Advanced Balance Sheet Theory
If you are not familiar with balance sheets you should take my bookkeeping course first as I don’t want to put anyone off with this article. OK, with the warning out of the way, let’s press on…
With most accounting systems, things like balance sheets are considered as reports. That is, something you need to compile on such and such a date. The same convention also applies to the profit and loss account etc. What very few people realise is that they can all be expressed as accounts. Radical thinking eh!
Balance Sheet as an Account
A balance sheet usually consists of three items:
It represents the accounting equation: Assets = Liabilities + Equity (or ALE to help you remember – imagine yourself drinking an ice cold beer on a hot summer’s day whilst entering a journal or two).
The system of double-entry is based (at its simplest level) on two things:
Your debits must equal your credits for everything to balance, hence the name balance sheet. But wait a minute, we are looking at three things on most balance sheets (ALE). How does that work?
- Assets = Debits
- Liabilities = Credits
- Equity = Credits
Hence the accounting equation shown above. This is also why a horizontal balance sheet only shows two sides (you wont see this pattern in a vertically oriented balance sheet).
Profit and Loss as an Account
Let’s take a look at an extended Profit and Loss report:
- Costs of Sales
It contains a whole bunch of account groups. But each group consists of accounts with either a debit or a credit balance. When you consolidate those accounts in each group you end up with either a debit or credit balance. Here we go:
- Sales = Credit
- Costs of Sales = Debit
- Expenses = Debit
- Depreciation = Debit
- Taxes = Debit
The final balance of the Profit and Loss ‘account’ will be placed in the Equity section of the balance sheet. All your individual liability accounts will be summarised and placed into the Liability section, and all your assets (Bank, Cash, Debtors, Stock etc.) end up being summarised or consolidated into the Assets section.
The pattern is very simple and clear. Whether an account is some individual thing (like Stationery or Bank) or consists of a group of accounts (like Cost of Goods) you can look at them all as examples of ‘accounts’. Go that one step further and consolidate their balances into balance sheet ‘categories’ and you can see the same pattern.
So the result is quite simply that a balance sheet and a profit and loss report is at its core just another account. That is why I talk about the first rule of accounting as ‘everything is an account, and there are no special cases’. It is wonderfully elegant.