How Are the Balance Sheet and Income Statement Connected
The balance sheet and income statement, two of the primary financial statements in accounting, are closely connected and influence each other in several ways:
- Retained Earnings: The net income or loss from the income statement flows into the retained earnings section of the balance sheet. Specifically, net income increases retained earnings, while a net loss decreases it. Additionally, any dividends paid out to shareholders, which are decided based on net income, decrease retained earnings.
- Depreciation: The income statement includes depreciation expense, which reduces net income. Meanwhile, the balance sheet shows accumulated depreciation, which is the sum of all depreciation expense taken over the asset’s life, and is subtracted from the asset’s gross amount to arrive at its net book value.
- Inventory and Cost of Goods Sold (COGS) : The inventory reported on the balance sheet is directly linked to the COGS reported on the income statement. When inventory is sold, its cost is moved from the balance sheet to the income statement as COGS.
- Accounts Receivable and Revenue: When a company makes a sale but hasn’t yet collected cash, it records accounts receivable on the balance sheet and revenue on the income statement. When the cash is later collected, it reduces accounts receivable but doesn’t affect revenue (since the revenue was recognized at the time of sale).
- Accounts Payable and Expenses: Similarly, when a company incurs an expense but hasn’t yet paid cash, it records accounts payable on the balance sheet and the expense on the income statement. When the cash is later paid, it reduces accounts payable but doesn’t affect expenses.
- Income Taxes: The income tax expense reported on the income statement is linked to the income taxes payable or deferred tax liabilities or assets reported on the balance sheet.
Understanding the links between the balance sheet and income statement can provide valuable insights into a company’s financial health and performance. For instance, if a company consistently reports high net income but its retained earnings aren’t increasing correspondingly, it could indicate that the company is paying out most of its profits as dividends rather than reinvesting them in the business.
Example of How the Balance Sheet and Income Statement Are Connected
Let’s consider an example to understand the connection between the balance sheet and income statement.
ABC Company – Income Statement for the Year Ended Dec 31, 2023
- Sales Revenue: $1,000,000
- Cost of Goods Sold (COGS): $600,000
- Gross Profit: $400,000 (Sales Revenue – COGS)
- Operating Expenses:
- Selling, General, and Administrative Expenses: $150,000
- Depreciation: $50,000
- Total Operating Expenses: $200,000
- Operating Income (EBIT): $200,000 (Gross Profit – Total Operating Expenses)
- Interest Expense: $20,000
- Income Before Tax: $180,000
- Income Tax Expense (20%): $36,000
- Net Income: $144,000
And here is ABC Company’s Balance Sheet at the end of 2023:
ABC Company – Balance Sheet as of Dec 31, 2023
- Assets
- Cash: $200,000
- Accounts Receivable: $100,000
- Inventory: $250,000
- Property, Plant & Equipment (net of $200,000 accumulated depreciation): $800,000
- Total Assets: $1,350,000
- Liabilities
- Accounts Payable: $100,000
- Income Tax Payable: $36,000
- Long-term Debt: $400,000
- Total Liabilities: $536,000
- Equity
- Common Stock: $500,000
- Retained Earnings: $314,000 (Retained earnings at the beginning of the year were $170,000)
- Total Equity: $814,000
- Total Liabilities and Equity: $1,350,000
The link between the two statements is evident:
- The net income of $144,000 from the income statement has been added to the beginning retained earnings of $170,000 to give a year-end retained earnings balance of $314,000 on the balance sheet.
- The depreciation expense of $50,000 from the income statement is part of the accumulated depreciation of $200,000 that is deducted from the gross value of Property, Plant & Equipment on the balance sheet.
- The income tax expense of $36,000 on the income statement is shown as income tax payable under liabilities on the balance sheet.
This example clearly shows the relationship and interaction between the income statement and the balance sheet in financial reporting.
