What is a balance sheet, and how do you create one?

In order to determine your company’s profits or losses, and to be able to calculate taxes at the end of the financial year, you need to record book of entry. Book­keep­ing records all business trans­ac­tions for a company, and serves as the basis for the profit and loss account and the pre­par­a­tion of the balance sheet. Together with the income statement, the balance sheet is a main component of the annual report. But what exactly is a balance sheet, and how is it created?

The balance sheet is a statement of a company’s assets and li­ab­il­it­ies at a given point in time. It’s divided into two parts, with the assets on the left and the li­ab­il­it­ies on the right. The assets side provides in­form­a­tion on the company’s resources. The li­ab­il­it­ies side shows the company’s ob­lig­a­tions. It’s important that the total sum of assets always matches the total li­ab­il­it­ies.

The assets are organised according to their liquidity. The li­ab­il­it­ies are struc­tured according to their maturity, and cover the entire financing of the company.

The UK has no specific re­quire­ments about how you choose to keep your books, and the creation of a balance sheet can be excluded depending on the type of business. In general, though, balance sheets are required and must contain a certain amount of in­form­a­tion. The structure and size of the balance sheet can be flexibly based on the size of the company and the required com­plex­ity. Small busi­nesses, for example, tend to have much simpler balance sheets than large cor­por­a­tions. Even as an en­tre­pren­eur, though, a balance sheet and profit and loss report are a good idea to help keep track of your financial per­form­ance. Un­in­cor­por­ated busi­nesses in the UK are not required to create a balance sheet, though they may still choose to do so.

Depending on the size of your business, the reporting re­quire­ments may change. Be sure to consult account filing standards provided by the HMRC before preparing financial state­ments to make sure not to miss anything.

The goal of a balance sheet is to provide in­form­a­tion about the financial health of a company at a point in time. It also documents the company’s com­pli­ance with ac­count­ing reg­u­la­tions. The profit and loss report, together with the balance sheet, makes up the annual report, and is carried out before the balance sheet is created.

There are few basic types of balance sheets which you can create to suit different purposes.

The most popular type, a clas­si­fied balance sheet divides in­form­a­tion by sub­cat­egor­ies. These cat­egor­ies are then clas­si­fied to make it easy to find the in­form­a­tion in question. There are no re­quire­ments about which cat­egor­ies must be included, but main­tain­ing a con­sist­ent structure sim­pli­fies the process of comparing in­form­a­tion over multiple periods.

An un­clas­si­fied balance sheet doesn’t employ the cat­egor­ies and sub­cat­egor­ies of the clas­si­fied version, and instead lists all items at once. Assets are generally ordered first, followed by li­ab­il­it­ies. There are no subtotals as would be included in a clas­si­fied balance sheet, but instead totals are listed for assets, li­ab­il­it­ies, and equities. This type of balance sheet is mostly suitable for small reports with few items to list, or for internal reporting purposes. Assets are listed according to their liquidity, with cash assets at the top and fixed assets at the bottom. Li­ab­il­it­ies are also presented in a similar manner, generally organised by due date.

A com­par­at­ive balance sheet is used to compare account balances at multiple points in time. This is par­tic­u­larly useful for gaining an overview of the company’s general financial position, i.e. the tra­ject­ory of its net worth and debts. The subtotals for the various points in time are presented side by side. Com­par­at­ive balance sheets are the required form under FRS 102, just like with the old UK GAAP.

Since balance sheets are composed to encompass an entire fiscal year, the term “interim” does not really apply to them. However, interim financial state­ments can be useful to present periods that cover less than one year. For example, publicly-held companies that are required to issue quarterly reports may make use of interim balance sheets. Since the balance sheet is only used to refer to a specific point in time, not a span of time, the interim balance sheet will differ slightly from the other reports included in an interim financial statement.

The structure of a balance sheet usually follows the clas­si­fied style (see above). The values for the in­di­vidu­al items are taken from data in the ac­count­ing records that were used to record all business trans­ac­tions for the fiscal year. For example, if the purchase of a machine was financed with a loan, then the value of the “property, plant, and equipment” (asset side) increases – and so does the value of the cor­res­pond­ing liability on the other side. De­pre­ci­ation for wear and tear, i.e. the de­teri­or­a­tion of the machine, and the interest paid on the loan are recorded in the profit and loss report to adjust profit totals. The cal­cu­lated profit or loss is shown under the balance sheet item “equity” on the li­ab­il­it­ies side of the balance sheet.

On the assets side, a dis­tinc­tion is made between current assets and non-current assets. The dif­fer­ence is based on how long they’re held for. Here, fixed assets are long-term, such as machinery and vehicles. These valuables remain in the company for a longer time. Current assets, on the other hand, are “in cir­cu­la­tion”, i.e. finished products, goods, and items that the company needs for further pro­cessing (material), as well as re­ceiv­ables from customers (open invoices), cash, and bank assets.

Property, plant, and equipment includes long-term assets that are acquired for op­er­a­tion­al use in the company. Ac­quis­i­tion costs for these assets de­pre­ci­ate as they’re used, depending on the asset and annual wear and tear, on a pro rata basis, which reduces the profit. It’s then recorded in the balance sheet at the re­spect­ive carrying value.

Short-term in­vest­ments, such as raw materials, are not de­pre­ci­ated. The costs for their ac­quis­i­tion are fully deducted from the profit, since they serve the purpose of making the current profit. The value of raw materials reported in the balance sheet comes from the company’s inventory at the balance sheet date, which is de­term­ined by means of the annual stock count.

The li­ab­il­it­ies side shows the source of the capital. It records equity, pro­vi­sions, li­ab­il­it­ies, and, if ap­plic­able, deferred income as well as deferred tax li­ab­il­it­ies. The li­ab­il­it­ies show where or to whom the company owes something and what the owner is entitled to.

On this side, maturity is important. Stock­hold­ers’ equity is regarded as long-term capital that remains in the company for a long time, with other long-term li­ab­il­it­ies such as mortgages and bank loans listed below. The situation is different for short-term li­ab­il­it­ies, such as supplier invoices – these are usually settled within a few days and therefore are po­si­tioned lower than long-term li­ab­il­it­ies.

Pro­vi­sions are li­ab­il­it­ies whose value isn’t yet de­term­ined: These include taxes, pension payments, and an­ti­cip­ated lit­ig­a­tion costs from pending pro­ceed­ings.

Accruals/pre­pay­ments result from payments that occurred at a different time than when the service was used. On the assets side, an example of this would be advance rent payments, say if the rent for January and February was paid in December of the previous year (pre­pay­ment). On the li­ab­il­it­ies side, examples would be services that were invoiced in advance but not rendered until the following financial year, such as advances (accrual).

Generally speaking, the creation of a balance sheet and income state­ments requires a certain amount of expert knowledge. Though you’re certainly not required to, it’s advisable to hire a tax con­sult­ant to prepare your annual financial state­ments – not least because you can avoid any costly cor­rec­tions at a later date, but also because both the tax au­thor­it­ies as well as banks ap­pre­ci­ate pre­par­a­tion by an in­de­pend­ent third party.

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