1. Balance Sheet This module provides an introduction to the balance sheet, one of the essential financial statements in accounting and includes an introduction to debits and credits, and double entry accounting. We suggest doing the Balance Sheet module prior to the Income Statement. Author: Stu James © 2014 Stu James and Management by the Numbers, Inc.

2. The balance sheet is one of the essential financial statements (reports) for a company and is a required filing for all public companies. Understanding how to read and interpret a balance sheet is an important skill for a business person or investor. The balance sheet provides important information about the financial health of a company at a particular point in time – a “snapshot”. This information includes: Assets (what the company owns) Liabilities (what the company owes) Shareholder’s Equity (what is left for shareholders) I NTRODUCTION TO THE B ALANCE S HEET 2 Introduction to the Balance Sheet MBTN | Management by the Numbers

3. S AMPLE B ALANCE S HEET 3 Sample Balance Sheet MBTN | Management by the Numbers Facebook, Inc. As of Sept 30, 2013 $Millions Assets14,933 Liabilities1,885 Shareholder Equity13,048 Here is a (very) simplified balance sheet for Facebook, Inc. as of Sept 30, 2013. Facebook’s balance sheet consists of three major categories. What else can we say? First, note that Assets = Liabilities + Shareholder Equity ($14,933 = $1,885 + $13,048) This must always be true! Second, note that the figures are as of Sept 30, 2013, a particular moment in time. We can also say that Facebook’s assets (what it owns) far outweighs its liabilities (what it owes). Now let’s look at these three parts of the balance sheet in more detail.

4. L EGAL R IGHTS 4 Legal Rights MBTN | Management by the Numbers Facebook, Inc.$Millions AssetsProperty14,933 LiabilitiesPrimary Rights1,885 Shareholder EquitySecondary Rights13,048 Another way to look at this is a more formal legal definition where we have property (assets) and two general classes of property rights (liabilities and shareholder equity). So we can also say that Facebook has $14,933 of property, of which $1,885 is claimed through liabilities, and $13,048 is left for shareholders. Legally, this is generally how it works.

5. A SSETS 5 Assets MBTN | Management by the Numbers Facebook, Inc. Assets$Millions Cash and Cash Equivalents3,100 Short-Term Investments6,228 Receivables879 Inventory0 Other Current Assets342 Total Current Assets10,549 Plant, Property and Equipment2,685 Intangible Assets1,609 Other Assets90 Total Assets14,933 Let’s look at Facebook’s assets in more detail: First, note that assets are divided into current assets and non-current assets. Examples of current assets include cash, CDs, marketable securities (stocks and bonds), accounts receivable (payments owed to a company by customers), inventory, and pre-paid expenses (when a company pays a bill in advance). Definition: Current Assets are those assets which can reasonably be expected to be converted into cash within one year.

6. A SSETS 6 Assets MBTN | Management by the Numbers Facebook, Inc. Assets$Millions Cash and Cash Equivalents3,100 Short-Term Investments6,228 Receivables879 Inventory0 Other Current Assets342 Total Current Assets10,549 Plant, Property and Equipment2,685 Intangible Assets1,609 Other Assets90 Total Assets14,933 Now let’s consider non-current assets: Examples of non-current assets include buildings, vehicles, operating plants, equipment, office furniture, and intangible assets. Intangible assets would include intellectual property and goodwill. Most long-term assets are depreciated or amortized over time. Depreciation and amortization represent how a long-term asset gets used up over time. Definition: Non-Current Assets are longer-term assets that are not expected to be liquidated. These are depreciated or amortized over time.

7. L IABILITIES 7 Liabilities MBTN | Management by the Numbers Facebook, Inc. Liabilities$Millions Accounts Payable489 Short-Term Debt459 Other Current Liabilities36 Total Current Liabilities984 Long Term Debt287 Other Liabilities614 Total Liabilities1,885 Let’s look at Facebook’s liabilities in more detail: Just like current assets, current liabilities are those debts that are expected to be paid during the coming year. Examples of current liabilities include accounts payable (what a company owes vendors for products or services purchased), taxes payable, debt of less than one year or debt coming due within a year (bonds that mature in the coming year). Definition: Current Liabilities are those debts which are expected to be paid within the coming year.

