $6,000 ($500 x 12 months).

This concludes the assumptions section of our example. Now lets examine each of the four
Balance Sheet items and components:

Balance Sheet Items and Components:

1. The Heading of the Balance Sheet

2. Balance Sheet Assets
3. Balance Sheet Liabilities
4. Balance Sheet Equity

HE HEADING
(first component of the Balance Sheet)

The first component of the balance sheet is the heading. The Heading is extremely important
since it tells the readers of the balance sheet three important pieces of information:

1. the name of the company;

2. the type of statement to follow (in this case the Balance sheet);
3. the date at which each account value applies.

Below is the heading for our balance sheet example:

THE TOY COMPANY
Balance Sheet
As of December 31, 200X

As you can see the company is called THE TOY COMPANY, the statement is the Balance Sheet
and the date is "As of December 31, 200X". The date is the most important section of the
Heading. As mentioned earlier, the date indicates the "time" at which the account values apply. If
the date was AS OF DECEMBER 10 - 200X, the account balances (values) would be different.
For example, the amount of cash the Toy Company had on December 10 would be different than
the amount of cash it had on December 31. You will begin to understand the importance of dates
as you become more familiar and more comfortable with financial statements.

ASSETS (second component of the Balance Sheet)

Assets are economic resources of a business. For example, cash is an asset which allows a
company to buy other assets or resources, pay debts a company may have, or pay Operating
Expenses. Assets can be classified into two categories; - Current Assets and Fixed Assets.

Current Assets:
Current assets consist of cash and other resources (assets) that are expected to be converted into
cash within one year or less. Examples of other resources expected to be converted into cash
would include inventory (products a company sells to its customers), accounts receivable (money
customers owe a business for products purchased on credit) and marketable securities (short term
investments made by a company). Current assets also include items that add "value" to a
business and become "used up" or "consumed" in less than a one year. Examples of these current
assets would include: office supplies, store supplies, and prepaid items such as prepaid fire
insurance, & prepaid rent. When these items become used up or consumed, they are no longer
considered assets to the company - they are considered expenses.

The Toy Company's Current Assets on its Balance Sheet as of December 31, 200X are as
follows;

Current Assets:

Cash $10,122

Accounts Receivable $ 5,000

Prepaid Fire Insurance $ 1,200

Inventory $12,558

Total Current Assets $28,880

Let examine each component in detail !!!

Cash
Cash is the amount of money a company has in its bank account. Cash is necessary for paying
bills and for maintaining the day to day operations. As you can see, The Toy Company has
$10,122 cash in its bank account on December 31, 200X. This balance will change on the
following day if any of the following activities take place: if the company makes cash sales, pays
on its debt, receives additional investments or loans, pays on expenses, and other transactions
requiring cash.

Many businesses, having extra cash in the bank, may decide to pay down liabilities, invest into
new markets, or buy marketable securities. A marketable security, in most cases, is a very short
term investment a business purchases from the government, for instance.

Accounts Receivable
An account receivable is a promise by a customer to pay for a product or service at a later point
in time. Many of us have purchased items on credit, promising to pay for them in the future.
Companies offer credit terms as an added service to customers in an attempt to increase sales.
When you, as a consumer, purchase something on credit, the company you purchase the product
or service from will consider you an account receivable. If you, as a business owner, allow
customers to buy your products on credit, then those customers are considered accounts
receivable. As of December 31, 200X, The Toy Company has $5,000 outstanding in accounts
receivable. This means, some of the company's customers purchased $5,000 worth of toys, and
as of December 31, 200X, haven't paid for them.

Usually businesses will give their customers 30 days to pay for items placed on credit. The pay
back period, however, depends on the industry norm and the company's credit granting policy.
Most businesses charge interest to customers who fail to pay within an allotted time frame. The
interest rate varies from company to company, however, it usually ranges between 2 and 5
percent of the amount owed.

Prepaid Items
Prepaid items are expenses businesses pay for in advance. Common prepaid expenses include,
prepaid rent and prepaid insurances. You may ask why would a business pay for something that
is not due. Proper cash management dictates "not to pay for something unless it's due". Some
contracts , however, call for payment of goods and services up front. Think about your personal
car insurance. If you are not on a monthly payment plan, chances are you're required to pay for
your automobile insurance in advance; usually six months in advance.

Prepaid items are considered assets because full payment is made for services that have not been
fully rendered. As a company receives the service, the prepaid item is no longer an asset, but
rather an expense. To explain this concept, lets refer back to one of our assumptions which
stated.

"On July 1, 200X, The Toy Company purchased fire insurance on its building and its inventory
of toys. The insurance company quoted a yearly rate of $2,400. The insurance contract called for
1 year payment to be made in advance".

In short, on July 1, 200X Donald wrote a $2,400 check to his insurance company. The fire
insurance "covers" the building and inventory for a 1 year period. Therefore, on July , 200X, The
Toy Company's balance sheet would show an account called prepaid fire insurance for $2,400.
The company's balance sheet as of December 31, 200X, however, shows the prepaid fire
insurance account balance as $1,200. From July 1 through December 31, 200X, the prepaid fire
insurance account reduced by $1,200 ($2,400 - $1,200 = $1,200). The reason behind the
reduction is simple. The $2,400 paid on July 1 protects the company against fire for a 1 year
period (from July 1, 200X to July 1, 200Y). Since six months of the insurance has expired ( July
to December of 200X), only six more months is left on the insurance policy (from January to
July 1 of 200Y). Therefore, only six months (or half) of the policy still has value to the Toy
Company. The other six months of the insurance has no value and is considered to be an
expense. The Income Statement on December 31, 200X would show an account called Fire
Insurance Expense. The fire insurance expense would have a value of $1,200 - the used or
consumed portion of the insurance policy.

