Basic Accounting:
The Balance Sheet and the Income Statement
What do these two statements have in common, other than they happen to be a part of the Financial Statement set? At first glance, to the untrained eye, there would be very little common ground; but if you’re an accountant, you know that the Balance Sheet and the Income Statement share interdependence. What is it, and what is the significance?
The interdependence shared by the Balance Sheet and the Income Statement can be found in each area of the Balance Sheet, and in the numbers reported for each section. The most impacted areas: Assets and Owner’s Equity.
When changes occur in the assets of a business, these changes are reflected in the asset values reported on the Balance sheet. Quite often, purchases of equipment, machinery, buildings, and property are necessary. A purchase increases the fixed asset value of the company; it is also a change that is reflected in the insurance expense, depreciation expense, and utilities expense. When new equipment is added to a company’s asset listing, there is often a debt incurred that increases the liability of the business. But, there is also additional depreciation expense, insurance expense, and often utility expense that must be reported on the Income Statement each month. This directly affects the Net Income figure and this in turn directly impacts the equity or retained earnings of the business.
Changes found in these areas should flag the need for further examination of the Balance sheet in order to accurately assess the actual operating and financial circumstances surrounding these changes. When you see significant changes in the balances for the asset value, owner equity or retained earnings values, and there is an increase in expense values, you should begin to further investigate. Is the business growing, or is the equipment outdated and in need of replacement? Will the purchase increase revenues, or will they remain constant?
The notes that are incorporated into the Financial Statements data should provide anyone (accountant or investor) with enough information to accurately assess the impact of the change, either positive or negative. With the use of the multiple-step Income Statement there are generally notes provided to explain significant changes in any area; the same is true of the Statement of Cash Flows. Generally, these notes will explain to the creditor, investor, or business valuator enough information that there is no need to include additional notes in the other financial statements.
The Financial Statements set of information is designed to give the examiner, investor, auditor, or business owner a picture of the overall health of the business. Each statement holds some interdependence upon the other. The information that is reported in one statement will either directly or indirectly affect the information that is reported on the other statements. The Income statement directly impacts the Statement of Owner Equity; the Income statement also provides information for the Statement of Cash Flows; but the Balance Sheet and Statement of Cash flows share a larger interdependence than any of the remaining statements.
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