8. L IABILITIES 8 Liabilities MBTN | Management by the Numbers Facebook, Inc. Liabilities$Millions Accounts Payable489 Short-Term Debt459 Other Current Liabilities36 Total Current Liabilities984 Long Term Debt287 Other Liabilities614 Total Liabilities1,885 Now let’s consider Facebook’s long-term liabilities: Long-term liabilities include items such as long-term bonds with a maturity date over a year, real estate loans, and other long-term bank loans. Definition: Long-Term Liabilities are those debts which are expected to be repaid more than a year in the future.

9. S HAREHOLDER E QUITY 9 Shareholder Equity MBTN | Management by the Numbers Facebook Shareholder Equity$Millions Retained Earnings2,636 Capital Surplus10,399 Other Shareholder Equity13 Total Shareholder Equity13,048 Now let’s look at Facebook’s Shareholder Equity: Shareholder equity includes retained earnings (from the Income Statement), Capital Surplus (any initial or subsequent investment in the company by shareholders beyond the par value of the stock). In addition, the par value of any preferred or common stock would be listed here separately. Definition: Shareholder Equity accounts are the residual accounts – what would be left for the shareholders after all liabilities are paid. Insight Equity accounts represent the (residual) value of the company (or, assets minus liabilities)

10. T RANSACTIONS 10 Transactions MBTN | Management by the Numbers An accounting transaction is an event that must be recorded in a company’s accounting system that impacts the balance sheet and/or income statement. These are also call journal entries. Let’s look at a few simple transactions that impact the balance sheet so you can better understand how the balance sheet works in practice. Consider the following transaction events: Receiving a 30 day loan as a $1,000 cash deposit from a bank Obtaining $5,000 from an investor Buying $3,000 of inventory with cash Paying a $3,000 bill owed to vendor Receiving a $500 wire payment from an international customer How do these transactions impact the balance sheet?

11. T RANSACTIONS 11 Transactions MBTN | Management by the Numbers Receiving a $1,000 loan will impact two areas as shown below. It will increase your cash balance by $1,000 and increase your short-term liabilities by $1,000 (maintains assets = liabilities + shareholder eq.). AssetsLiabilitiesShareholder Equity CashS-T Liabilities +$1000 = +$1000+ $0 Obtaining $5000 from an investor will also increase your cash balance. But instead of a liability, the offsetting entry is capital surplus under equity (maintains assets = liabilities + shareholder equity). AssetsLiabilitiesShareholder Equity CashCapital Surplus +$5000 =+$0+ $5000

12. T RANSACTIONS 12 Transactions MBTN | Management by the Numbers Buying $3,000 of inventory with cash only impacts the asset side of the balance sheet as shown, but the net effect maintains the equation. AssetsLiabilitiesShareholder Equity Inventory +$3000 =+$0 Cash -$3000 =+$0 $3000 -$3000 =+$0 What if the inventory is purchased on credit with the vendor, instead? AssetsLiabilitiesShareholder Equity InventoryAccounts Payable $3000 = +$3000+$0

13. T RANSACTIONS 13 Transactions MBTN | Management by the Numbers When the vendor sends an invoice for the inventory and it is paid with cash, cash will decrease and so will accounts payable. AssetsLiabilitiesShareholder Equity CashAccounts Payable -$3000 =-$3000+$0 Note that the net on the accounts payable account is zero for the last two transactions. Paying on credit, instead of using cash, basically creates a temporary condition of a short-term liability, called accounts payable (A/P). Take a moment to recognize that the net impact of a cash purchase of inventory is the same as a purchase on credit after paying the vendor. The accounting system just records the fact that the company owes the vendor a payment for the inventory, which is reflected in liabilities.

14. T RANSACTIONS 14 Transactions MBTN | Management by the Numbers Receiving a $500 wire payment from a customer is kind of the flip side of paying a vendor for inventory already received. Here, a customer owes you money (recorded in accounts receivable), and pays it, removing the expected, but not yet received, payment owed by the customer. AssetsLiabilitiesShareholder Equity Cash +$500 =+$0 Accounts Receivable -$500 =+$0 +$500 - $500 =+$0 Just like the purchase of inventory earlier, this transaction only impacts the balances on the asset side of the balance sheet.

