Preparing a projected balance sheet, or financial budget involves analyzing every balance sheet account. The beginning balance for each account is the amount on the balance sheet prepared at the end of the preceding period. Then, managers consider the effects of any planned activities on each account. Many accounts are affected by items appearing in the operating budget and by either cash inflows or outflows.

The complexities encountered in preparing the financial budget often require the preparation of detailed schedules. These schedules analyze such things as planned accounts receivable collections and balances, planned material purchases, planned inventories, changes in all accounts affected by operating costs, and the amount of federal income taxes payable. Dividend policy, inventory policy, financing policy and constraints, credit policy, and planned capital expenditures also affect the amounts in the financial budget.

To prepare a projected balance sheet, we will analyze each balance sheet account starting with cash. First, let’s take a look at GelSoft’s balance sheet as of the close of business for the current year, which will be the starting point for the budget for next year. This will likely also be a projected balance sheet since the budgeting process for next year will begin during the current year.

We will look at each account and determine the new budgeted balances based on the previous schedules.

Cash

We can get the ending cash balance from the Ending Cash balance in the cash budget.

Accounts Receivable

The balance in Accounts Receivable represents credit sales that have not been collected during the year. In our example, this would be 40% of Quarter 4 sales of $1,574,370, which is $629,748 to be collected during the 1st quarter of the next year.

Inventory

For a manufacturer like GelSoft, there are two inventory accounts: Raw Materials inventory and Finished Goods inventory. Raw Materials inventory will come from the materials purchases budget using desired ending inventory for quarter 4 or the year x cost per material. For GelSoft, we projected 11,200 kilograms of materials for ending inventory at $11 per kilo of material = $123,200. For Finished Goods inventory, we will use the desired ending inventory units from the production budget x production cost per unit. For GelSoft, the production cost is $22.48 per unit including direct materials, direct labor, variable and fixed overhead. The ending balance in finished goods inventory is projected to be 16,200 units x $22.48 per unit or $364,176.

We can now fill in the current assets portion of the balance sheet:

Property, Plant, and Equipment

This section will look at the balances from the previous year and add any depreciation and additional purchases for the year. Property, Plant and Equipment (also called Fixed Assets) refer to long term assets used in the business including land, equipment, machinery, buildings, etc. Depreciation is applied to all of these items except for land, which is not depreciated.

For Gelsoft, at least at this point in the budgeting process, there are no planned purchases or sales of fixed assets.

However, there is $200,000 of depreciation expense in the manufacturing overhead budget, which increases accumulated depreciation. Remember that depreciation expense is the allocated cost of the equipment that spreads the initial expenditure out across the periods for which the equipment is being used in order to better match the cost to the revenue. Likewise, according to the selling and administration expense budget, we had depreciation on the office equipment of $100,000 so we will add this to the existing balance from the previous year to get a new balance of $300,000 ($200,000 prior year + $100,000 current year depreciation).

The third component of the master budget is the capital expenditures budget. That budget is based on the long-term decision-making process around buying (and selling) fixed assets, and would therefore affect this section. However, we’ll continue to focus on the operating budget for now.

We can now fill out the next section of the balance sheet:

Current Liabilities

Current Liabilities are liabilities we expect to pay in the next year. We determined Accounts Payable when we built the purchases budget (material purchases for a manufacturer or inventory purchase budget for a merchandiser) and the schedule of cash payments.

Gelsoft assumes payments for purchases occur 80% in the quarter of purchase and 20% in the quarter after the purchase. Therefore, the company’s ending accounts payable is Quarter 4 purchases for all goods and services of $1,340,313 x 20% to be paid in the first quarter of next year for $268,063.

Income taxes are typically paid in the first quarter of the next year. We determined the budgeted income tax amount from the budgeted income statement in the amount of $63,152, and in the cash budget calculation, we included the prior balance of $20,000 as being paid off.

Owners’  Equity

Owners’ Equity goes by various names. For instance, if GelSoft is a corporation where the owners hold shares of stock as evidence of their ownership, this section would be called Stockholders’ Equity and would include common stock and retained earnings. Common stock represents ownership in the company. Retained Earnings is the earnings of the company over time minus any dividends paid. If this was a sole-proprietorship, the owner’s investment would probably be called Capital Contributions. For GelSoft, we’ll use generic terms.

We know from the basic accounting equation that Assets = Liabilities + Equity. Another way to state this is Assets – Liabilities = Owners’ Equity. Since projected assets are $3,483,588 and projected liabilities are $331,215, we can then surmise that equity will be $3,152,373.

We also know that equity is increased by net income and decreased by any owner withdrawals. Assuming there were no owner withdrawals, the complete budgeted balance sheet will look like this:

One final step and a note.

First, we can see that retained earnings reconciles to net income with a slight exception. Retained earnings at the beginning of the budget period is $1,005,000 and we project to add $147,354 to that in new earnings, however, back in the cost of goods sold budget, we found we had a $19 error due to the compounding of rounding errors. For instance, if you were to round a unit cost down from $10.551874532… to $10.55, and then applied that rounded amount to a million units, the rounded total cost would be $10,550,000, but the actual cost would be $10,551,874.53, an accumulated rounding error of $1,874.53.

The $19 rounding error that haunts us has accumulated over time. For instance, way back in the direct materials budget, we rounded 107,851.40 kilograms of materials to 107,851 which then resulted in a $4.40 overall rounding error on that portion of the budget. In addition, we rounded beginning and ending inventory volumes and other items. None of this is unusual in budgeting, and is immaterial, especially since all of our calculations are based on estimates, projections, and forecasts that are fraught with uncertainty. It is an unusual business indeed that comes in right on budget on every line item.

However, these rounding errors can be troublesome when we want everything to add up and to cross-check. As we finalize this budget by reconciling beginning and ending retained earnings, we will simply account for our error as a line item. Beware though: a seemingly small error like this in a complicated budget could be multiple items that are offsetting each other, but since we have verified all of the other numbers on the balance sheet, and since we have been aware of this discrepancy since we calculated cost of goods sold, we can feel confident that it is just this one, insignificant item, and that trying to go back and change our assumptions to eliminate it would be “stepping over a dollar to pick up a dime” — in other words, the cost of finding the exact source of this error and tracking it down to correct it would exceed any benefit that we got from doing that.

The preparation of the budgeted balance sheet completes the financial budget.

Now, check your understanding of the budgeted income statement.