How to prepare balance sheet

2. Classifications on balance sheet

All balance sheets are normally classified: that is, different financial elements on a balance sheet are grouped into categories and presented under a common caption. This is a general practice that helps to compare balance sheets of different companies. You can see an example below. For instance, if there are two companies within different industries, they may have different items (components) going into the Current Assets category. However, due to this classification rule, it may sometimes not be as relevant to compare components of current assets. Instead, you may just compare the total current assets of the two companies, and that may be all you need in your analysis.

Illustration 1: Example of classifications on the balance sheet (horizontal)

Assets

Liabilities

Current Assets

Current liabilities

Investments

Non-current liabilities

Fixed Assets

 

Intangible Assets

Equity

Other Non-current Assets

Common Stock

 

Retained Earnings

The example above shows a balance sheet in a horizontal format: Assets are on the left side, and Liabilities and Equity are on the right side. It is also possible to present a balance sheet in a single column format (vertically) as follows:

Illustration 2: Example of classifications on the balance sheet (vertical)

Assets

Current Assets

Investments

Fixed Assets

Intangible Assets

Other Non-current Assets

 

Liabilities

Current liabilities

Non-current liabilities

 

Equity

Common Stock

Retained Earnings

It is a matter of preference, but normally balance sheets are presented vertically as shown in Illustration 2.

Important term to remember, as we discuss balance sheet classifications further, is a balance sheet date. A balance sheet date is the date as of which the balance sheet is prepared. For example, most businesses prepare their balance sheets at least once a year as of December 31. However, the balance sheet date is not the date when a balance sheet is actually prepared and becomes available.

As you may have noticed in Illustration 1, assets are on the left side, and liabilities and equity are on the right side. There is a reason why they are presented liked that. Total assets equal the sum of total liabilities and total equity. This is a fundamental accounting equation that results in this equality:

Assets = Liabilities + Equity

This equation must hold true in any balance sheet, and if it doesn't, then it is due to an error somewhere in the balance sheet. You can use this rule in situations where your assets don't equal your liabilities and equity.

The reason the equation must hold true is because assets are economic resources of a business used to accomplish its main goal, i.e. increase owners' wealth. Liabilities and equity are the sources of such assets. In other words, liabilities and equity show where assets were obtained from. Liabilities are claims of third parties for resources provided to the business (e.g. creditors). Equity is claims of business owners for resources they invested in the business. Equity, therefore, is an indicator of how many assets the owners can claim in the business after all liabilities are settled. The difference between assets and liabilities (i.e. equity) is sometimes called net worth.

Any trial balance account (trial balances are a starting point in preparing a balance sheet see further) has a balance. An account may have a debit or credit balance. The normal account balance also indicates whether the account is increased or decreased when it's debited or credited. There are rules stating which account has a debit or credit balance. The illustration below shows accepted conventions about such balances:

Illustration 3: Normal balances, increases and decreases for balance sheet accounts

Balance Sheet Category

Increase (Normal
Balance)

Decrease

Assets

Debit

Credit

Contra Asset Accounts

Credit

Debit

Liabilities

Credit

Debit

Contra Liability Accounts

Debit

Credit

Equity

Credit

Debit

For example, an asset account called Cash increases when it's debited and decreases when it's credited. The Cash account normally has a debit balance.

Note that there are "contra" accounts. Such accounts are opposite to their related accounts and thus have a different normal balance. Contra accounts are presented as a reduction to their related accounts on the balance sheet. An example of such accounts is Accumulated Depreciation. This account has a credit balance and is related to the Fixed Assets account. On the balance sheet, Accumulated Depreciation (credit balance) is shown under Fixed Assets (debit balance) and reduces the balance of Fixed Assets creating Net Fixed Assets.

Going back to the accounting equation, note that assets normally have debit balances, and liabilities and equity have credit balances:

Debit Balance

 

Credit Balance

 

Credit Balance

Assets

=

Liabilities

+

Equity

Let's review each balance sheet classification in more detail.

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