Balance Sheet (Sole Proprietorship)

Balance Sheet

The Balance Sheet is one of the primary financial statements prepared by a business. Unlike the Trading and Profit and Loss Account, which shows the results of operations over a period, the Balance Sheet presents a snapshot of the business's financial position on a specific date (usually the last day of the accounting period). It is often described as a statement showing what the business owns (Assets), what it owes to outsiders (Liabilities), and what it owes to the owner(s) (Capital).

The Balance Sheet is structured based on the fundamental Accounting Equation:

Assets = Liabilities + Capital

The left side of the Balance Sheet typically lists the Liabilities and Capital, while the right side lists the Assets. In India, the horizontal format of the Balance Sheet usually follows this structure, although companies under the Companies Act, 2013, are required to present a vertical format. For a sole proprietorship, the horizontal format is commonly used.

Key characteristics:

It is a statement, not an account.
It is prepared on a specific date, hence it is called a "Statement of Financial Position".
It shows the balances of Real and Personal Accounts only. Nominal accounts are closed to the Profit and Loss Account before the Balance Sheet is prepared.
Both sides (Liabilities + Capital and Assets) must always agree, reflecting the double-entry system.

The Balance Sheet is essential for evaluating the solvency (ability to pay long-term debts) and liquidity (ability to pay short-term debts) of a business, as well as its capital structure.

Preparing Balance Sheet

The Balance Sheet is prepared using the balances of all Real and Personal accounts that remain open after the nominal accounts have been closed to the Trading and Profit and Loss Account. These balances are readily available from the agreed Trial Balance.

Steps in preparing the Balance Sheet from Trial Balance:

From the Trial Balance, identify all accounts with Debit balances that represent Assets. List these on the Assets side of the Balance Sheet. Examples: Cash, Bank, Debtors, Bills Receivable, Closing Stock (if shown in Trial Balance, which implies purchases adjusted or is valued outside), Machinery, Land, Building, Furniture.
From the Trial Balance, identify all accounts with Credit balances that represent Liabilities. List these on the Liabilities side of the Balance Sheet. Examples: Creditors, Bills Payable, Bank Overdraft, Loans.
Identify the Capital Account balance from the Trial Balance (usually a credit balance). Show this on the Liabilities side.
Adjust the Capital balance for Net Profit (add) or Net Loss (deduct) as determined by the Profit and Loss Account. Also, deduct Drawings from Capital.
Ensure that any adjustments made for items outside the Trial Balance (like Closing Stock if not in TB, Outstanding Expenses, Prepaid Expenses, Accrued Income, Unearned Income) are correctly shown on both sides of the Balance Sheet or affect the appropriate items. For example, Closing Stock is shown as an asset and also credited to Trading Account (if not in TB). Outstanding expenses are shown as liabilities and added to the relevant expense in P&L.
Finally, total both the Liabilities & Capital side and the Assets side. The totals of both sides must be equal.

If the Balance Sheet totals do not agree, it indicates an error, likely one that did not affect the Trial Balance agreement (e.g., error of principle, complete omission), or an error in making adjustments.

Relevant Items In The Balance Sheet

The Balance Sheet presents Assets, Liabilities, and Capital. These are further classified based on their nature and time horizon.

Assets Side (Right Side):

Represents what the business owns. Classified into:

Non-Current Assets (Fixed Assets): Assets held for long-term use (more than one accounting period), not for immediate resale.
- Tangible Fixed Assets: Have physical existence. E.g., Land and Building, Plant and Machinery, Furniture and Fixtures, Vehicles. These are shown at Cost less Accumulated Depreciation (Book Value).
- Intangible Assets: Do not have physical existence but have value. E.g., Goodwill, Patents, Trademarks, Copyrights, Software. These are shown at cost less Amortisation.
- Capital Work-in-Progress: Cost of fixed assets under construction.
- Non-Current Investments: Investments held for more than one year.
Current Assets: Assets expected to be converted into cash or consumed within one accounting period (usually 12 months or the operating cycle).
- Current Investments: Investments held for less than one year.
- Inventories (Stock): Raw materials, Work-in-Progress, Finished Goods, Stock-in-trade.
- Trade Receivables: Amounts due from customers (Debtors) and Bills Receivable.
- Cash and Cash Equivalents: Cash in hand, Balance with Banks, Cheques/Drafts on hand, Short-term highly liquid investments.
- Short-term Loans and Advances: Loans given by the business repayable within 12 months.
- Other Current Assets: Prepaid Expenses, Accrued Income (Income earned but not received).

Liabilities and Capital Side (Left Side):

Represents the sources of funds for the business – claims of outsiders and the owner(s).

