The Balance Sheet at Work

The equation always balances. That is settled, and it is not very interesting on its own. What is interesting is what happens to it when the business actually does something.

A business does a lot of things. It buys inventory. It buys equipment. It sells something. It pays a bill. It takes a bill and does not pay it yet. It collects from a customer who owed it money. It watches an insurance policy tick away a month at a time. Every one of those moves lands on the balance sheet, and every one of them keeps it in balance. But they do not all mean the same thing. Some of them create value and some of them only rearrange it, and the balance sheet lets you tell which is which if you know where to look.

That is what this section is. We are going to take one small business and walk it through eleven moves, one at a time, and after each one ask the same two questions: what changed, and why does it still balance.

Two moves that change nothing

Here is the business on the day it opens. We are going to invest $10,000 in a business born today that hasn’t done anything, no transactions.

Now let’s get started on this business. I am going to take some of the cash that’s in the business and buy some inventory, so we have some stuff to sell. What’s going on here?

If you look on the asset side, cash goes down by $3,000 because we’re spending it. But where does it go? We bought some inventory at the value of $3,000. Now we have two assets, cash and inventory. See what we’ve done here? We’ve had to split the total value that we had before over the two of them, because we used some of that cash to buy the inventory. Now we have less cash, $7,000, but we do have $3,000 of inventory. It’s still $10,000.

And notice that on the other side nothing has changed. We still have $10,000 of equity.

Here’s another way of thinking about it. This business turned some of its assets into another asset. We converted cash into inventory. We haven’t created any value yet, because we haven’t sold anything. We haven’t given anything to a customer and taken in some cash. Nothing like that is happening.

Whenever you take cash and buy inventory or buy other stuff, you’re converting one asset into the other. The total asset base is still $10,000. We don’t see any change in the totals of the balance sheet, either assets or owner’s equity, which have to match, because the business hasn’t created any new value yet. We’ve converted the value from one asset to another.

Now let’s say we use some more of that cash and buy some equipment.

We have some inventory, but we have to buy some equipment, like some computers or tooling. We spent $2,000 on it. Cash goes down by $2,000, and equipment, an asset, goes up by $2,000. The whole thing still sums to $10,000, and nothing has changed on the right side. We are taking assets that we have and trading them in for other assets. Cash is down and equipment is up. Inventory stays the same.

We’re preparing for operations in all of this, and in this preparing we haven’t created any value yet, which is why the asset total and the total of equity plus liabilities still stay at $10,000. These are activities that we do, but we haven’t created any value yet, and that is why we see no changes in the totals of the balance sheet.

Two transactions in and the business looks completely different. It has inventory it did not have, equipment it did not have, half the cash it started with. And the balance sheet reports, correctly, that nothing has happened. Hold on to that, because it is the reason the next transaction matters.

The sale

New business, new balance sheet. All those totals from before are old news. This is our current balance sheet.

We’ve got some payables, we owe some things to suppliers, to the tune of $1,000, and that’s the only liability we have. Owner’s equity is the remainder, $7,000. Total liabilities plus owner’s equity equals $8,000. We have a balance sheet that balances, so let’s get to work.

We sold some stuff for $2,000. What’s going on here?

The first thing is cash goes up by $2,000. It goes from $5,000 to $7,000. At the same time inventory is going to decrease by $1,200, because we don’t have that stuff anymore. The stuff that leaves our warehouse is to the tune of $1,200. We only have $1,800 of inventory left.

The total assets now are $8,800. That’s $800 more than what we had last time, before we made the sale. Where did that come from? We got a profit of $800, because we sold something for $2,000 but it only cost us $1,200. The difference between those is the profit that we’re pocketing. That’s why the assets are now up by $800, up to $8,800.

Now if the assets are $8,800, on the other side we’ve got to make that thing balance. How do we do that? Accounts payable, that debt, hasn’t changed. That’s going to stay at $1,000. But the owner’s equity is now no longer $7,000, it’s $7,800. When you add those up, we get a total of $8,800, so they balance.

