A balance sheet is a statement of the companies health. How does the liabilities and equity compare to the assets? Balancing the balance sheet is a critical part of accounting as it gives the company, bankers, and investors an idea of how the company is doing. Does the balance sheet need to balance? Yes. It always needs to balance; otherwise, it’s an indicator that either something was forgotten or there is potential fraud.
Purpose of Balancing the Balance Sheet
The purpose of balancing the balance sheet is to create a snapshot of the company’s financial status. It highlights three important categories: assets, liabilities, and shareholder’s equity. In other words, the balance sheet looks at what the company owns, how much it owes to debtors, and how much is invested.
Before we go into how to balance the balance sheet, we need to know why we need to do that. It all comes down to double-entry accounting.
How to Balance the Balance Sheet
Use the following formulas to calculate each categories (assets, liabilities, and equity):
Assets = Liability + Equity
Equity = Assets – Liability
Liability = Assets – Equity
First, make two columns. In the first column, list your assets. In the second column, list both your liabilities and owner’s equity. Each column should balance to one another.
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Reasons Why Your Balance Sheet Is Out Of Balance
If your balance sheet isn’t balanced, then you want to look in particular areas for inconsistencies. Some of these areas include retained earnings, loan amortization issues, paid in capital, and inventory changes.
Retained Earnings
Retained earnings can be tricky at times. After all, it is supposed to be the sum of all your net profits/losses ever since you began the business. If you have an accurate record of every number since you began, then this shouldn’t be a problem. However, a far to common problem is that some businesses do not have all the data required to calculate retained earnings. A common practice for this situation is to use retained earnings as a plug number and make it what it needs to be in order to balance the balance sheet.
Paid In Capital
Some people have misunderstanding of what “Paid in Capital” is, and one simple way to define it would be: The amount of money that was invested in the business to get you started. It can either be your own personal investment, or it can be capital contributed by investors. The sum of all initial investments should be under Paid in Capital in the owner’s equity section of the balance sheet.
Inventory Changes
One common mistake that some people forget to consider is inventory changes. It might seem simple to just take a count of whatever inventory you have at the moment, but that may be inaccurate. If you are working towards financial projections, then you will need to predict future inventory amounts as well, and this will affect your balance sheet. A change in inventory also affects your cash flow statement. What you need to do is take the amount from last month’s inventory and subtract the amount from this month, then reduce your cash balance by that amount.
How to Protect Against Fraud With a Balance Sheet
After various global fraud scandals in 2002, the U.S Congress passed the Sarbanes-Oxley act which protected investors from the risk of fraud by corporations. It mandated strict improvements within the financial disclosures of corporations. It was responsible for the improvement of the following areas: corporate responsibility, increased criminal punishment, accounting regulation, and new protections.
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