Welcome to part four in this series. 

In this fourth part of the series, we will be focused on the balance sheet and we'll be covering the following three areas. First, what does the balance sheet show and what is its purpose? Second, we'll discuss the key components of the balance sheet, the accounting equation, and why a balance sheet balances. Finally, we'll consider some useful questions a director should consider when reviewing a balance sheet. 

We'll be referring to an example income statement for a fictitious company, Creative Arts Limited, and you can download a copy from the link in the video description. It will be helpful for you to have a copy of it available as we go through this session. 

A balance sheet can also be called by other names, including a statement of financial position or a statement of assets and liabilities. But fundamentally, they all refer to the same document. 

So what does a balance sheet show? A balance sheet shows the organisation's assets, liabilities, and equity, sometimes called an accumulated surplus or reserves, at a specific point in time. For example, the end of the financial year. 

And what is the purpose of a balance sheet? A balance sheet is a snapshot of the financial position of the organisation at a point in time. It also shows how assets owned or controlled by the organisation have been paid for, and we will discuss this further during the session. 

What is an asset? An asset is a resource that is owned or controlled by an organisation and which is expected to provide a future benefit. Examples include cash, office, equipment, and property. 

What is a liability? A liability is an obligation to transfer a resource such as cash to settle an amount owed at some point in the future. Examples include trade payables, which is monies owed to suppliers, employee leave liabilities, and lease liabilities. 

Equity, sometimes called an accumulated surplus or reserves, represents what is left over in the organisation's assets once all liabilities are deducted. In other words, it represents the net resources accumulated over time and available to advance the organsation's purpose now and in the future. 

So why is it called a balance sheet? It's called a balance sheet because it balances. The accounting equation is assets minus liabilities equals equity. Referring to Creative Arts Limited balance sheet, total assets have $842,700 minus total liabilities of $472,200 equals equity of $370,500. 

Let's take a closer look at assets. On a balance sheet, assets are categorised as either current assets or non-current assets. Creative Arts Limited has total current assets of $239,400 and total non-current assets of $603,300, which add together to give total assets of $842,700. 

A current asset is an asset that is expected to be used or converted into cash within the next 12 months. A non-current asset is an asset that is expected to last greater than 12 months. 

As a director, when it comes to assets, there are two general questions you should consider. The first question is, do all the assets actually exist and are all the assets owned or controlled by the organisation? As an example, if we own lighting and sound equipment, do we have the processes in place to periodically count or inspect the equipment and assure we still own and control them? 

The second question is, how have each of the assets been valued and have they been valued in accordance with the requirements of the Australian Accounting Standards? As directors, we have duty to understand how the management team has valued the assets and be prepared to ask questions and challenge the assumptions management have made. 

Turning now to liabilities, just as assets are split into current and non-current categories, the same split is required for liabilities. Creative Arts Limited has total current liabilities of $260,700 and total non-current liabilities of $211,500, which add together to give total liabilities of $472,200. 

A current liability is an obligation due to be paid or settled in the next 12 months. Examples include: Trade payables, in other words, amounts owed to suppliers, unpaid invoices or employee leave liabilities. A non-current liability is an obligation that is not due to be paid or settled for at least 12 months. Examples include a lease liability, which is money due to be paid under a lease greater than one year in the future. 

As a director, when it comes to liabilities, there are two general questions we should consider. First, have all liabilities been identified? For example, do we have adequate procedures and internal controls to ensure that all amounts due to suppliers have been recorded? Second, how have each of the liabilities been valued and have they been valued in accordance with the requirements of the Australian Accounting Standards? 

The total value of all assets less the total value of liabilities, gives the net assets of the organisation. Creative Arts Limited total assets are $842,700, and its total liabilities are $472,200, giving net assets of $370,500. This is equal to the total equity for the company. 

In an arts organisation, the equity section of the balance sheet is sometimes called accumulated surpluses or reserves, and equity is usually built in one of more of the following three ways. 

First, depending on the type of organisation, members or shareholders may make an initial contribution of funds. Creative Arts Limited members have contributed $1,500, which is shown on the balance sheet as issued capital. Second, organisations may build an accumulated surplus or deficit over the life of the organisation. This is the total of all revenue, minus all expenses over time. Creative Arts Limited has an accumulated surplus of $354,100. 

And third, we have reserves. There are different types of reserves, but a common one is an asset revaluation reserve. This is where the organisation recognises the increase in the fair market values of an asset. For Creative Arts Limited, the reserve here relates to the increase in value of financial assets, which are a small portfolio of financial investments. 

In arts organisations, it is common for certain grants or donations to be made on a strict condition that they only be used for a specified purpose, for example, to buy a building, commission a new work, or fund a fellowship. In these cases, the funds are not available to be used for other purposes. 

It is best practise to recognise these funds in a separate reserve so that directors and other stakeholders are aware of what funds have restrictions as to what they can be used for. Generally, these are called restricted reserves, where the general purpose reserves are called unrestricted reserves. 

To summarise the key learnings from this part of the series: First, a balance sheet is a snapshot of the financial position of the organisation and its assets, liabilities, and equity at a specific point in time. Second, the accounting equation is assets minus liabilities equals equity. Finally, we discussed some key questions directors should consider when reviewing a balance sheet. 

Part six of this series will further explore how directors can read and interpret the balance sheet and what additional questions we should ask.