The Balance Sheet Effect
The balance sheet is a valuable statement in your set of financials. When most entrepreneurs start up their business, they tend to focus primarily on the income statement. Rightfully so, as that is the statement that shows their operations. However, the statement they don’t pay much attention to, or don’t truly understand, is the balance sheet. The best way to understand a balance sheet is when you think of it as a representation of what your company is owed, and what your company owes at a single point in time.
It is a snapshot of the fiscal moment.
The balance sheet is made up of your assets, liabilities, and owners equity. The textbook formula for the balance sheet is Assets = Liabilities + Equity. This is what makes a balance sheet…well…balance.
But why is the balance sheet so important? One word, cash. Most balance sheets have cash as the first line item, and yes this is reconciled to your respective bank account. However, the cash line item on the balance sheet is only one aspect of the balance sheet. The other accounts on the balance sheet all have an effect one way or another on the actual cash balance of the organization. But before you can analyze the cash position of your company, you must ensure that all material balances are reasonable.
In the auditing world there is a phrase, “tie out the balance sheet.”
What does this actually mean? Well, simply, it means that all the line items on the balance sheet have supporting documentation that supports, or ties, to the balance. When you have an audit performed by an independent auditor, this is their main task. They are ensuring there is supporting information for every material balance.
How do you tie out your balance sheet?
First, make sure that you have reports to support the balance. Sometimes clients misunderstand this to mean the general ledger detail equals the balance on the balance sheet. Most of this time, this is not the case.
For example, your general ledger detail for your accounts receivable balance may indicate $100,000. However, your accounts receivable subsidiary ledger, the detail ledger that breaks out your individual customers and what each of them owe you, indicates $90,000.
Which is correct?
Most of the times in these situations your subsidiary ledger is correct. However, you still need to tie out the report to the general ledger or control account, which then leads to the balance sheet.
Let’s continue this example and say that the subsidiary ledger balance of $90,000 is correct and the reason the AR balance on the general ledger is $100,000 is due to a $10,000 expense mis-posting. The $10,000 should have gone to the income statement as an expense item.
In this situation, if the balance sheet had not been tied out, two drastic decisions could have been made:
- The first is the net income would have been overstated by $10,000.
- The second is the accounts receivable, which usually converts to cash at a point in the future, would have been overstated by $10,000.
Using this faulty financial information, the owner of the company could have erroneously decided to give out bonuses or dividends thinking they:
- Had net income higher than actual.
- Had the future cash resources.
The income statement is ultimately the change in the balance sheet accounts from one period to the next. So the importance of tying out the material balance sheet accounts is paramount to any management decision.
This leads back to the overall importance of the balance sheet effect–cash.
When you make a decision on the direction your company is headed, you first see how much cash you have and how much cash you will need. Errors in your balance sheet will impact not only your true cash position, but your overall management decisions.
In our next blog post, we will discuss how to read a balance sheet and tips and tricks to look out for when reading a balance sheet.
Steven D Hovland is a Certified Public Accountant and a Certified Forensic Accountant. He has 20+ years experience in auditing, accounting, and forensic investigations. He is the founder of Hovland Forensic and Financial, a virtual CFO service company as well as forensic litigation services.
For a free consultation https://hovlandforensic.com/scheduling