Inventory
Inventory is the product a company buys or produces and sell to end consumers (you and I). For
example, The Toy Company is a retailer that buys products from a wholesaler and sells them to
end consumers. Most retailers and service providers buy finished inventory and sell it to end
consumers. A manufacturer, on the other hand, buys raw materials and manipulates
(manufactures) those materials into finished products. A retailer's inventory generally is
"finished" and ready for resale upon unpacking the products. Where as a manufacturer may have
three types of inventory - raw materials, work in process, and finished goods inventory.

If you are a retailer/service provider your inventory is always recorded at its cost (IE historical
value). That is; the money you pay your suppliers for the goods you buy for resale plus any
shipping charges. Thus, as of December 31, 200X The Toy Company has finished inventory on
hand valued at $12,558. Therefore, The Toy Company paid wholesalers and shipping companies
$12,558 for the toys that are on display and that are in storage. The inventory will decrease in
value if the company makes sales to customers. The inventory account will increase when more
inventory is purchased. Remember when a sale is made the inventory is removed and is recorded
as a cost of good sold (COGS). Cost of Goods Sold appears on theIncome Statement.
If you are a manufacturer, your inventory will be recorded at the cost of all raw materials, plus
direct labour costs (labour costs directly related to producing the finished product), plus factory
overhead charges required in manufacturing the raw materials into finished products. Usually,
manufacturers will separate finished goods (products ready for resale) from non-finished goods
(raw materials and work in process) on the balance sheet.

Total Current Assets

Total current assets is the sum of all the current assets listed on a company's balance sheet. As
indicated below, The Toy Company has total current assets valued at $28,880.

Current Assets:

Cash $10,122

Accounts Receivable $ 5,000

Prepaid Fire Insurance $ 1,200

Inventory $12,558

Total Current Assets $28,880

Fixed Assets:
The second classification of an asset is known as a Fixed Asset. Fixed Assets are economic
resources that have long lives before they become "used up" or consumed. Unlike current assets
which are used up or consumed in less than 1 year, fixed assets generally take more than one
year before they become consumed. Don't be confused with the term FIXED ASSET; it
does not mean assets that are stationary or immobile - it's simply a financial term. Examples of
fixed assets include; office equipment (computers, fax machines, photocopiers, etc) office
furniture (office desk, fixtures, etc), buildings, automobiles, production equipment, land, patents,
trademarks, copyrights.

When current assets such as inventory, office supplies and store supplies are used up or
consumed, they are no longer considered assets, but rather they are considered expenses. Fixed
assets undergo a similar process called depreciation. Depreciation attempts to estimate the
reduction in the value of fixed assets. When fixed assets are depreciated, two accounts are
created; namely, Depreciation Expense and Accumulated Depreciation. The depreciation
expense appears on the income statement while the accumulated depreciation appears on the
balance sheet. To explain these terms, lets look at the fixed assets section for the Toy Company
on December 31, 200X.

Fixed Assets:

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

Total Fixed Assets $26,500

As you can see, The Toy Company's fixed assets include office equipment and a building. Let's
look at each fixed asset separately and line by line.

OFFICE EQUIPMENT:

THE FIRST LINE - Office Equipment ($12,500):

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

As indicated under the assumption section of our example, The Toy Company purchased two
computers for $4,400, a fax machine for $300, and a mobile photocopier for $7,800. These assets
were purchased on January 1, 200X and were grouped together into one account called Office
Equipment. When added together, the office equipment account balance is $12,500.

As you can see, the first line (office equipment - 2 year life) has a balance of $12,500. This
figure represents the amount the fixed assets were "worth" at the time of purchase. This is known
as the asset's historical cost. The account balance of $12,500 (historical cost) will remain at this
amount each year unless The Toy Company purchases more office equipment or sells off any of
the existing office equipment.

THE SECOND LINE - Less: accumulated depreciation-office equipment:

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

The second line (less: accumulated depreciation - office equipment) keeps track of the
reduction in value of the office equipment over time. Furthermore, from January 1 to December
31, 200X, the office equipment reduced in value by $6,250. In other words, the office equipment
depreciated in value by $6,250. How was this reduction in value calculated? Recall, under the
assumption section of our example, Donald's accountant estimated the office equipment would
have a useful life of 2 years, after which time, the equipment would be worthless. In addition, the
accountant suggested the office equipment should be depreciated using a straight line method
(straight line method of depreciation attributes an equal reduction in value each year of the
asset's useful life). Since Donald is using the straight line method of depreciation, he would
simply divide the asset's historical cost ($12,500) by the asset's useful life (2 years), to arrive at
the depreciation amount for one full year. Therefore, The Toy Company estimates the office
equipment will depreciate $6,250 each year ($12,250 / 2 years).

As mentioned earlier two accounts are created when depreciating fixed assets; depreciation
expense and accumulated depreciation. In our example, the depreciation expense, appearing on
The Toy Company's December 31, 200X income statement, will have a account balance of
$6,250 each year. And the accumulated depreciation, appearing on The Toy Company's
December 31, 200X balance sheet, will have an account balance of $6,250 as of December 31,
200X. If you refer to the accumulated depreciation - office equipment account as of December
31, 200X, you will see $6,250.

