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About Balance Sheets

Management (MGT)
Course Code
H Laurence

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Balancing the Balance Sheet
You have a balance sheet, and you have som e transactions that will change it. How do those transactions affect the balance sheet, and how do
you record the changes?
Suppose you sell something.
You normally sell something from i nventory. That is one of the assets. Since you have sold it, you no longer have it, and you must reduce the
inventory by the value of the item sold. So you determine the value at which you were carr ying t hat item in inventory. That is t he value you
recorded when you put the item into inventory. Take that value off theinventor y” line.
But something happened when you sold t he item. You got something for it. If you got cash for the item, you now have more cash t han you
had before. So you increase t he cash line by t he amount you received in cash for t he item. You have traded one asset (the inventor y item) for
another (the cash).
Suppose the item of inventory was recorded in inventory at $100. If you sold it for $100, you simply transfer red the $100 in value from
inventory to cash. But you usually sell items for more than their cost to you. Suppose you sold the item for $200. Now you have reduced
your inventory by $100, but you have increased your cash by $200. Your assets have increased by 200-100= $100.
Wait – the accounting equation must balance. That means that we must always ensure t hat: assets = liabilities + equity
If we increase t he assets, we must also increase either liabilities or equity. Since we have sold the item, we cle arly do not have a liability. So
we must enter the increase in the assets (the $100 extra) in the equity section. We add that to retained earnings. If there is no line for retained
earnings, just add one and put the $100 in it. That way the accounting equation balances. You must always ent er the net amount of each
transaction on BOTH sides of the accounting equation. If you increase one side, you must increase the other. If you reduce one side, you
must reduce the other.
In many commercial transactions items are sold on credit. You deliver the item and with it you deliver a bill or invoice for t he value of the
item sold. The customer must pay the bill wit hi n a cert ain number of days. You have created an account receivable. So if you sell the item
of inventory for $200, instead of adding the $200 to cash, you add it to your a ccounts receivable. If there is no line for accounts receivable,
add one. Remember to also increase the retained earnings line of the equity section to keep the balance sheet in balance.
Suppose you buy something
If you buy something, you have an asset you did not have before. So you must make an addition to the appropr iate line on theasset side of
the balance sheet. Suppose you purchased an item of inventory and paid $100 for it. You have a new asset worth $100. You add that amount
to theinventory” line. If you do not have an inventory line, add one.
Wait – the accounting equation must balance. That means that we must always ensure t hat: assets = liabilities + equity
In this case, we have added something to t he asset side. So we must either reduce the some other asset or increase the liabilities. If you paid
cash for t he item, you reduce the cash” line by $100 and increase theinventory” line by the same amount. This leaves t he accounting
equation in balance. If, however, you purchased t he item on credit, you increase theinventor y” line by $100 but you now owe the seller
$100. This must be recorded as a liability – an account payable. So you add $100 to theaccounts payable” line to balance the accounting
equation. If there is no such line, create one.
Suppose you put money into the business
One way to put money into the business is by borrowing t he money. You will then have to pay t hat money back. The borrowed money is a
liability, and must be recorded as a liability on the balance sheet. Put the amount in the appropriate line of the balance sheet. Loans due
within t he year are a current liability; longer term loans are long term liabilities.
Wait – the accounting equation must balance. That means that we must always ensure t hat: assets = liabilities + equity
You received the loan money, and t hat must be a new asset. So add the amount of the loan to cash. That way t he accounting equation will
You follow a similar process in adding equity. The amount you pay for shares of t he business will be added to thecontributed capital” line
in the owners' equity section, and the value recorded as an asset in thecash” line.
The point of all this is to ensure that the balance sheet ALWAYS balances. This requires entering each transact i on in TWO places. Some
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