15. D EBITS AND C REDITS 15 Debits and Credits MBTN | Management by the Numbers This module provides basic understanding of how balances change with transactions. We’d be remiss if we didn’t mention one additional dimension to transactions – credits and debits. Every accounting transaction consists of one or more credits and offsetting debits such that the balance sheet equation is maintained (assets = liabilities + shareholder equity). You can have debits and credits in each major category of the balance sheet. What matters is that credits = debits and that change in assets = change in liabilities + shareholder equity! Definition: For every transaction, Credits = Debits Assets = Liabilities + Shareholder Equity - and - Net Change in Assets = Net Change in (Liabilities + Shareholder Equity)

16. D EBITS AND C REDITS 16 Debits and Credits MBTN | Management by the Numbers Account CategoryDebit / CreditIncrease / Decrease AssetDebitIncrease AssetCreditDecrease LiabilityDebitDecrease LiabilityCreditIncrease EquityDebitDecrease EquityCreditIncrease The table below is a summary that you can use to determine if a transaction is a debit or a credit, or whether it will increase or decrease the balance of the account category. So, rather than putting in a negative number to decrease an asset account, we credit it. Rather than putting in a negative number to decrease a liability account, we debit it.

17. D EBITS AND C REDITS 17 Debits and Credits MBTN | Management by the Numbers The system of using debits and credits, or double entry bookkeeping, originated in Venice over 500 years ago. The system is still in use today, though obviously modernized through the use of computers. Computers have vastly improved on the manual approach of “T” tables, but the approach is still the backbone of the system. Insight While the computer ensures that values balance, the data entered must be accurate and the right accounts must be chosen or the balance sheet will not be an accurate portrayal of the company’s position. AssetsLiabilitiesShareholder Equity CashS-T Liabilities DebitsCreditsDebitsCreditsDebitsCredits $1000 “T” Table

18. D EBITS AND C REDITS 18 Debits and Credits MBTN | Management by the Numbers Now let’s try our examples again, but using the full system of debits and credits, as well as showing the impact on the account. Receiving a 30 day loan as a $1000 cash deposit from a bank Obtaining $5000 from an investor Buying $3000 of inventory with cash Paying a $3000 bill owed to vendor Receiving a $500 wire from an international customer Here is the entry for the first transaction. Now try the others: AssetsLiabilitiesShareholder Equity CashS-T Liabilities DebitsCreditsDebitsCreditsDebitsCredits $1000 Increase No change

19. D EBITS AND C REDITS 19 Debits and Credits MBTN | Management by the Numbers Obtaining $5,000 from an investor AssetsLiabilitiesShareholder Equity CashCapital Surplus DebitsCreditsDebitsCreditsDebitsCredits $5000 IncreaseNo change Increase The cash account is debited (increases) by $5,000 and the capital surplus account is credited (also increases) by $5,000. Debits and credits are equal ($5,000 = $5,000). Change in assets = Change in liabilities + shareholder equity ($5,000 = $5,000)

20. D EBITS AND C REDITS 20 Debits and Credits MBTN | Management by the Numbers Buying $3,000 of inventory with cash AssetsLiabilitiesShareholder Equity Cash DebitsCreditsDebitsCreditsDebitsCredits $3000 Inventory DebitsCreditsDebitsCreditsDebitsCredits $3000 Cash decreases (credit) and Inventory increases (debit), but no net change in assets. No change

21. D EBITS AND C REDITS 21 Debits and Credits MBTN | Management by the Numbers If instead, the inventory had been purchased on credit (terms)… AssetsLiabilitiesShareholder Equity InventoryAccounts Payable DebitsCreditsDebitsCreditsDebitsCredits $3000 Increase No Change Later, paying the $3,000 bill owed to that same vendor AssetsLiabilitiesShareholder Equity CashAccounts Payable DebitsCreditsDebitsCreditsDebitsCredits $3000 Decrease No Change