What’s going on here? We had owner’s equity of $7,000, but now we have this extra stuff, because we made some profits, and that profit flows to what the owner owns. That’s why owner’s equity goes up. As it goes up, we have a balance sheet that balances out again.

This is the first transaction in the sequence where the totals moved, and it is worth being precise about why. It is not because cash came in. Cash came in when we bought inventory too, in reverse, and nothing moved. It moved because we gave up something worth $1,200 and got something worth $2,000, and the gap between those two numbers is value that did not exist before.

How the profit actually gets there

A sale raises equity even though nobody voted on it. Students find that mysterious, and it is worth walking the path.

It comes back into the balance sheet through an indirect route.

First, go to the income statement. We sell something, revenues go up, and there are some costs to capture that revenue, because of matching. Those costs go into it and go up too. Hopefully the revenue goes up higher than the costs, and that’s why we have some profit.

Second, that profit is going to show up on the income statement. That makes its way into the retained earnings of the balance sheet, and that’s where we see a rise in equity.

Third, if you imagine a simple cash sale, cash is going to go up. Whatever costs were required to get that revenue are going to go down. Either inventory goes down, because those are those costs, or we have to spend some things, and those are going to be expenses. Expense items on the income statement are going to lower profit. What we see is the net value creation, which is the revenue minus all the costs to incur it, is going to get netted out and end up impacting retained earnings. It creates a profit, and that profit number, whatever the residual is, gets moved over to retained earnings.

That’s where the income statement talks to the balance sheet.

So the $800 in the table above did not appear on the balance sheet directly. It went through the income statement first, and it arrived as retained earnings. Every transaction in the rest of this section that moves owner’s equity moves it by that same route.

Two ways to have an expense

Now the other direction. Here is a fresh business, and we are going to run the same expense through it twice, paying for it two different ways.

First way: we pay an expense with cash. We pay $1,500 for supplies.

Cash is going to decrease by $1,500, to $4,500. Inventory stays the same, so assets are down. We are now down to $7,500. It’s got to equal $7,500 on the other side. What’s going on?

Our accounts payable hasn’t changed. We still have this debt, but we’ve paid these expenses. Expenses are going to lower profits, because revenues minus expenses equals profits, which means we’re going to take a hit on our owner’s equity to the tune of what those expenses were. We see an owner’s equity that has been reduced by $1,500, and because we reduced $1,500 from both sides, the balance sheet still balances.

Second way: back to the same baseline, and this time we incur the expense on credit instead of paying cash.

Cash hasn’t changed, because although we incurred an expense we didn’t have any cash outlay to pay for it. Inventory is still $3,000. The total assets are $9,000, so we know that liabilities and owner’s equity are also going to be $9,000.

Look at what happened on the right side. Owner’s equity has gone down by $1,000. That makes sense, because we incurred this expense. Like before, expenses mean a lowering of profit. That’s going to hurt our equity, so it goes down by $1,000.

How do we make this thing balance? Our accounts payable. We are going to pay this supplier for the expense, so it goes up from $1,000 to $2,000. We didn’t have to pay them yet. Instead of taking a reduction of $1,000 in cash on the left side, what we are doing is raising our debt level on accounts payable. It’s $1,000 more that we’re going to owe somebody else.

What’s happened on the asset side? Nothing has changed, and that makes sense, because nothing has in fact changed. We’ve incurred an expense. We didn’t sell anything. We have no more cash. We haven’t got a reduction or an increase in inventory.

So on the right side we observe two things:

1. We owe somebody more. That’s why accounts payable went up.
2. Our owner’s equity had to go down. It had to go down to make the balance, but it makes sense intuitively, because that expense is a hit to our profit. Even though we didn’t pay any cash out, our profit takes a hit, and therefore our owner’s equity takes a hit, and the balance sheet balances.

Put the two tables next to each other and the comparison is the whole point. The expense is the same expense. It hits owner’s equity the same way in both cases, because expenses reduce profit whether or not you have paid them. What differs is the left side in one case and the liability line in the other. Paying with cash makes the business smaller. Paying on credit leaves the business the same size and moves a claim on it from the owner to a supplier.