PLEASE NOTE: If no other office equipment is purchased, then the depreciation expense for the
office equipment (appearing on the income statement) will always remain the same each year
throughout the asset's useful life ( ie $6,250). The accumulated depreciation shown on the
balance sheet, however, accumulates the office equipment's reduction (loss) in value each year,
for the useful life of the office equipment. Therefore, the depreciation expense on the income
statement for the year ending December 31, 200Y will have an account balance of $6,250,
while the office equipment's accumulated depreciation on the December 31, 200Y, balance sheet
will show an account balance of $12,500 ($6,250 depreciation for 200X and $6,250 depreciation
for 200Y = $12,500 accumulated depreciation for office equipment).

THE THIRD LINE- net office equipment

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

The third line is called Net Office Equipment. This line is calculated by subtracting the historical
cost of the office equipment ($12,500) and the accumulated deprecation of the office equipment
($6,250). The resulting figure ($6,250) is an estimation of the economic value remaining on the
office equipment on December 31, 200X. Recall the office equipment was worth $12,500 when
it was purchased on January 1, 200X. Donald's accountant estimated the equipment would
reduce in value (depreciate) by $6,250 each year of its useful life. Therefore, on December 31,
200X, the office equipment is estimated to be worth $6,250.
How much would the office equipment be worth one year from December 31, 200X; (which
would be December 31, 200Y)? The answer should be apparent. Since the office equipment was
estimated to have a two year life, and December 31, 200Y represents the equipments two year
anniversary, it would have a economic value of zero. Furthermore, if no other office equipment
was purchased during 200Y, the office equipment section of the balance sheet on December 31,
200Y would look like this.

Office Equipment (2 year life) $12,500

Less Accumulated Depreciation $ 12,500

Net office Equipment $ 0.00

Remember the accumulated depreciation account, accumulates the depreciation estimated each
year. Thus, 200X depreciation was $6,250 and 200Y depreciation was $6,250, resulting in total
(accumulated) depreciation of $12,500. Now lets briefly look at the Toy's Company's second
fixed asset; namely Building.

BUILDING
The following has been taken from the fixed asset section of The Toy Company's balance sheet
as of December 31, 200X.

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

As you can see, the same structure is used for the building as was used for the company's office
equipment. The first line describes the name of the fixed asset along with its historical cost. The
second line estimates how much the building has depreciated over the years. And the third line
estimates the "net worth" of the building on the balance sheet date (December 31, 200X). To
explain where these values came from, lets look at each line separately.
FIRST LINE - Building
The first line represents the historical value of the building. Recall, The Toy Company received a
bank loan on July 1, 200X. The bank loan was used to purchase a $22,500 building. Therefore,
the historical cost of the building is $22,500.

The building's historical cost account on the balance sheet will always remain at $22,500 unless
any of the following events occur;

1. Major renovations are made to the existing building;

2. If the Toy Company's sells the existing building; or

3. An additional building(s) is purchased by the company.

Notice the building was purchased using borrowed money. Although, the bank loan was used to
buy the building, it's still considered an asset of The Toy Company. Our point is this,

DON'T think of an asset (current or fixed) as something a business owns. Rather, view an
asset as a resource that can be used to strengthen a business. Although, The Toy Company
doesn't really "own" the building, it's still considered the company's fixed asset. It's an
economic resource that can be used to strengthen their business. In addition, when assets are
purchased with borrowed money, an asset account and a liability account will be created and
placed on the Balance Sheet. This will become clearer to you when we discuss the liabilities
section of balance sheet.

SECOND LINE - Less Accumulated Depreciation - Building

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

As you can see, the "less accumulated depreciation" account shows an amount of $2,250 on
December 31, 200X. To explain how this was calculated, we will have to refer back to the
assumptions section of our example. Recall;

"Donald's accountant suggested the building will have a useful life of 5 years and will be
depreciated in equal amounts per year over these 5 years using a straight line method of
depreciation. Therefore, depreciation expense on the building for one full year will be $4,500
($22,500 divided by 5 years = $4,500 per year)."

Notice the above assumption indicates that deprecation expense will be $4,500 for one full year.
In other words, the accountant is estimating the building will reduce in value each year by
$4,500. Since the building was purchased on July 1, 200X, it has only depreciated 6 months
(from July 1 to December 31 = 6 months). Therefore, the depreciation expense and accumulated
depreciation as of December 31, 200X would be half of the yearly amount or $2,250. If you look
at the amount in the accumulated depreciation account on December 31, 200X, you will see
$2,250. If the building had been purchased on January 1, 200X, then the full depreciation rate of
$4,500 would apply.

What amount will appear in the accumulated depreciation account on December 31, 200Y (one
full year from the December 31, 200X). To answer this, we must determine the amount the
building is estimated to depreciate each year. This was already calculated above to be $4,500 per
year ($22,500 / 5 years = $4,500).

Since the accumulated depreciation account "tallies" the depreciations for each year, the amount
showing in the accumulated depreciation account on the December 31, 200Y balance sheet
would be $6,750 ($2,250 depreciation from July to December 200X + $4,500 depreciation from
January to December 200Y = $6,750). Below shows the changes in the accumulated depreciation
account from December 31, 200X to December 31, 200Y.

