Before explaining the debits and credits related to the equity types of accounts, Lesson 10, the reader is introduced to the relationship between the financial statements. Specifically, the relationship between the income statement and the balance sheet.
With accounting there are four financial reports plus a set of notes typically included in the annual report of a business operation. The following are those 5 respective information presentations:
- Balance Sheet – usually the first of the five and it depicts a particular moment in time. It is snapshot of the value of the assets in the upper half and in the lower half, liabilities and equity. The most common date in the title is the last calendar day of the accounting cycle, usually year end.
- Income Statement (AKA Profit and Loss Statement) – identifies how much profit was generated over a period of time, the most common time period reported is one calendar year.
- Retained Earnings – explains a subsection of the equity section of the balance sheet in more detail. It usually covers two years of information by stating the beginning balance and the changes in that balance related to earnings and dividends/distributions or draws issued during the reported period of time.
- Cash Flows Statement – one of the more difficult reports to understand and generate. This report basically incorporates the elements of the three prior reports and converts the entire financial change into the aggregated cash adjustment.
- Notes – generally explains what the company does, the tax issues, some detail related to the respective subsections of both the balance sheet and income statement and identifies any major issues that may impact the financial status of the company.
With bookkeeping, the first two reports are the most important. In general, the last three reports are merely results of information reported in the balance sheet and income statement.
The financial reports illustrate changes in the businesses’ financial condition over time. Just as man has evolved, a business grows over time. Naturally, most small businesses want to be highly successful and the reports are issued to evaluate change.
The balance sheet is a report of a single moment in time; in accounting we call this a ‘Snapshot’ of the company’s financial condition. Most sophisticated business owners look at the picture last year and at the end of the current year to identify the changes. The income statement calculates that financial change. Remember the income statement covers the entire period under review.
For example, suppose the sales in the current year went up significantly. How does this affect the balance sheet? It may or it may not. It depends on a multitude of other factors. For this example, it is qualified that all expenses and cost of sales remained equal in their ratios to the sales. Over on the balance sheet in the upper half (assets), the only real change occurs in cash and receivables (amounts customers paid and owe). This would increase in direct relationship to the increase in sales.
My point to all this is that there is a relationship between the financial reports. What happens over in the income statement affects the balance sheet and often it works the other way too.
In prior lessons, it was illustrated that as an entry is recorded in a journal, the actual debit or credit can get posted to any type of an account. Before continuing look at the account types (6 account types) and their typical ending balances and where they are reported for accounting purposes:
- Assets – balance sheet account and normally has DEBIT balances as the ending balance;
- Liabilities – also a balance sheet account and is the opposite of assets and customarily ends in CREDIT balances;
- Equity – a balance sheet account and the normal balance is CREDIT based;
- Revenue – this is another CREDIT type of an account is found on the income statement;
- Cost of Sales – DEBIT driven and also on the income statement;
- Expenses – DEBIT values are the most common and rarely are credits posted, also an income statement type of an account.
Notice that three of the types of accounts are DEBIT driven and the other three are CREDIT driven. Three are on the income statement and three are on the balance sheet. Both statements have debit and credit based types of accounts.
A journal records the function of the entry such as a payroll journal or a purchases journal. This entry will have an equal debit and credit as required in the dual entry system. Remember the entry may dictate any two types of accounts and therefore affect both financial reports.
Now for the really important part of this lesson. There is one direct link between the income statement and the balance sheet. It is the final net earnings for the period of time. This net amount is automatically transferred to the equity section of the balance sheet as ‘Current Earnings’.
Over on the income statement as stated in Lesson 6, sales are credit driven. Hopefully sales volume in dollars exceeds the cost of sales (debit value) and the expenses (debit value) for the company during this period of time. This means the business generated a profit. A profit is a credit balance. Why? Because sales are credit based and the corresponding costs and expenses are debit based. When you subtract out the costs and expenses from the sales you get a profit (hopefully). If so, this profit is credit based and is also located over in the equity section of the balance sheet and is identified as ‘Current Earnings’.
The next lesson goes into more detail about this. The goal of this lesson is to help you understand that there is a relationship between the two primary financial reports. The income statement generates a final value that is reported in the equity section of the balance sheet. In addition, other accounts on the income statement may impact the balance sheet and a reader’s understanding of the financial condition of the business. The balance sheet is used to identify what is the financial status of the company at the present moment in time. The income statement illustrates the change over a period of time. By incorporating balance sheets at consistent intervals and reviewing the income statement between the intervals a reader can evaluate the evolution of the business. ACT ON KNOWLEDGE.