Truing up: nothing happens, and that is correct

Here is the transaction students find hardest, because it feels like something good happened and the statement disagrees.

This balance sheet balances. This is a great starting point. Now let’s imagine we’re going to collect $1,000 from our customers, so we’re going to true up some accounts receivable. We made a sale earlier but they didn’t give us cash. They said we’ll pay you later, so we chalked this up to accounts receivable. Now later on they pay off some of that. A customer comes in to pay off $1,000.

What’s happening here is that we got $1,000, so cash is going to go up by $1,000. Cash is $6,000 now, because they paid us. Our receivables balance is going to go down, because they don’t owe us this anymore. They’ve paid us, so that number goes down from $2,000 to $1,000. Inventory stays the same, and total assets are still $10,000. No change on the right side. Owner’s equity hasn’t changed. Accounts payable hasn’t changed.

What’s going on here is an asset exchange. We’re not a business that created any value. We’re exchanging one asset, accounts receivable, for the other, cash, when we get paid off.

Here’s the thing. When we get paid off we get more cash, but what people owe us goes down. That nets out, which is why total assets haven’t changed. We’re exchanging our customers’ debt for cash, so our total assets are the same whether they owe us $1,000 or they pay that off. Now they don’t owe us $1,000, but we actually have the $1,000 in cash. That is the same.

And notice that the right side hasn’t changed. We have the same liabilities, and owner’s equity didn’t move. Now you might say, I feel richer today, because somebody came in and gave me cash. Before I didn’t have this cash and now I do, so shouldn’t I have more value from the business?

Here is why not. It’s because you already took credit for it when you had the sale last time. Instead of giving you cash they gave you a promise, an account receivable, to pay you later, and you took credit then. Today when they pay you, you’re truing up their account. Instead of them owing you, they’ve now given you the cash, so the business now has more cash and less accounts receivable. But you can’t say that the business has created value when you’re truing things up.

That’s the important thing in accounting. We take credit for a sale once, and then when the cash follows in later, we’re truing things up. That doesn’t affect how much value the business is going to create. It doesn’t affect your owner’s equity. It does affect the mix of assets reflected on the left, but not the total assets, because you’re exchanging accounts receivable for cash.

Students walk into this with a specific wrong reasoning, and it is worth naming, because it is not a stupid one. It goes: cash is real and a promise is not, so turning a promise into cash must be an improvement. The accrual answer is that we already decided the promise was real, back when we recognized the sale, and we wrote it down as an asset at full value. Having decided that once, we cannot collect a second gain for being right.

Truing up the other direction

The deck trues up receivables and then moves on. The same logic runs on the liability side, and it is worth doing, because paying a bill feels like it should hurt and the statement has a specific opinion about that.

Take the same balance sheet. Now we are going to true up our accounts payable. We are going to take $1,000 that we owe people and pay it off.

What would happen here? First of all accounts payable would go down, so we go from $1,500 to $500. We have brought down the right side by $1,000. Now for this to match, we have to get this balance sheet to balance.

What’s happening when we pay off the payables? What do we pay with? We owed some people money and we’re going to pay off $1,000 of it. We pay that off in cash, so on the cash side that’s going to drop from $5,000 to $4,000. The total assets are going to be $9,000. Now it’s going to balance, because our accounts payable has dropped by $1,000, the right side has been reduced by $1,000, and the left side, in cash, has been reduced by $1,000. Total assets are $9,000. Total liabilities plus owner’s equity is $500 plus $8,500, which is $9,000.

That’s how you true up a payable.

Owner’s equity did not move, and that is the same answer as the receivable, for the same reason. We took the hit when we incurred the expense. Paying the bill is settling up, not a second loss. The business did get smaller here, which the receivable case did not, so the two are not identical - but the part that measures whether the business created or destroyed value stayed exactly where it was.

An asset that expires on its own

Everything so far needed somebody to do something. This one happens because time passed.