22. D EBITS AND C REDITS 22 Debits and Credits MBTN | Management by the Numbers Receiving a $500 wire payment from an international customer AssetsLiabilitiesShareholder Equity Cash DebitsCreditsDebitsCreditsDebitsCredits $500 Accounts Receivable DebitsCreditsDebitsCreditsDebitsCredits $500 Cash increases (debit) and Accounts Payable decreases (credit), but no net change in assets. No change

23. B UILDING A B ALANCE S HEET 23 Building a Balance Sheet MBTN | Management by the Numbers The last example we’ll use is to create a balance sheet from scratch for a start-up coffee shop. While this is obviously a very simplified exercise, it will help you understand how the transactions build together to create the balance sheet. On the next page, there are 7 transactions that you can use to test your comprehension. Try to build it yourself before checking the answer key. We’ve also provided the detail on all the individual transactions so you can follow how the accounts were updated.

24. B UILDING A B ALANCE S HEET 24 Building a Balance Sheet MBTN | Management by the Numbers Create a balance sheet from the following transactions: An investor starts the company with $25,000 of cash. The manager obtains a $15,000 long-term loan from a local bank. The manager purchases an espresso maker for $1,500 on credit. The manager purchases a computer for $1,000 for cash. The manager purchases $2,500 of goods to resell (inventory) using cash. The manager signs a 3 year contract to rent a building space that requires a $1,000 deposit and first month’s pre-paid rent of $1,000. The manager writes the check for the deposit and rent. Ready, set, go – don’t advance until you’ve tried it!

25. B UILDING A B ALANCE S HEET 25 Building a Balance Sheet MBTN | Management by the Numbers Assets$ Cash$34,500 Inventory$2,500 Pre-Paid Rent$1,000 Current Assets$38,000 Equipment$2,500 Deposit$1,000 Total Assets$41,500 Liabilities$ Accounts Payable$1,500 Current Liabilities$1,500 L-T Liabilities$15,000 Total Liabilities$16,500 Shareholder Equity$ Capital Surplus$25,000 Total SH Equity$25,000 Total Liab. + Equity$41,500 Though very simple (and only including transactions that impact the balance sheet alone), this exercise provides a good sense of how the balance sheet changes over time. The detail of the transactions and T accounts are shown on the following pages for reference.

26. B UILDING A B ALANCE S HEET 26 Building a Balance Sheet MBTN | Management by the Numbers AssetsLiabilitiesShareholder Equity CashCapital Surplus DebitsCreditsDebitsCreditsDebitsCredits $25,000 IncreaseNo changeIncrease AssetsLiabilitiesShareholder Equity CashLong-Term Liab. DebitsCreditsDebitsCreditsDebitsCredits $15,000 Increase No Change AssetsLiabilitiesShareholder Equity Equipment (or PPE)Accounts Payable DebitsCreditsDebitsCreditsDebitsCredits $1,500 Increase No Change

27. B UILDING A B ALANCE S HEET 27 Building a Balance Sheet MBTN | Management by the Numbers AssetsLiabilitiesShareholder Equity Cash DebitsCreditsDebitsCreditsDebitsCredits $1,000 Equipment DebitsCreditsDebitsCreditsDebitsCredits $1,000 No net change in AssetsNo change AssetsLiabilitiesShareholder Equity Cash DebitsCreditsDebitsCreditsDebitsCredits $2,500 Inventory DebitsCreditsDebitsCreditsDebitsCredits $2,500 No net change in AssetsNo change

28. B UILDING A B ALANCE S HEET 28 Building a Balance Sheet MBTN | Management by the Numbers AssetsLiabilitiesShareholder Equity Cash DebitsCreditsDebitsCreditsDebitsCredits $2,000 Prepaid Rent DebitsCreditsDebitsCreditsDebitsCredits $1,000 Deposits DebitsCreditsDebitsCreditsDebitsCredits $1,000 No net change in AssetsNo change Signing the contract generally does not create an accounting transaction, only when the deposit and pre-paid rent is actually paid.

29. MBTN Income Statement Module. This MBTN module provides a similar introduction to the income statement. F INANCIAL S TATEMENTS – F URTHER R EFERENCE 29 Financial Statements - Further Reference MBTN | Management by the Numbers