Liabilities: Obligations to external parties. Classified into:
- Non-Current Liabilities (Long-term Liabilities): Obligations payable after more than one accounting period. E.g., Long-term Loans from Banks/Financial Institutions, Debentures.
- Current Liabilities: Obligations payable within one accounting period (usually 12 months). E.g., Trade Payables (Creditors and Bills Payable), Bank Overdraft, Short-term Loans, Outstanding Expenses, Unearned Income (Income received but not earned), Provision for Taxation.
Capital (Owner's Equity): The owner's claim on the assets.
- Initial Capital: Amount originally invested.
- Add: Fresh Capital Introduced: Additional investments by the owner.
- Add: Net Profit: Profit earned during the period increases owner's equity.
- Less: Net Loss: Loss incurred during the period decreases owner's equity.
- Less: Drawings: Funds or goods withdrawn by the owner for personal use.
- Reserves and Surplus: Accumulated profits retained in the business (General Reserve, Specific Reserves, Capital Reserves, Credit balance of P&L A/c if Net Profit).

Example 1. Items in a Balance Sheet of a small shop in Chennai.

Cash in hand, amount owed by customers, stock of goods, shop building, loan from bank (repayable in 5 years), amount owed to suppliers, owner's initial investment, profit for the year, owner's withdrawals.

Answer:

Assets Side: Cash in hand (Current Asset), amount owed by customers (Debtors - Current Asset), stock of goods (Closing Stock - Current Asset), shop building (Non-Current Asset).

Liabilities Side: Amount owed to suppliers (Creditors - Current Liability), loan from bank (Non-Current Liability).

Capital Side: Owner's initial investment (Capital) + Profit for the year - Owner's withdrawals (Drawings).

Marshalling And Grouping Of Assets And Liabilities

Marshalling refers to the arrangement or ordering of assets and liabilities in the Balance Sheet in a particular sequence. Grouping refers to grouping similar items together under appropriate headings (e.g., grouping all fixed assets under 'Fixed Assets').

Purpose of Marshalling and Grouping:

To present information in a clear, organised, and systematic manner.
To facilitate the analysis and interpretation of the financial position by users.
To comply with legal requirements or standard practices.

There are two common orders of marshalling, though companies in India generally follow a prescribed format under the Companies Act, 2013, which combines aspects of both.

1. Order of Liquidity:

Assets are listed in the order of their liquidity, i.e., the ease with which they can be converted into cash. The most liquid asset (Cash in Hand) is shown first, followed by less liquid assets, ending with the least liquid assets (Fixed Assets).

Liabilities are listed in the order of their urgency of payment. Short-term liabilities (Current Liabilities) payable in the near future are shown first, followed by long-term liabilities, and finally Capital (which is owed to the owner but not repayable in the ordinary course of business).

Order of Liquidity (Assets): Cash in Hand $\rightarrow$ Cash at Bank $\rightarrow$ Trade Receivables (Debtors, BR) $\rightarrow$ Short-term Investments $\rightarrow$ Closing Stock $\rightarrow$ Prepaid Expenses $\rightarrow$ Long-term Investments $\rightarrow$ Tangible Fixed Assets $\rightarrow$ Intangible Assets.

Order of Liquidity (Liabilities): Current Liabilities (e.g., Creditors, BP, Outstanding Expenses, Bank Overdraft) $\rightarrow$ Non-Current Liabilities (e.g., Loans, Debentures) $\rightarrow$ Capital.

This order is useful for assessing the short-term financial health (liquidity) of the business.

2. Order of Permanence:

Assets are listed in the order of their permanence, i.e., the period for which they are intended to be held in the business. The least liquid/most permanent assets (Fixed Assets) are shown first, followed by less permanent assets, ending with the most liquid assets (Cash).

Liabilities are listed in the order of permanence, starting with Capital (the most permanent claim on assets), followed by long-term liabilities, and ending with short-term liabilities.

Order of Permanence (Assets): Intangible Assets $\rightarrow$ Tangible Fixed Assets $\rightarrow$ Long-term Investments $\rightarrow$ Current Assets (Prepaid Expenses, Stock, Trade Receivables, Short-term Investments, Bank, Cash).

Order of Permanence (Liabilities): Capital $\rightarrow$ Reserves and Surplus $\rightarrow$ Non-Current Liabilities $\rightarrow$ Current Liabilities.

This order is often preferred by manufacturing concerns as it highlights the long-term assets used in operations.

For sole proprietorships and partnerships, either order can be used, though the order of permanence is quite common in practice, mirroring the format for companies where fixed assets are shown first. Regardless of the order, the total of both sides of the Balance Sheet must always match.