What is a Balance Sheet and Why Does it Need to Balance?

why does a balance sheet need to balance

The balance sheet is packed with financial information crucial to understanding the health of your company. However, for a lot of people, it’s one of the hardest financial statements to get to grips with. 

Even the most fundamental pillar of the balance sheet, “why it needs to balance”, eludes many of us.  It’s easy to look up the formula, but not so easy to understand why this formula is the way it is.

It’s actually a lot simpler than you think. Let’s take a look.

What is a balance sheet?

In essence, a balance sheet is a financial report that provides a snapshot of a company’s financial position at a specific point in time. It presents the company’s assets, liabilities, and shareholders’ equity. The balance sheet follows the fundamental accounting equation, which states that assets must equal liabilities plus shareholders’ equity.

What does a balance sheet consist of?

The balance sheet is split into two halves. Each half should add up to the total value in the business. The balance sheet equation can be expressed as follows:

Assets = Liabilities + Shareholders’ Equity

The top half (Assets) breaks down how this value is being used in the business.

The bottom half (Liabilities + Equity) breaks down how this value was acquired, i.e. the sources of funding. 

The two halves must balance because the total value of the business’s assets will all have been funded through liabilities and equity. If they aren’t balancing, it can only mean that something has been missed or an error has been made. 

Balance sheet assets: what does the company own?

The assets of a balance sheet include everything that could contribute to the value of the business. It can range from the cash in your bank account to the value of equipment you own.  You’ll even see the value of money owed to you but not yet received (accounts receivable). This still counts as an asset even though you the cash isn’t with the business just yet.

Balance sheet liabilities: what does the company owe?

Liabilities represent the company’s debts or obligations to external parties. It takes all forms of debt into consideration, such as outstanding loans or tax payments. They are also classified into different categories, current liabilities and long-term liabilities.

  • Current liabilities are obligations that are expected to be settled within one year, such as accounts payable or short-term loans
  • Long-term liabilities are obligations that are due beyond one year, such as long-term loans

Balance sheet shareholders’ equity

Shareholders’ equity represents the residual interest in the company’s assets after deducting liabilities. It consists of:

  • Share capital: This includes the value of shares issued by the company to shareholders
  • Retained earnings: Retained earnings are the accumulated profits or losses of the company that have not been distributed to shareholders as dividends
  • Additional paid-in capital: This represents the amount shareholders have paid for shares that exceeds the share capital

With all of these components in mind, it should be impossible for the balance sheet to ever be unbalanced.

But sometimes it doesn’t balance! Which means something must have gone horribly wrong…

what are the components of a balance sheet

What could cause a balance sheet not to balance?

For a balance sheet not to balance, there must be an error somewhere in the report. This can either be human or a software error:

Data entry errors

Incorrect recordings of financial data can lead to imbalances in the balance sheet. Simple mistakes, such as entering the wrong numbers or misplacing decimal points, can result in assets not equalling liabilities plus shareholders’ equity.

Omissions or missing transactions

If certain transactions or items are not included in the balance sheet, it can cause an imbalance. For example, if a transaction is mistakenly omitted or a particular liability or asset is overlooked, the balance sheet will not reflect the accurate financial position.

Timing differences

If transactions occur at different times but are not accounted for properly, it can cause an imbalance. For instance, if an expense is recognized in one accounting period but the corresponding payable is recorded in the subsequent period, it can disrupt the balance sheet balance.

Reconciling items

Certain items may require adjustments or reconciliation between different financial statements, leading to temporary imbalances. A common example of this is differences in foreign currency translation, which can cause the balance sheet to be temporarily out of balance until the correct adjustments are made.

Complex financial instruments

In some cases, complex financial instruments or arrangements, such as derivatives or structured products, may introduce complexities in determining their fair values or accounting treatment. This can result in difficulties in accurately reflecting these items on the balance sheet, potentially causing imbalances.

When a balance sheet does not balance, it is important to thoroughly review the financial records, investigate potential errors, and reconcile any discrepancies. Such issues can impact the reliability of the financial statements and may require adjustments or corrections to ensure accurate reporting.

What is a balance sheet

Making a start on your balance sheet

Looking at the two halves of the balance sheet is like looking at two sides of the same coin.

Remember, the top half and the bottom half of the balance sheet break down the same figure. The total value of the business. It should always balance because every individual transaction impacts both sides. Where the money came from and what it’s being used for.

So, if the double-entry accounting process has been followed correctly, it’ll always be the same. If your balance sheet isn’t balancing then the only explanation is that an error of some kind has crept in along the way. 

Understanding this fundamental pillar of the balance sheet should make it a bit easier to analyse this key report.

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Further information on your balance sheet

A balance sheet example

Let’s say you have £10,000 sitting in your bank account. This is classed as an asset so sits on the top half

Over on the bottom half, we have two activities going on. We have a loan that we need to pay back of £5,000 and retained profit (money earned by the business in a previous period) of £5,000.

In this simple example, there is £10,000 sitting in our bank account because we took out a loan of £5,000 and collected £5,000 worth of profit last month. 

So the assets are describing where the value in the business is (my bank account), and the bottom half is showing where it came from (a loan and my past profits). 

This will balance because both halves are looking at the same money. This isn’t very obvious if you are looking at a full balance sheet. The value of most businesses won’t just be sitting in a bank account. It’ll be split across a variety of places.

Likewise, the liabilities can become more complex too. With more going on it becomes far harder to see how the two halves relate to each other at a glance. It all works due to a process that accountants refer to as ‘double-entry accounting’. This process means that every time a single transaction occurs it will be recorded in at least two places. 

Similar to our example above, if an additional £5,000 is recorded in our bank account then this must be ‘balanced’ by a record on the bottom half showing where it came from (from making sales, borrowing money, or receiving investment for example). 

With both records always being entered at the same time, the balance sheet should always balance. 

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