How to Calculate and Understand Your Balance Sheet

Simply stated, a balance sheet is a statement of your business' worth: a snapshot of your business position on a given day, usually calculated at the end of the month or quarter. It is a listing of assets (what your business owns), liabilities (what your business owes), and equity-- the net worth of the business (the difference between your assets and liabilities). These numbers change on a daily basis, but it’s important that every small business owner knows and understands them.

Check out the chart of accounts on your software program. For QuickBooks, go to Lists on the top ruler bar and select Chart of Accounts. This will show how every account is classified. The first main headings of assets, liabilities, and equity are the accounts that appear on the balance sheet. The accounts under the two main headings of income and expenses comprise the profit and loss statement.

Assets are broken down into sub-categories.

Current Assets are composed of assets that can be liquidated in a year or less. For example: cash in the bank, petty cash funds, accounts receivable, inventory and prepaid expenses.

Prepaid expenses are expenses incurred for a long term, but paid for immediately, such as equipment maintenance agreements spanning more than one year, or insurance policies with coverage extending beyond the current year.

For example, if you purchase a liability policy for $3,600 on July 1 with coverage from July 1 to June 30 of the following year, your accountant will set up this policy as an asset on the balance sheet rather than as an insurance expense on your income statement. Each month, $300 (1/12 of $3,600) will be taken out of prepaid insurance and placed on the income statement as an expense for that month. You can see the result: your income statement for July will not be distorted by the inclusion of a $3,600 expense that is truly an expense to be spread over a one-year period. Your profit margin will be higher on the income statement. Your net worth will be higher on the balance sheet because the asset side is increased by $3,600, and you will be in compliance with taxing agencies that require prepaid expenses to be allocated in this manner. Generally, you cannot write off the entire $3,600 in one calendar year; you must write off the last six months of coverage (Jan. 1 through June 30) in the subsequent year. After posting a prepaid expense, it’s a simple matter to set up a memorized transaction in most accounting software products that will automatically allocate the expense from the balance sheet to the profit and loss on a monthly basis.

Fixed assets are items that have a life of more than one year. These may include: an automobile used in the business, machinery and equipment, office furniture and leasehold improvements.

Goodwill and covenant not to compete are intangible assets. You cannot create values for these and place them on the balance sheet if you started the business on your own. You can only show these items if they were allocated from the cost of a business you purchased. Someday you may sell your business. When you do, you may assign a value to goodwill and covenant not to compete as part of the sale price of the business. Intangibles can be written off over a fifteen-year period.

Liabilities can be short term (payable in one year or less) or long term (payable in more than one year). Short-term liabilities may include accounts payable, payroll taxes payable, business credit cards payable, sales taxes payable, customer deposits on work in process, or security deposits made to your business.

Equity is the difference between liabilities and assets. It is a balanced number, not the result of subtraction, and is made up of subdivisions based on your legal form.

Sole proprietors and partnerships: If your legal form is sole proprietor or partnership, equity involves beginning net worth, owner contributions, owner withdrawals and fiscal year earnings. Beginning net worth is a summary of your capital account from prior years. It is the total of contributions, fiscal year earnings, and withdrawals.

Beginning net worth + contributions - draws +/- profit or loss = net worth.

An owner contribution is the amount of money and the value of personal property you put into the business from your personal holdings. If you deposit $500 from your personal savings account into your business checking account, you need to identify this separately from sales.

A contribution from your personal funds is not taxable income, and it will be classified under equity contributions. Contributions also include the value of any personal property you contribute to the business (furniture, equipment, etc.).

An owner withdrawal is the amount of money or goods you take out of the business for personal use and does not include expense reimbursements.

Fiscal year earnings are the bottom line from your year-to-date income statement. A profit increases your net worth; a loss decreases your net worth.

At year-end owner contributions, owner withdrawals, and fiscal year earnings accounts are summarized into one line item to be carried forward to the next year in the form of beginning net worth.

For example, in your first year of business, you deposited from savings a total of $10,000 for the year, your draw checks totaled $5,000. Your profit and loss at the end of the year reflected a profit of $7,000. Your beginning net worth going into the next year of business will be increased by $12,000.00: ($0.00 + 10,000- 5,000+ 7,000= $12,000)

Corporations: If your legal form is corporate, equity includes stock, paid-in cap ital, fiscal year earnings, dividends paid, and retained earnings.

Each stockholder in the company purchases shares. That value is reflected as a separate line item entitled "stock" under equity on the balance sheet.

Paid-in capital is the value of personal property or monies paid in to the corporation that is not otherwise classified as a loan or as an exchange for stock. If paid in by the shareholders of the corporation it is not taxable income to the corporation.

Retained earnings are the corporation's prior years' accumulated earnings. At the end of the year fiscal year earnings (profit or loss) are added to retained earnings, increasing or decreasing the net worth of the corporation.

Fiscal year earnings are the net profit or loss reflected on the year-to-date income statement. This figure is carried over to the balance sheet and is included in the equity accounts.

It is important to have a professional set up the beginning balance sheet for you—it can be tricky, and I have found that most of the accounting errors on a set of books are balance sheet issues.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.