The balance sheet: assets, liabilities, net assets
The balance sheet is a photograph of a business on one day. It has two sides that are always equal:
Assets = Liabilities + Net assets
- Assets are things the business owns that help it earn: cash, goods, buildings, machines, shares.
- Liabilities are amounts it must pay to others: bills, bank loans, bonds.
- Net assets (also called equity) are what is left for the owners: capital they put in plus retained earnings (past profits kept in the business).
Current items are used or paid within one year (or the normal business cycle). Fixed (non-current) items last longer than one year.
Revenue, expenses and profit
Revenue is what the business earns by selling goods or services (sales, fees, interest received). Expenses are the costs of earning it (materials, wages, rent, depreciation, interest paid, tax).
Profit = Revenue − Expenses. If expenses are bigger, it is a loss. At the end of the period profit is added to retained earnings, so net assets go up. Revenue is recorded when it is earned and expenses when they are incurred (matched to the same period), not simply when cash moves. This is the accrual basis.
Financial products (securities)
Financial products are things like shares, bonds, loans receivable and derivatives. Businesses hold them to trade, to earn interest, or to keep long-term relations. They are usually put in groups:
- Trading securities: held to sell quickly. Valued at market price; gains and losses go to profit.
- Held-to-maturity bonds: kept until they are repaid. Shown at cost (adjusted slowly to face value).
- Other (available-for-sale) securities: valued at market price; the change is kept in net assets until the security is sold.
The idea is simple: the balance sheet should show a fair value for items that can easily be sold.
Tangible and intangible fixed assets
Tangible fixed assets can be touched: buildings, machines, vehicles, land. Intangible fixed assets cannot: patents, software, trademarks, goodwill.
They are used for years, so their cost is spread over their useful life. This is depreciation for tangible assets (land is not depreciated) and amortisation for intangible assets.
- Straight-line: yearly depreciation = (cost − residual value) ÷ useful life. Equal each year.
- Declining-balance (fixed-percentage): a fixed rate on the book value at the start of each year; larger early, smaller later.
Book value = cost − accumulated depreciation. Depreciation is an expense but no cash leaves; it only records the wearing out.
Long-term liabilities
Liabilities due after more than one year are long-term (fixed) liabilities. Examples: long-term bank loans, bonds payable (a business borrows from many investors and promises interest and repayment), and provisions for retirement benefits (money the business owes to staff in the future). The part of a long-term loan that is due within the next year moves to current liabilities. Interest is an expense of each year.
Tax-effect accounting
The profit shown in the books (accounting profit) can differ from the profit on which tax is calculated (taxable income) because the rules for timing differ. These timing gaps are temporary differences: they reverse later.
Without adjustment, the tax expense would jump around. Tax-effect accounting fixes this by recording deferred tax:
- Deferred tax asset: tax paid early now, which will lower tax later.
- Deferred tax liability: tax delayed now, which must be paid later.
Then total income taxes in the income statement = accounting profit × tax rate (about), so the tax expense matches the profit shown. Example: accounting profit 100, taxable income 120, rate 30%: tax paid 36; tax expense 30; deferred tax asset 6.
Try it: your own mini ledger
List what you or your family own (assets) and owe (liabilities). Net assets = assets − liabilities. Next, for one week note money earned and spent. Find revenue − expenses. Then in the 3D, set the sliders to your numbers and check that the two sides stay equal.
Key formulas and definitions
- Assets = Liabilities + Net assets
- Profit = Revenue − Expenses
- Net assets (end) = Net assets (start) + Profit − Distributions
- Straight-line depreciation = (Cost − Residual value) ÷ Useful life
- Book value = Cost − Accumulated depreciation
- Income taxes (total) ≈ Accounting profit × Tax rate
Worked examples
1. Assets are 500 and liabilities are 300. Find net assets.
Net assets = 500 − 300 = 200.
2. Revenue is 800 and expenses are 650. What is the profit and its effect on net assets?
Profit = 800 − 650 = 150. Net assets increase by 150.
3. A machine costs 1,000,000 with no residual value and a 5-year life (straight-line). Find yearly depreciation and the book value after 2 years.
Depreciation = 1,000,000 ÷ 5 = 200,000 a year. After 2 years the accumulated depreciation is 400,000, so book value = 600,000.
4. A vehicle costs 1,000, has a residual value of 100 and a life of 5 years. Find yearly straight-line depreciation.
(1,000 − 100) ÷ 5 = 180 a year.
5. Declining-balance at 40% on a machine costing 1,000. Find depreciation in years 1 and 2.
Year 1: 1,000 × 0.40 = 400 (book value 600). Year 2: 600 × 0.40 = 240 (book value 360).
6. Trading shares were bought for 500 and are worth 540 at year end. What do we record?
They are trading securities, so they are shown at market value 540 and the gain of 40 goes to profit.
7. Accounting profit 100, taxable income 120, tax rate 30%. Find tax paid, tax expense and the deferred tax asset.
Tax paid = 120 × 30% = 36. Tax expense = 100 × 30% = 30. Deferred tax asset = 36 − 30 = 6.
Common mistakes
- Writing land as depreciated. Land is not used up, so it is not depreciated.
- Thinking depreciation is cash paid out. It is a non-cash expense that only spreads the cost.
- Mixing up net assets and profit: profit is for one period, net assets are the balance on one day.
- Forgetting the residual value in straight-line depreciation: use (cost − residual) ÷ life.