We had prepaid insurance for $1,200, and now let’s imagine one month passes. This prepaid insurance, $1,200, was for the whole year, and now one month has gone by. You can say we’ve used up one twelfth of this prepaid insurance, because it was covering us for this period of time. Now this insurance isn’t $1,200 worth. We’ve used some of it up. How much? One twelfth of it, which is $100. We’ve used up this insurance, but no cash is going to come out, because we already paid it all up front in a prepaid. How do we take care of this on the balance sheet?

The first thing we have to do to true this up, after one month has passed, is note that cash hasn’t changed, because no money is going out or in. Prepaid insurance goes down. Now instead of $1,200 we have it at $1,100, because $100 of the prepaid insurance was used up. Inventory hasn’t changed at $3,000, so our total assets are down to $9,100. We’re down $100.

Now how do we make the right side balance? Unearned revenue is still $1,500, but our owner’s equity has to go down by $100. That’s because we’ve incurred this expense with the passage of time. Even though you haven’t paid any cash out, we’ve used up this insurance. How much? We’ve used up $100 worth, so that’s what we’re going to expense through. It’s going to hit our income statement and come through as a reduction of retained earnings, a reduction of owner’s equity. That’s why owner’s equity is now $7,600.

When you add those two up, total liabilities plus owner’s equity is $9,100, and the balance sheet balances.

This is the same idea you met when we did expense recognition. An asset is a future benefit, and prepaid insurance is an asset because the benefit is still ahead of you. Once a month of coverage is behind you, one twelfth of the benefit is gone, and the balance sheet has to say so. Nobody wrote a check. The asset shrank anyway.

A liability that turns into revenue

That unearned revenue line has been sitting on the right side of the last two balance sheets without explanation. Here is what it is doing there.

What’s unearned revenue? If you get some money in advance because someone prepays you, but you haven’t done the work yet, that’s unearned revenue. Now we don’t owe that person money, but we owe that person our goods or service.

Imagine you run a lawn care service and somebody has paid you for the next 15 months, and they paid $100 a month. They prepaid you and you haven’t done any work yet. Instead of booking that revenue right away and saying you earned it, you haven’t, because you haven’t done the work yet. Where do we put this? We don’t put this on our income statement. We put it on our balance sheet, under a liability, because we still owe somebody. Not money, but work.

Now imagine five months later. We’ve earned the monthly fee of $100 five times over, so of that $1,500 of unearned revenue, we’re going to say we’ve earned $500 of it.

The unearned revenue has to go down by $500, because now we’ve earned it. How do we make this thing balance? We haven’t got any more cash. That’s not going to change, because they paid us all up front.

What’s going on is that this finally hits the income statement, the revenue line item, because we’re going to increase it by $500. To the extent that we’ve increased revenue by $500, that’s going to increase our owner’s equity by $500. So unearned revenue goes down by $500 to $1,000, and owner’s equity goes up by $500 to $8,200. Add those up and it still matches the asset side of $9,200.

Now the owner’s equity is up $500. In this whole business they have gained more, and it makes sense, because it has created some value. That revenue has finally hit the income statement and now they have more profits.

They have no more cash, because all the cash was prepaid, but it was sitting in this liability account. This is one of the ways we move a liability into an increase in owner’s equity, because we are retiring what we owe people. We no longer owe them this. We have earned it outright. So assets have not changed, but owner’s equity has gone up and our liabilities have gone down.

Notice what this pair does to the totals. Total assets never moved. The business did not get bigger. But the owners’ claim on it grew by $500, entirely at the expense of a liability. Doing the work you were already paid for is value creation, and this is the only transaction in the section where the balance sheet records it without a single number on the left side changing.

Splitting owner’s equity in two

So far owner’s equity has been one number. Here is a business where we break it out.

Nothing happened to this business. No transaction occurred. We took one line and made it two, and the totals are untouched, which is the point of showing it as a table at all.

Paid-in capital is what the owners of the business put into the business to make it run. We put in this value to give the business some assets, and that was our initial putting-in so the thing could run. As the business runs we might put in some more. These are things the business didn’t earn money with. The owners put it in to support it.

