Your balance sheet: the first financial tool you should review

No one wants to pay any more taxes than they need to.

But for three years this is exactly what Susan, the owner of a SaaS business, did. She paid the IRS an additional $50,000 each year.

What’s worse?She didn’t even know it until she explored a different issue, and realized she had been duplicating certain income items for more than three years!

In 2015, Susan noticed that her QuickBooks bank register showed that she had more than $350,000 in one of her accounts. Susan had never had $350,000 in her account. She knew it was supposed to be around $20,000.

After connecting with an accounting firm to help her review, she discovered what was wrong. Susan had connected her bank account to automatically feed into her QuickBooks file, which meant that each time a deposit was pulled in from the bank account, it was posted to revenue.

Susan had also connected one of her sales systems to QuickBooks to automatically post invoices. However, the two connections were not working together correctly. The result? Every sales transaction from that system was counted twice. This happened again and again for nearly three years.

What your balance sheet tells you

Your balance sheet tells you the health of your business. And more importantly, it tells you if your profit and loss statement is accurate.

Your balance sheet details the assets you own, the liabilities you owe and the equity you have in your business. A balance sheet is a point-in-time report. It tells you what balances you have in all accounts as of a given day. The balance sheet can be reviewed at any time, but is typically run as of the last day of the month to gauge the current state of the business.

Assets

Your assets will include cash, bank accounts, securities, accounts receivable, inventory, fixed assets, deposits on account – essentially anything your business owns. Assets are typically divided into current and long-term assets. Current assets are those assets that are fairly liquid and could be turned into cash within a year. Long-term assets are those assets that are longer-term investments that you don’t intend to sell within a year or that would be harder to convert to cash.

Liabilities

Liabilities include amounts your business owes – credit cards, vendor payables, loans, accrued expenses. Liabilities are also separated into current and long-term liabilities. Liabilities will include your accounts payable balances, credit cards, loans and any other obligations to creditors, vendors, or owners.

Equity

Your equity section represents the contributions you have made to the business, the distributions you’ve taken from the business and the earnings that you’ve left in the business. Your equity is essentially your net worth. While it does not necessarily represent market value for your business, you can evaluate the health of the business by the strength of your equity balances.

Why you should care about your balance sheet

When it comes to a monthly review of financial statements, most business owners want to skip the balance sheet. They don’t think it’s important and it’s not as fun. Susan was one of those business owners. She looked at sales reports and her profit and loss statement, but she didn’t give her balance sheet a second thought.

If she hadn’t skipped this critical review, she would have realized that something was wrong before it cost her time and money, and ultimately almost cost her the business.

Here's how accounting works. For every entry, there has to be an off-setting entry to another account. It’s called double-entry accounting. If you debit cash, you have to credit something else. In Susan’s cash, when the sales transactions were being duplicated, there was a debit to cash and a credit to revenue, twice! This resulted in the bank balance continually increasing, because for every $5,000 sale, there was actually $10,000 in debits being recorded to the bank account. This meant that the bank account balance on the balance sheet was incorrect. Through review of the balance sheet, this would have been easy to catch. Susan would have seen that the bank balance was unreasonable, because she would have seen that there was $50,000 on the balance sheet, when it was actually only $30,000. Or, the following month, she might have seen $70,000 when there was actually only $20,000 in there.

This is how the balance sheet tells you if your profit and loss statement is accurate. If you can review your balance sheet and feel confident that the balances represented are accurate, then you can feel comfortable that the profit and loss statement is at least generally correct. There might be an expense coded to one account that should have gone to another, but your bottom line is accurate. However, if you review the balance sheet and see issues with your balances, you know you need to investigate further.

Further investigation by Susan would have uncovered two $5,000 transactions on the same day and maybe two $10,000 deposits on another day. For each of those incorrect debits to cash, there was an incorrect credit to revenue, thereby overreporting revenue on the profit and loss statement.

How to review your balance sheet

There are three primary items to consider when reviewing your balance sheet.

First, review every account that is on the balance sheet and be sure you understand what it is and why it is there. If there are three bank accounts listed and you only have two, you need to figure out why the bank account that doesn’t exist is still on your balance sheet. Did you close the account and withdraw the cash? Maybe you forgot to record that transaction. If there is a truck loan that is still on the balance sheet for a truck that you sold three years ago, something is wrong. Make sure every account on the balance sheet should be there.

Next, review the account balances for reasonableness. Maybe you do still have a truck loan for a vehicle, but you know you only owe $2,000 and the balance sheet still shows the original balance of the loan. This means the payments have not been recorded correctly. In Susan’s case, if she would have reviewed her bank balance and realized that it didn’t make sense, because she knew she didn’t have that much money in the account, she would have uncovered the sales duplication issue. As you review each account, the balances should all make sense to you.

And, finally, review for negative balances. Most accounts on the balance sheet should be represented by positive balances. While there are some exceptions, if you review for negative balances, you’ll be able to uncover those negative balances that are issues versus those that are accurate. If you have a loan account that is negative, this likely means that the interest portion of the payments has not been properly recorded with each payment. If your bank balance is negative, then you’ve either written checks out of your account when the money wasn’t there to cover them, or something might have been recorded twice, or you might have recorded an expense to the bank account when it was actually paid on the credit card. Reviewing for negative balances can give you a good starting point for accounts to investigate further.

Performing a regular monthly review of your balance sheet can help you catch small mistakes before they turn into business-altering issues.

Avoid costly mistakes

Susan discovered the issue and corrected it, and she was able to recover her overpayments to the IRS. But it wasn’t without cost.

She spent nearly $20,000 to hire a company to correct her books and have her CPA amend three years of tax returns. She also had significant cash flow issues over this three-year period, as she was paying out more than $50,000 per year in additional taxes and it took her more than a year to recover the overpayments after amendments were filed.

Ultimately, she had to sell some real estate to cover the cash flow shortfall during that period and keep her company afloat.

Had Susan been reviewing her balance sheet regularly, she would have discovered the issue and corrected it within a couple of months. She could have avoided not only the headache and cost, but the negative impact to her business.

Want to gain a better understanding?

While it’s best to leave the technical accounting to your accountant, it’s important to have a general understanding of what you might see represented on your balance sheet. Here are some examples of the accounts you may see within the different sections of the balance sheet.