Dec. 31 Dec.
200X 200Y

Building (5 year life) $22,500 $22,500

Less: Accumulated Depreciation - Building $ 2,250 $ 6,750

Net Building $20,250 $15,750

THIRD LINE - Net Building

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

The third line (Net Building) is calculated by subtracting the total reduction in economic value of
the building (depreciations over the years) from the historic cost of the building. The result is
known as - Net Building. The Net Building estimates the value of the building on the balance
sheet date. Therefore, on December 31, 200X the building is estimated to be worth $20,250.

What is the building's estimated worth at the end of the company's second year of operation (IE
on December 31, 200Y). To determine this, we will have to know the historical cost of the
building and the accumulated depreciation of the building on December 31, 200Y. The historical
cost of the building is known ($22,500) and the accumulated depreciation as of December 31,
200Y has already been calculated. The following chart has been extracted from above;

Dec. 31 Dec. 31
200X 200Y

Building (5 year life) $22,500 $22,500

Less: Accumulated Depreciation - Building $ 2,250 $ 6,750

Net Building $20,250 $15,750

Therefore, the building would have an estimated value (worth) of $15,750 on December 31,
200Y. The building reduced in value by $4,500 from the previous year. The $4,500 is the
depreciation or reduction in value estimated by The Toy Company's accountant.

This concludes our discussion on The Toy Company's fixed assets. Remember that all fixed
assets will consist of three lines;

1. The name and historical cost of the fixed asset

2. The accumulated deprecation of the fixed asset; and

3. The NET fixed asset name and its estimated worth

The next balance sheet item to be discussed will be Total Fixed Assets.

Total Fixed Assets

Total Fixed Assets is the sum of all the Net Fixed Assets listed on a company's balance sheet. As
indicated below, The Toy Company has Total Fixed Assets on December 31, 200X valued at
$26,500.

Fixed Assets:

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

Total Fixed Assets $26,500

As you can see, Total Fixed Assets of $26,500 was arrived at by adding the Net Office
Equipment of $6,250 to the Net Building of $20,250. In essence, on December 31, 200X The
Toy Company Total Fixed Assets are estimated to be worth $26,500. The next section explains
Total Assets.

Total Assets:
Total Assets are the sum of the total current assets and the total fixed assets. Below depicts The
Toy Company's current assets and fixed assets as of December 31, 200X.

Total Assets of The TOY Company as of December 31, 200X

Assets:

Current Assets:

Cash $10,122

Accounts Receivable $ 5,000

Prepaid Fire Insurance $ 1,200

Inventory $12,558
Total Current Assets $28,880

Fixed Assets:

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

Total Fixed Assets $26,500

TOTAL ASSETS $55,380

As you can see, The Toy Company has Total Assets on December 31, 200X of $55,380 In other
words, The Toy Company's assets on December 31, 200X have an estimated value of $55,380.
This concludes the total assets section as well as the Asset Component of the Balance Sheet.
Next we will look at the Third Component of the Balance Sheet, namely Liabilities.

LIABILITIES (third component of the Balance Sheet)

Thus far we have discussed the first two components of the Balance Sheet, namely the Heading
and the Assets. The third component of the balance sheet is known as Liabilities. Liabilities are
those items a business owes to other businesses, governments, shareholders, employees, and so
on. Think of liabilities as items placing an economic burden onto a company. Examples of
liabilities include accounts payable, taxes payable, interest payable, wages payable, bank loan
payable, property taxes payable, and mortgage payable.

Like Assets, Liabilities are broken down into two classifications;

1. Current Liabilities

2. Long-term Liabilities

Current Liabilities are liabilities that are due in a short period of time; - usually within one year
or less. Long-term Liabilities, on the other hand, are liabilities that require payment beyond a
company's operating cycle (ie longer than one year). Lets look at both classification of liabilities
and examine examples of each.

Current Liabilities:
As mentioned above, current liabilities are items a company owes that must be paid within one
year. Examples of current liabilities would include; accounts payable, wages payable, property
taxes payable, insurance payable, interest payable, notes payable, taxes payable, utilities payable,
short-term bank loan payable and so on. The Toy Company's Current Liabilities on its Balance
Sheet as of December 31, 200X are as follows;

Current Liabilities:

Accounts Payable $12,254

Income Taxes Payable $ 5,676

Short-Term Loan Payable $ 5,179

Total Current Liabilities $23,109

Let's look at each of The Toy Company's current liabilities; beginning with Accounts Payable.

Accounts Payable
An account payable is a short-term liability a company incurs when it purchases items on credit.
Furthermore, many businesses buy inventory, offices supplies, office equipment, store supplies,
etc. and elect to pay for them at a later date. As of December 31, 200X, the Toy Company still
owes $12,254 for office supplies, equipment, store supplies, inventory, and so on. As the
company pays for these items, the account balance ($12,254) will decrease. Also, when the
company purchases more items on credit, the accounts payable increases.

Accounts payable are considered current liabilities because payment is usually due in less than
one year. Further, a company offering credit will usually request payment within 30, 60, or 90
days from the date of payment.

Income Taxes Payable

The second current liability shown on The Toy Company's balance sheet is income tax payable.
Businesses, like individuals, must pay taxes on the income they make. The amount of income tax
obligation a business is responsible for depends upon several factors. Four important factors
include;

1. Whether the business is a sole-proprietorship, partnership or corporation. Sole proprietorships

and partnerships are generally taxed at the same rate as individuals (non business owners).
Corporations have their own tax rates and rules.

2. The amount of income made by the business. Established tax rates or percentages have been
created for income levels for geographic areas. A tax percentage is multiplied by a company's
Net Income Before Taxes to arrive a businesses' income tax obligation.

