In this video, we're going to talk about the balance sheet, sometimes referred to as the statement of financial position. One of the frustrating things about learning accounting is that unfortunately, there's not universally standard definitions for terms, and so you're going to get used to the fact that one company might call it the balance sheet, and another company might call it something slightly different. The key components of the balance sheet are assets, liabilities, and shareholder's equity. An important thing to remember is that a balance sheet is like a snapshot, it's at a specific point in time. There'll be a date on a balance sheet, maybe December 31st, the fiscal year end. What the balance sheet does, is it describes the resources, those are the assets, and who has claims on the resources, those are the creditors, or the liability holders, and the owners, okay or the stockholders. One of the most important relationships in accounting, is referred to as the balance sheet equation, and this links the resources and the claims on the resources. It's got a very simple structure. Assets equals liabilities plus owners equity. That is, all of the resources are claimed by somebody, if it's not an outside creditor, then it's going to be the owners. This seemingly simple equation governs everything we do in accounting. It provides a lot of the discipline, okay that makes accounting work. Now, another way to say the balance sheet equation, rather than assets equals liabilities plus owners equity, is to say that owners equity or shareholders equity is assets minus liabilities. Sometimes you'll see the term net assets or net worth to describe the shareholders equity account as well. A simple way to think about these three types of accounts is if you own a house. The value of the house, the house is the resource, that's the asset. If you've got a mortgage on the house, that's a liability. If you've got $1 Million house and a $300,000 mortgage, then your shareholders equity is $700,000. So, assets equals liabilities plus owner's equity, or owner's equity is the difference between assets and the liabilities. Now, one of the things that a balance sheet has to do is balance. Okay, and that balance, balance to the penny, often gives the illusion of exactness to accounting that really is not justified. Okay, just because a balance sheet balances, doesn't mean everything is okay. If we've overstated the value of the house, it means we've overstated the value of something else, probably the equity that we have in the house. Now, every transaction and event that is recorded in financial statements has to preserve the balance in the balance sheet. This means if any transaction or event makes one asset, let's say move up, it's going to make something else change as well. Okay, this is referred to as the double entry feature of accounting. At least two things have to be impacted by each transaction. So, for example an asset going up could be accompanied by another asset going down, or it could be accompanied by a liability going up, or a stockholders equity account going up, or some combination of all of those. Being able to figure out which one happens for a given transaction is an important part of understanding how accounting works. Now, there's also different formats for presenting the balance sheet equation, and U.S. firms often do this slightly differently than IFRS firms do. It's the same structure just presented in a different way. In a U.S. firm, you typically see the assets ordered by their liquidity, or how quickly they're going to generate their benefits. The current assets like cash, and receivables, and inventory are shown first, and then the longer term assets. You see the liabilities are shown first on the other side of the balance sheet, and then the stockholder's equity to make the overall balance sheet equation balance. But under IFRS accounting, you'll often see things in a slightly different order. Many IFRS firms flip flop the asset side, and show the long term assets first, and then the current assets. And similarly on the other side of the balance sheet, they'll often show the stockholders equity first, and then the liabilities. So, it's the same things just presented in a slightly different order. The last thing we want to talk about in this video is the relationship between the balance sheet and the other financial statements. Remember the balance sheet is at a specific point in time. Income statements and cash flow statements on the other hand are about a period of time. Income statements in cash flow statements help explain how the balance sheet changes from one point in time to the next. So, at the beginning of the year, we might have a balance sheet assets equals liabilities plus owners equity. And let's just expand the assets into cash and non-cash, and expand the shareholders equity section into contributed capital and retained earnings. We'll be talking about those more later. There's similarly a balance sheet at the end of the year. Well, how did the balance sheet change from the beginning of the year to the end? The cash flow statement is about how the cash balance changed from the beginning to the end, and the income statement is about how the stockholders equity account retained earnings changed from the beginning to the end. Okay, so the income statement and cash flow statement relate to changes in the balance sheet. This balance sheet equation is extremely important in understanding how accounting works. If we can understand how a given transaction impacts the different types of balances on the balance sheet, we go a long way to understanding how accounting works. On the other hand, if we can look at the financial statements, and try to understand what accounts have changed, and what that implies about the underlying economic events and activities that have happened, that's a big step in terms of trying to understand how to do analysis of financial statements.
