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Accounting is commonly referred to as the "language of business" because it is a method of communicating financial information. One of the purposes of any language is to enable the communicator to communicate a message to all people in a clear and concise manor. In order to make accounting a standard way to communicate, accounting language contains accounting principals, concepts, and standards that have been developed over a long period of time that are now commonly used in any legitimate businesses, regardless of size.
By looking at a company's financial reports, one can not only learn whether or not the company is earning a profit, but it is also possible to gain an understanding of where the company has been in the past, and where it might go in the future. An income statement is not the only indicator of a company's performance. To gain a full understanding, one must also look behind the scenes at the balance sheet.
The balance sheet can be intimidating to the inexperienced accountant, or to an employee who does not get involved with the financial aspects of the company. But it is an absolutely necessary report in order to see the big picture. The purpose of the balance sheet is to show the financial position of a company at a specific point in time. It shows the company's assets (things the company owns that can be converted into cash), liabilities (something that the company owes, or a financial obligation), and equity (also known as net worth). If the liabilities exceed the assets, then there is negative equity, and vice versa if the assets were to exceed the liabilities.
This formula is also known as the balance sheet equation: Assets = Liabilities + equity. Let's say a company has $500 in assets, and $300 in liabilities. After the liabilities are paid off, the company is left with $200 in equity (500 = 300 +200). Looking from the other way around, if a company has $300 in assets, and $500 in liabilities, there will be a negative net worth of $200 (300 = 500 + (-200)).
Another important concept to grasp when looking at a balance sheet is understanding debits and credits. Debits and credits are the two sides of each financial transaction. Every debit transaction must have a corresponding credit transaction, and vice versa. It is important to know that a debit transaction will increase an asset account and decrease both a liability and equity account. A credit transaction will do the opposite. For example, if a company purchases $1,000 worth of merchandise, Inventory (asset) would increase by $1,000, and cash (also an asset) would decrease by the same amount. In the situation there would be a credit entry to cash causing a decrease, and a debit entry to inventory causing an increase. When the merchandise is bought or consumed, there is a credit entry decreasing the inventory, and a debit entry to the income statement.
In most cases, all asset accounts will have a debit balance, and liabilities will have a credit balance. There are certain times where there are exceptions to this general rule of thumb. When an asset account should have a credit balance, this is called a contra asset. An example of a contra asset is accumulated depreciation. Depreciation is when the cost of an asset is recognized over its useful life to the entity. For example, if an entity bought machinery that cost $10,000 and has a useful life of 5 years, $10,000 would be entered as a debit entry in an account that might be called "machinery". Each year, there would be a $2,000 credit entry to and account called "accumulated depreciation" (The debit entry would be on the income statement). A contra asset can be thought of as a subtraction to an asset account. At the end of the first year, the machinery account would still have the debit balance of $10,000, and the accumulated depreciation account would have a credit balance of $2,000, leaving the value of the machinery at $8,000.
All in all, the balance sheet is an important tool that is necessary to measure the financial situation of a company. It is not the only tool needed, but without looking at and understanding the balance sheet, one will not have a full understanding of a companies finances.