3. State/provincial tax rate applied to taxable income. Each state and province has their own
state/provincial tax rate or percentages. Therefore, before a business can calculate its tax
obligation, it must first know the state/provincial tax rates at the various income levels.

4. Whether tax credits are available to the business. Some states and federal governments will
provide tax credit to companies to encourage more business start-up. Business tax credits will
ultimately reduce the amount of tax a company pays.
Income tax is an extremely specialized field and should be left to professionals. If you are an
existing business owner, chances are you already have an accountant preparing your tax returns.
If however, you are planning to open a business and preparing your financial forecasted
statements, it would be wise to contact an accountant. The accountant will be able to tell you the
tax rates, at different levels of income, for your particular state/province and country. Now lets
return to our Toy Company example. The following assumption applies to our example.

"The Net Income before taxes for the Toy Company in 200X (from January 1 to December 31) is
$14,190. Donald's accountant determined a tax rate of 40% would apply to the net income before
tax. Therefore, the income taxes to be paid will be $5,676 ($14,190 x 40% = $5,676). As of
December 31, 200X, the tax obligation has not been paid and therefore is considered income
taxes payable".

Remember that Net Income Before Taxes must be calculated before a business can determine its
income tax obligation. Net Income Before Taxes is a calculated by subtracting business expenses
from business revenues. After the Net Income Before Taxes have been calculated, an accountant
will apply a percentage(s) to this amount to arrive at your tax obligation. Moreover, The Toy
Company's Net Income Before Taxes (Revenue - Expenses) was $14,190. The accountant
applied a rate of 40% to arrive at The Toy Company's tax obligation. In other words, the
company is obligated to pay $5,676 in income tax ($14,190 x 40% = $5,676). Since the company
didn't pay the income tax as of December 31, it's considered a payable. When the company pays
the tax, the income tax payable account will be reduced to zero. For more information on how to
calculate net income before taxes, refer to the Income Statement.

Income tax payable will always be considered a current liability since payment is due in less than
one year. The Toy Company will most likely pay the $5,676 tax obligation before April 30,
200Y. Depending on where you live, laws are in place that require businesses to pay income tax
on an installment basis. Be sure you discuss this matter as well as other tax issues with an
accountant.

Short-Term Loan Payable

Short-term loans that require payment in less than one year are classified into an account called
Short-Term Loan Payable. For example, on August 10, 200X The Toy Company received a
$7,000 short-term loan (1 year) from a local bank. The loan is considered a current liability
because it's due in less than one year. The company is required to make monthly payments on the
loan until it's fully paid on July 30, 200Y. As of December 31, 200X the outstanding balance
owed on the loan is $5,179 (see balance sheet above). This means that from August to
December, 200X, the company paid $1,821 on the loan ($7,000 - $5179).

Long-Term Liabilities:
The second classification of business liability is called Long-Term Liability. As mentioned
earlier, a long-term liability is money owed by a business that must be paid beyond a company's
operating cycle. In other words, it is debt that is due beyond a one year period. To put liabilities
into perspective we can say;
Current liabilities are debts that must be paid in one year or less,
while long term liabilities are debts that must be paid sometime beyond one year.

Examples of long term liabilities include; a 3 year business bank loan, a 5 year business car loan,
a mortgage on a corporate building, a 2 year loan from a family members who invests into your
company, and the list goes on and on. Think of a mortgage on your house for a moment. Your
house mortgage is a long-term liability to you personally - not your business. Therefore, the
balance sheet for your business would not include your house mortgage as a long term liability.
In other words, personal items are personal items and business items are business items; they are
considered to be separate entities.

The Toy Company's Long-Term Liabilities on its Balance Sheet as of December 31, 200X are as
follows;

Long-Term Liabilities:

Mortgage on Building $19,757

Mortgage on Building
Recall under the assumption section of our example, the following;

"On July 1, 200X, The Toy Company received a 10 year, $22,500 loan. The loan was needed to
purchase a building. The building will be used to sell the company's preassembled toys".

The $22,500 dollars is a loan the company must pay back to the bank. All loans are considered
liabilities and since the loan is payable over 10 years, it is considered a long term liability. On
December 31, 200X the balance owning on the Mortgage is $19,757. As you can see, the loan
has reduced from $22,500 down to $19,757 in half of one year (July to December, 200X). This
reduction represents the amount of principal the company paid on the loan. Therefore, it's safe to
say the Toy Company paid $2,743 in principal payments ($22,500 - $19,757).

Total Liabilities
Total Liabilities represent the sum of all Current Liabilities plus the sum of all Long Term
Liabilities. Simply stated Total Current Liabilities plus (+) Total Long-Term Liabilities = Total
Liabilities ($23,109 + $19,757 = $42,866). Below depicts the Liabilities of the Toy Company as
of December 31, 200X.

LIABILITIES:
Current Liabilities:

Accounts Payable $12,254

Income Taxes Payable $ 5,676

Short-Term Loan Payable $ 5,179

Total Current Liabilities $23,109

Long-Term Liabilities:

Mortgage on Building $19,757

TOTAL LIABILITIES $42,866

As of December 31, 200X, The Toy Company owes $42,866 dollars to other businesses (banks,
governments and other businesses). $23,109 is required to be fully paid within one business year
(short-term liabilities), while $19,757 is required to be paid later than one year (long-term
liabilities). This concludes the Liabilities section of the Balance Sheet. The next component of
the balance sheet is called the Equity section.

