What is the Relationship Between Balance Sheet and Income Statement?
The relationship between balance sheet and income statement is that the profit of the business shown in the income statement, belongs to the owners and this is shown by a movement in equity between the opening and closing balance sheets of the business.
The Opening Balance Sheet
Suppose the business starts off with the owner injecting cash of 600 into the business bank account. The opening balance sheet is shown below, the business has an asset of cash of 600, and the owners equity in the business is 600.
The Closing Balance Sheet
The business now trades for an accounting period. It buys goods costing 500 for cash and sells them on credit to customers for 800.
In balance sheet terms, the asset of cash has fallen by the amount we paid to the supplier 500, and the closing cash balance is 600 – 500 = 100. The accounts receivable have increased by 800 which is the amount due from the customers, and the closing accounts receivable is 0 + 800 = 800.
Using this information the business can now produce a closing balance sheet, shown below.
Because the net assets are now 900, to maintain the accounting equation, and make the balance sheet balance, the equity must also be 900.
The Balance Sheet Movement
If we now add another column to show the movement on the balance sheets we get the following.
Two of the movements can be explained. The movement on cash is -500, the amount paid to the supplier. The movement on accounts receivable is 800, the amount invoiced and outstanding from customers. However, to make the balance sheet balance there has to be a movement on equity of 300, which needs to be explained.
The Income Statement
The explanation for the movement in equity lies in the relationship between balance sheet and income statement. If we now look at the income statement for the period we see the following.
The income statement reflects the fact that the business sold goods costing 500 for 800 and made a profit of 300. The profit belongs to the owners and increases the owners equity by 300. This increase is the same as the movement in equity between the opening and closing balance sheets, as shown in the diagram below.
So the relationship between balance sheet and income statement is that the profit for the period which comes from the income statement, represents the movement on equity which is the difference between the opening and closing equity in the balance sheets of the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.