We will explain the relationship between the balance sheet and income statement in this post.
We have explained that the income statement shows the net profit for a specific period of time, and that the balance sheet shows the financial position on a specific date.
That means if we make profits during a period, the balance sheet should improve by the same amount. Conversely, if we incur losses during a period, the balance sheet should deteriorate by the same amount. In other words, if we compare the balance sheets between the beginning and end of a period, the difference in its amount should reflect the result of the income statement for the same period.
More specifically, change in the equity section of the balance sheet equals the net profit or net loss on the income statement, as follows.
Equity at the beginning - equity at the end = net profit or net loss for the period.
It’s easier to understand the above equation if we use illustrations.
For example, let’s say we have the following balance sheet at the beginning of a period.
Also, let’s say our income statement for the same period is as follows.
In this case, the ending balance sheet would look like the following.
First, the assets go up by 100 compared to the beginning. If we receive cash for our revenues, the assets increase by 110 since cash belongs to the asset category. Similarly, if we pay the expenses by cash, the assets decrease by 10. Thus, the total increase in the assets is 100.
Secondly, the equity also goes up by 100, because our income statement has a net profit of 100.
Therefore, the aforementioned equation holds true.
Equity at the end (400) - equity at the beginning (300) = net profit or net loss for the period (100)
In the previous post, we have explained the left side and right side of the balance sheet are equal, and their equality can be expressed by the following equation.
Assets = Liabilities + Equity
We can expand the equation using the relationship between the balance sheet and income statement we’ve just examined.
Assets = Liabilities + Equity at the beginning + (Net profit or loss for the period)
We can expand it further by replacing the net profit with revenues and expenses.
Assets = Liabilities + Equity at the beginning + (Revenues - Expenses)
We can see the equation is true by applying the number from our previous example.
Assets (500) = Liabilities (100) + Equity at the beginning (300) + (Revenues (110) - Expenses (10))
In bookkeeping, there are a total of 5 ledger account categories, namely assets, liabilities, equity, revenues, and expenses. Because the above equation shows the relationship among all 5 categories, you can greatly improve your bookkeeping skills by understanding and remembering it.