Retained earnings are the accumulation of all the previous times this business has earned money and had positive profits. That stuff, if it doesn’t get paid out, flows back into the business. This is all the money the business has generated for itself that the owner has claims to.

What you put in is an owner’s claim on the business, and whatever the business generates is also something the owners have a claim to. Both are equity. Only one of them is evidence that the business works, which is why we keep the accounts apart.

What to do with the earnings

Now the business has $10,000 of retained earnings and a decision to make. There are a couple of things you could do.

You could distribute them as dividends. Now that you’ve earned this money, it can be paid out to the owners or stockholders, whoever owns this business. They can do with it whatever they want. They can go out and spend it on a vacation or buy groceries with it.

Or the business has some money that it made for itself, and you could reinvest it in the business. You could take those retained earnings and buy new assets to expand operations.

Here is the first choice. We return $2,000 to the owners.

How do we pay that? $2,000 is in cash, so cash goes down from $10,000 to $8,000, which means our total assets are going to be $13,000. What happens on the right side? We pay dividends out of retained earnings, so retained earnings also gets reduced by $2,000.

What we need to know here is that the business shrank. We took $2,000 of cash and pulled it out of the business and gave it to the owners, and that’s why total assets are down to $13,000. Where are the reductions happening on the right side? Retained earnings is the only place you can pay out dividends from, so that’s what’s going to get reduced. The value of the business that’s tied to the owners, in terms of what the company has earned in retained earnings, is going to go down, because they took that cash and paid it back to the owners. It no longer exists in the business.

Paid-in capital is not reduced, because that is the piece we put in there and we want to bookmark it. That was the initial stuff. We cannot pay dividends out of paid-in capital, because that is the initial investment. We can only pay dividends from what the business has already earned, and that’s why we keep a separate account for retained earnings.

Now the other choice. We didn’t pay out our retained earnings, we reinvested them. We took $3,000 of cash to buy more equipment.

Cash goes from $10,000 to $7,000, and equipment goes up from $5,000 to $8,000. Total assets stay the same at $15,000, because we’re trading cash that we have accumulated for other assets, which in this case are equipment.

Retained earnings doesn’t change on the right side. This is the case where the retained earnings stay in the business, because we didn’t pay it out to shareholders or owners. We used that cash instead to reinvest in the business and buy more equipment, so it stays at $10,000 and doesn’t move.

The totals still balance. Assets equals liabilities plus owner’s equity. In this case they both sum to $15,000.

Owners have to decide whether they leave the money in the business and grow it, or take it out. In a year where they take it out, retained earnings goes down and cash goes down, and the owners walk away with some money. In the years when they reinvest, they leave retained earnings in, so the cash stays in, but they can use that cash to deploy against other assets. Cash goes down, other assets go up, and the retained earnings stay the same because we’re leaving it in the business.

Deciding how to use retained earnings impacts the balance sheet, and it reflects a strategic choice. Either we’re going to return value to the owners, or we’re going to reinvest it in this business for growth.

Look at the last table again, though. It is the same shape as the second transaction in this section, the one where we bought inventory on day one, and by the totals it says the same thing: nothing happened. The business converted cash into equipment. Whether that reinvestment was a good idea is a question the balance sheet is not built to answer, and you will not find out until the equipment shows up in next year’s income statement.

What the eleven moves add up to

Every transaction in this section kept the equation in balance, and they did it in one of three ways. Some changed only the left side, trading one asset for another. Some changed both sides by the same amount, growing or shrinking the business. And one changed only the right side, moving a claim from a creditor to the owner without the business getting any bigger.

Only three of the eleven moved owner’s equity for a reason that had anything to do with value being created or destroyed: the sale, the two expenses, and the unearned revenue we finally earned. Everything else was rearrangement - important rearrangement, the kind that determines whether you can pay next month’s bills, but not performance.

Which is a problem, because on the balance sheets we have been drawing, you cannot easily see the difference. Cash and equipment sit in the same column. A bill due next week and a loan due in nine years sit in the same column on the other side. The next section is about the fix.

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