When communicating financial information to readers of the information, standard formats for financial statements have been established. The two most widely used statements are the Balance Sheet and Income Statement. Here we will learn how the Income Statement and Balance Sheet relate.
THE INCOME STATEMENT AND BALANCE SHEET
The income statement communicates the inflows and outflows of assets, where inflows are the revenues generated and outflows are the expenses. An excess of inflows over outflows is called net income, and an excess of outflows over inflows is called a net loss.
The income statement can be expressed as an equation:
Revenue – Expenses = Net Income (Loss)
The income statement is a summary of the sources of revenues and expenses that result in a profit or a loss for a specified accounting period. Typically that period is one year but it can be a month or a quarter as well. Income statements are always prepared for a period of time and the term “for the period ended…” is included in the title.
Revenue: The sources of revenue for any business depend on the type of business being operated. A company that manufactures or resells a product would generate sales revenue. A service company on the other hand might generate fees revenue or service revenue.
Expense: Examples of typical expenses encountered are salaries, utilities, rent, insurance, and office supplies. Here again, each entity will have its own unique set of expenses depending on the type of business being operated.
Net Income (Loss): The difference between revenues and expenses is expressed as a positive or negative depending on whether revenues were greater or less than expenses.
If revenues for the month are $5000 and expenses are $3500, then the entity has a net income of $1500. If the expenses were instead $5500, then the entity would have a net loss of $500.
The balance sheet communicates what the entity owns in terms of assets, what it owes in terms of liabilities, and the difference between those two which represents what the owners of the company are entitled to. The owner’s portion is called equity.
The balance sheet can be expressed as the fundamental accounting equation:
Assets = Liabilities + Equity
The balance sheet shows a snapshot of an organization’s assets, liabilities, and equity at one point in time and it demonstrates the accounting equation. Balance sheets are always prepared for a point in time and the term “as at …” is included in the title.
Assets: The assets of a company represent the resources owned by the company. These assets can be in the form of cash or things that can be converted to cash like accounts receivable and they can also be fixed assets like cars and office equipment.
Liabilities: What a company owes to creditors is reported in the liabilities section of the balance sheet. Creditors are banks and other lending institutions as well as suppliers that are owed money in the form of accounts receivable as well as money that is owed but not yet paid (accruals). A common example of an accrued liability is yearly taxes.
Equity: The difference between what the entity owns and what it owes represents the owners’ share of the company. For sole proprietorships this equity is usually called capital and for public companies it is often referred to as common stock or share capital. The equity in a company is the owners’ claim against the assets owned.
The income statement and balance sheet of a company are linked through the net income for a period and the subsequent increase, or decrease, in equity that results. The income that an entity earns over a period of time is transcribed to the equity portion of the balance sheet. The income represents an increase in the owners’ claim against the assets: Income is NOT a cash asset. It is through the income and equity accounts that the balance sheet and income statement reflect the total financial picture of the entity.
For a teaching lesson plan for this lesson see:
Linking the Income Statement and the Balance Sheet Lesson Plan