This is the second part of our “Accounting for Small Business Owners” series. In the first module we covered the two types of accounting methods – cash and accrual. Next we are going to present the basics of financial statements and then focus on the balance sheet.
Much like it’s hard to explain to a fifth grader why learning math skills are important (“I can just use a calculator.”), it is often a challenge to express to small business owners who are just getting started or considering acquiring an existing business why understanding financial statements are important (“I can just hire an accountant”). Therefore, much like the way a nurturing and persuasive fifth-grade teacher must often do, we will offer . . . “Because I said so! You will thank me later.”
There are three components to a set of financial statements:
- Income statement
- Balance Sheet
- Cash flow statement
The income statement is simply a record of the sum of revenue and expenses over a given time period, with the difference expressed as the company’s earnings. And the cash flow statement, adjusts those earnings to account for the “accrual” method of accounting which includes non-cash transactions as discussed in module number one.
However, today we will be discussing just the Balance Sheet.
1. The Balance sheet serves to capture what the company owns or is owed and what the company owes. The difference between what a company owns and what it owes is called the company’s book value. (Also referred to shareholder equity)
Simply: Asset($) – Liabilities($) = Shareholder equity or Book Value
Examples of assets include:
cash, accounts receivable (money that people owe you for your product or service), inventory, prepaid expenses (If you have paid your liability insurance in full for the current year and today is July 1st, half of what you already paid for is considered a “pre-paid expense”), furniture, equipment and goodwill.
Examples of liabilities include:
Accounts payable (money you owe someone for a product or service that you have used), debts (of all shapes and sizes)
2. The Balance sheet only captures one moment in time. It does not cover a time period like the income and cash statements do. If business was a sport played on the playground, with the objective to collect as much “stuff” as possible (and limit what you owe to others), the balance sheet is the gym teach blowing the whistle and then everyone freezing in place.
“Stop!! Nobody move.”
Then the gym teacher records what each student has in their possession (and what they owe at that particular moment). Once the information is collected, the whistle is blown again and the activity again begins.
It is a picture of the scoreboard at some point during the game, not a description of the game itself.
Because of this, we must be very careful when reviewing balance sheets.. . ESPECIALLY, if our review is being performed with the consideration of a business acquisition in mind. A balance sheet from one month ago, may be substantially different than a balance sheet from today.
Therefore, LOOK AT THE DATE when reviewing a balance sheet. I wouldn’t be emphasizing this unless I have observed instances where a balance sheet from a few months ago is presented with a company’s financial records during a business acquisition due diligence period. “Ummm, No. I need today’s balance sheet.”
3. Beware of accounts receivable. Recall that accounts receivable is the money that you are owed by customers for products or goods that have been consumed but not yet paid for. Although, listed as an “asset” – it is important to understand what is underneath the hood on this one. Consider a magazine company that claims accounts receivable as $x. Clearly, we all know that they are never going to actually see $x but rather some fraction of x due to the propensity of “bill me later” subscriptions.
Another potential pitfalls in the “accounts receivable” world include singularly large amounts of capital “due” – from a non-paying or dissatisfied customer, judgments.
4. Goodwill. If you have never heard of considered “goodwill” from an accounting perspective, prepare to have your mind blown.
This term – which is usually given its own line item on a balance sheet represents the . . . take a breath . . . the value of the company in excess of (or occasionally, less then) the book value of its assets. In essence, goodwill is the intangible benefit of owning that company that the owners have, which cannot be accounted for my just doing an inventory of assets on hand. Think back to the “.com” bubble, thousands and thousands of companies had virtually no assets and little revenue, but were being sold for extraordinarily high prices. The difference between the prices they were being sold for and the tangible “assets” of the company, is goodwill.
For a company that has recently been sold or a company that is effectively “sold”everyday on the stock market, there restrictions on what can be considered goodwill. If you acquire a company for $1 million dollars, but the company’s hard assets were only worth $600k, then effective on the day of the sale, the company’s goodwill is $400k. For privately held businesses that have never been sold to another party, there is effectively no bounds on what the owner could “claim” for goodwill. In fact you could start a company tomorrow and then claim you own a million dollar business . . . .and prove it by providing a balance sheet with a goodwill number that is garbage.
At this stage, it is sufficient for you to know that goodwill can be highly subjective and should be handled with extreme care and reviewed with extreme scrutiny.
5. Value of your company’s assets. Accounting for assets of your business is MUCH DIFFERENT than buying or selling the assets. Consider the following two examples:
- Land is reported at the price you paid for it. It is not adjusted for the market value of the land.
- Some of your company’s assets may have no value on your balance sheet even thought they are fully functional and have a non-zero resale value. If you bought a equipment for $100k and then depreciated that expense over the last ten years at $10k/year (as discussed in MODULE 1), that asset now has no asset value on your balance sheet.
Keep this in mind when and if, you run across a situation where there seems to be an obvious mistake or oversight regarding the “value” of your assets or the company whose assets you are reviewing.
Balance sheet basics . . . there you have it.
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