EQUITY (fourth component of the Balance Sheet)

To date, we have discussed the Heading component of the balance sheet, the Asset component of
the balance sheet, and the Liability component of the balance sheet. The fourth and final
component of the balance sheet is known as Equity.

The equity section of the balance sheet represents all investments made into a company. Equity
comes in the form of cash investments or other asset investments. Other asset investments might
include personal items invested into a company by its owners such as office equipment, office
furniture, automobile, and land. When such items are invested by their owners, it's imperative
that each item be appraised and shown on the company's "books" at their current market value.
It's important to note that personal assets invested into a business become the property of the
business and should appear under the company's asset section of the Balance Sheet.

The appearance of the equity section will depend on the Legal Form of Your Business (sole-
proprietor, partnership or a corporation). Moreover, the equity section of a corporation is quite
different for the equity section of a sole proprietorship and a partnership. Lets look at the equity
section for each form of business structure, starting with the equity section of the balance sheet
for a sole proprietor.

The Equity Section for a Sole Proprietor

A sole proprietorship is a business owned by only one person. The equity section of a sole
proprietorship is rather simple. It consists of only one account called CAPITAL. Capital can be
referred to as an owner's direct investment into their company. These investments usually occur
within the initial stages of the company's formation, however, a owner may contribute cash or
other assets into the company at anytime. Recall under the assumption section of our example the
following;

"Donald Sutherland is the sole-proprietor of The Toy Company. He invested his life savings of
$10,000 (cash) into the business. The Company buys preassembled wooden toys from a supplier
in Maine and sells them to end consumers (you and I). Donald registered the company as a sole
proprietor on January 1, 200X and has been operating it since then".

Three important points stem from the assumption;

1. The business is a sole proprietorship

2. Donald invested $10,000 cash into the company on January 1, 200X
3. No additional investments (cash or other assets) were made.

On January 1, 200X The Toy Company accounting records would show a capital account with a
balance of $10,000. In essence, Donald gives The Toy Company $10,000 cash, in return, for a
capital account valued at the same amount.

If you're an existing sole proprietor and print off your financial statements every month, you may
notice a different capital account balance each month. Did you every wonder why? Well it's
simple, the capital account will always change if one of the following events occur;

1. When additional cash or other assets are invested into the company

2. When the owner withdraws cash from the business

3. When the company makes a profit or incurs a loss (income statement)

To illustrate this point, lets examine the changes that occurred in the Toy Company's Capital
Account from January 1 to December 31, 200X. Recall, the capital account on January 1, 200X
had a balance of $10,000. And on December 31, 200X, the capital account has a new balance of
$12,514. Below shows the change in the capital account from January 1 to December 31, 200X

Equity: January 1 December 31

200X 200X

Capital - Donald Sutherland $10,000 $12,514

How did the capital account change from $10,000 to $12,514 during this period? Remember
from above, the only way a capital account changes is if Donald invests additional assets (cash or
other assets) into the company, withdraws money from the company, or if the company makes a
profit or a loss.

We have to refer back to the assumptions section of our example to answer the following
question that will show us how The Toy Company's capital account changed.

1. Did Donald invest additional cash or other assets into the company during the business year
(January to December 200X)? Nowhere in our assumptions does it tell us that Donald made
additional investments. Therefore, we can assume that he didn't.

2. Did Donald withdraw any money from the business? The assumptions section tells us that
Donald drew $500 cash each month, for a total of $6,000 over the year ($500 x 12 months =
$6,000). Owners of sole proprietorships and partnerships withdraw cash from their company in
order to pay personal expenses, for instance. Think of a withdrawal as a reduction of an owner's
investment in the company. A withdrawal is not a wage expense or a salary expense since
owners of unincorporated business, such as sole proprietorships and partnership, cannot enter
into a legal binding contract with him or herself to hire and to pay him or herself a salary.
Moreover, a wage is an expense that doesn't reduce the owners investment. A drawing is not an
expense and does reduce the owner's investment account (IE capital account).

3. Did Donald's Company make a profit or incur a loss? Yes, every company either makes a
profit or incurs a loss. Under the assumptions section of our example, we know that the company
made a Net Income After Tax (profit) of $8,514. A Net Income After Tax is added to a sole
proprietor's capital account because the owner automatically invests it back into the company. A
Net Loss, on the other hand, reduces the capital account because the owner will have to "dip"
into his/her investment to absorb the loss. In order for Donald to determine if the company made
a profit or incurred a loss, he would have to develop an income statement of the year ending
December 31, 200X.
Those are the only three questions Donald must answer in order to determine the new capital
account balance on December 31, 200X. Here's how the new account balance would be
calculated;

Beginning capital account balance as of January 31, 200X $10,0

Add: Additional investments made during 200X by Donald $ 0.0

Add: Net income After Tax as of December 31, 200X $ 8,5

Less: Total withdrawal as of December 31, 200X ($6,0

Equals: New Capital Account as of December 31, 200X $12,5

Notice, the beginning capital (Donald's initial investment into the company of $10,000 is added
to Donald's other investments made into the company during the year ($0.00) and to the profit
made by the company during the business year ($8,514). The sum of these three items represent
the new total investment in the company. Donald's cash withdrawals represent a reduction of his
overall investment and therefore are subtracted from his total investment or capital. The end
result is known as the new or ending capital account balance ($12,514). Now lets look at the
equity section of the balance sheet for a partnership.

Equity Section for a Partnership

A partnership type of business involves more than one owner. For instance, a partnership
business could consist of two, three, four, or fifty owners. The equity section of the balance for a
partnership is the very same as that of a sole proprietor. A partnership also uses a capital account
to keep track of each owner's investment. In other words, a sole proprietor has one capital
account to track the sole owner's investment, while a partnership has a capital account for each
owner. For instance, a partnership with five owners would have five capital accounts; one for
each of the owners.

The Toy Company is a sole proprietorship, with Donald Sutherland being the only owner. Lets
assume for a moment that on January 1, 200X Donald and his friend Bill Jones formed a
partnership and each invested $10,000 into The Toy Company. Therefore, on January 1, 200X
the equity section of the balance sheet would look like this.
EQUITY:

Capital - Donald Sutherland $10,000

Capital - Bill Jones $10,000

As of January 1, 200X (their first day of operation), Donald and Bill each own $10,000 of the
business. No other investments were made by either owner. Lets further assume, they develop a
partnership agreement that simply states; "profits and losses will be shared equally. This means
50% of the profits or losses go to Donald and 50% of all profits or losses go to Bill. Over the
year (January 1 to December 31), Donald withdrew $6,000 cash from the company and Bill
withdrew $9,000 cash from the company. Lets also assume that the 200X net income after tax for
the Toy Company (partnership) remains at $8,514. What amounts would appear in each capital
account on December 31, 200X.

To calculate this, we need to answer the following questions;

1. Did either partner invest additional cash or other assets into the company after January 1,
200X? Assume no additional investments were made by either party after January 1, 200X.

2. How much did each owner withdraw for the company during the business year? Donald
withdrew $6,000 cash and Bill withdrew $9,000 cash from The Toy Company.

3. What was the Net Income after Tax as of December 31, 200X and how is it shared between
the partners? The Net Income After Tax is assumed to be $8,514 and will be shared 50 - 50. That
means, Donald's share of the profit is $4,257 ($8,514 x 50%) and Bill's share of the profit is also
$4,257 ($8,514 x 50%).

Now the ending capital account balances for each partner can be calculated.

Donald

Beginning capital account balance as of January 31, 200X $10,000

Add: Additional investments made during the year $ 0.00

Add: Partner's share of Net Income $ 4,257

Less: Total withdrawals as of December 31, 200X ($6,000)

Equals: New Capital Account as of December 31, 200X $ 8,257

Therefore, the equity section on the company's December 31, 200X balance sheet would look
like this;

EQUITY:

Capital - Donald Sutherland $ 8,257

Capital - Bill Jones $ 5,257

Total Equity $13,514

As you can see, Donald's capital account is larger than his partners' by $3,000. Although, they
both invested the same into the company ($10,000) and share the net income equally (50-50),
Donald's investment account is larger. The reason for this difference lies in the amount of cash
withdrew by each partner; Bill took $3,000 more cash drawings from the company than Donald.
As a result, Bill has less invested into the company than his partner as of December 31, 200X.

This concludes the equity section of a partnership's balance sheet. Notice that the only account
appearing under the equity section of a partnership and a sole proprietorship's is capital; one
capital account for a sole proprietorship and one capital account for each owner of a partnership.
Also notice, the capital account balances constantly change as a result of three factors;

1. Additional investments (cash or other assets) made into the business;

2. The withdraws of cash or other assets from the business; and

3. The net income made by the company.

These are the only factors that affect the capital account of a sole proprietor ship and a
partnership. Let's now look at how a corporation's equity section appears on the balance sheet.

The Equity Section for a Corporation:

As we have seen above, the equity section of a sole proprietorship and a partnership consist of
only one account called capital. The equity section of a corporation, however does not use the
capital account to illustrate the investments made into the company. Rather it uses "shares"
accounts to show all the investments contributed by its owners. In addition, a corporation is
required by law to distinguish between the company's investors (contributed capital by its
owners) and the company's earnings over the years. Therefore, corporations use accounts called
common shares, preferred shares (and/or other classes of shares), along with an account called
retained earnings. The shares account show the investments made by owners (shareholders) into
the company. The retained earnings account keeps track of all the company's earnings and all the
dividends paid to the owners (shareholders) over the years of the corporation's life.

A graphical view of a typical corporation's equity section would be;

SHAREHOLDER'S EQUITY:

Common Shares $XXXXX

Retained Earnings $ XXXX

Total Shareholders Equity $YYYYY

Notice the title of the equity section of a corporation is called Shareholders Equity. Don't be
confused with the term shareholder. It simply means all the people who own a share or portion of
the corporation. A corporation can have one shareholder or 100 million shareholders. To further
explain a corporation's equity section of the balance sheet, lets assume the following;

1. Donald Sutherland, Bill Jones and three other people formed a corporation on January 1,
200X.

2. Each of the five people invested $4,000 in the corporation by buying 1,000 shares of its
common stock. Therefore, the total investment by the shareholders was $20,000 ($4,000 * 5
investors).

3. The corporation earned $12,000 in its first year of operation (January 1 to December 31,
200X).
4. The Corporation's board of directors declared and paid dividends of $5,000 during 200X

On December 31, 200X (the corporation' year end) the Shareholders' Equity section would look
like this.

SHAREHOLDER'S EQUITY

Common Shares $20,000

Retained Earnings $ 7,000

Total Shareholders Equity $27,000

Notice the common shares depict the investment made by the owners (5 shareholders x $4,000
invested by each = $20,000). The retained earnings, on the other hand, are comprised of two
items;

1. The earnings (net income after taxes) of the corporation over the years.

2. The dividends paid to shareholders of the corporation. A dividend is similar to a withdrawal

taken by owners of a sole proprietorship or a partnership. A corporation's board of directors
declare when dividends will be given to its shareholders or owners. In this example, the board of
directors declared $5,000 dollars of dividends during the 200X business year.

To calculate the retained earnings simply add the beginning retained earnings to the current
year's net income (or net loss) and subtract any dividends. The following chart shows how the
ending retained earnings were calculated for our corporation example.

Beginning retained earnings (as of January 1, 200X)

Add: Net income(loss) after tax for 200X

Less: Dividends declared and/or paid during the year

Equals Ending Retained Earning for December 31, 200X

The beginning retained earnings has an account balance of zero because this is the first year of
the corporation's operations. Therefore, prior to January 1, 200X, the corporation would not have
any earnings nor dividends.

The $12,000 represents the corporation's net income for the year (from January 1, 200X to
December 31, 200X). The $5,000 represents the dividends that had been either declared or paid
to the shareholders during 200X. In summary, beginning retained earnings account is added to
the net income or net loss to arrive at the new contributed capital amount. Dividends are then
subtracted to give us the ending retained earnings. The December 31, 200X ending retained
earnings ($7,000) will become the beginning retained earnings for the 200Y business year.

In summary, the equity section of a corporation shows the same items as the equity section of a
sole proprietorship or a partnership. The only difference, however, is the name applied to the
accounts. Moreover, a unincorporated business only shows a capital account for each owner,
while an incorporated business shows a shares account and a retained earnings account. Below
summarizes the structure for each type of business.

Sole Proprietorship Partnership Corporation

Capital - Donald Sutherland Capital - Donald Sutherland Common Shares

Capital - Bill Jones Other Classes of Sha

Retained Earnings

You are advised to consult an accountant and/or a lawyer to determine which business structure
is best for you. Sole proprietorship and partnerships can be set up without the assistance of a
professional, however, we do suggest you utilize their services. The need for these professionals
greatly increases when setting up a corporation. Now let's look at how to calculate total equity.

Total Equity
The total equity calculation will depend upon the legal structure of the business (a sole
proprietorship, a partnership and a corporation). Total Equity for a sole proprietorship will
simply be the amount specified in the owner's capital account. As presented below, Donald's
capital account on December 31, 200X shows an account balance of $12, 514. Therefore, The
Toy Company's total equity is $12,514 .

Equity:

Capital - Donald Sutherland $12,514

Total Equity $12,514

Remember, the capital account was calculated by adding the Net Income After Tax of $8,514
(from the income statement) to Donald's investment in the company of $10,000 and subtracting
Donald's drawings over the business year of $6,000. ($10,000 + $8,514 - $6,000 = $12,514).

The total equity of a partnership is calculated by totalling all the ending balances in each owner's
capital account. In our partnership example, the ending capital account balances for Donald
Sutherland and Bill Jones are as follows;

EQUITY:

Capital - Donald Sutherland $ 8,257

Capital - Bill Jones $ 5,257

Total Equity $13,514

Therefore, the total equity for the partnership would be $13,514. Be sure to understand that the
ending capital account balances for each owner is calculated in the same fashion as for a sole
proprietorship. (Initial investment + any other cash or other asset investment made during the
year + portion of each partner's net income after taxes (or loss) - each partner's drawings during
the year).
The total equity of a corporation is calculated by adding the value of all contributed capital
(common shares, preferred shares, etc) to the ending balance in the retained earnings account.
The contributed capital account(s) changes as more shares are sold, while the retained earnings
account changes as earnings are made, loses are incurred, and when dividends are declared.

The final caption of the balance sheet is the total liabilities and equity.

Total Liabilities and Equity

The Total Liabilities (current liabilities + long-term liabilities) are added to the Total Equity to
arrive at the company's Total Liabilities and Equity account balance. The Toy Company's total
liabilities as of December 31, 200X amount to $42,866 and its total equity as of December 31,
200X amount to $12,514. Therefore the company's total liabilities and equity as of December 31,
200X amount to $55,380. See Below:

The TOY Company

Balance Sheet
As of December 31, 200X

ASSETS:

Current Assets:

Cash $10,122

Accounts Receivable $ 5,000

Prepaid Fire Insurance $ 1,200

Inventory
$12,558

Total Current Assets $28,880

Fixed Assets:

Office Equipment (2yr life) $12,500

Less Accumulated Depreciation $ 6,250

Net office Equipment $ 6,250

Building (5 year life) $22,500

Less Accumulated Depreciation $ 2,250

Net Building $20,250

Total Fixed Assets $26,500

TOTAL ASSETS $55,380

LIABILITIES:

Current Liabilities:

Accounts Payable $12,254

Income Taxes Payable $ 5,676

Short-Term Loan Payable $ 5,179

Total Current Liabilities $23,109

Long-Term Liabilities:

Mortgage on Building $19,757

TOTAL LIABILITIES $42,866

EQUITY:

Capital - Donald Sutherland $12,514

TOTAL EQUITY $12,514

TOTAL LIABILITIES & EQUITY $55,380

Notice the value of the company's Total Assets as of December 31, 200X is $55,380. As you can
see, the Total Assets equal the same balance (value) as the company's Total Liabilities & Total
Equity. This is how the balance sheet receive its name. Moreover, the total assets must
ALWAYS equal (balance) the sum of the total liabilities and equity account. If these two
amounts do not balance, then the balance sheet is incorrect (IE it's out of balance).