For any business to thrive, its accounting system must be accurate. Financial statements are some of the most important accounting aspects of a business. They include the statement of cash flows, the balance sheet and the profit and loss account, commonly known as the income statement. Let us look at the income statement and the balance sheet in detail.
The income statement
Simply put, the income statement summarizes how expenses have been used to generate revenue in a certain trading period. It gives an indication of how the business is able to use its resources to make profits. A company always aims at utilizing its resources in the most efficient manner and this is explained by the income statement.
Entries of an income statement
This section shows revenues and expenses that are related to the fundamental activities of the business. If the business is a manufacturing firm for instance, the entries that you are likely to find here involve acquisition of raw materials, the expenses involved in operating machines such as fuel and repairs, transportation costs among others. The revenues and expenses are matched appropriately in order to avoid misleading elements. Basically, sales are compared to the cost of goods sold to determine the difference, which is the gross profit. Operating expenses are deducted from this gross profit to get the net profit.
Non-operating activities of a business include income tax and other incomes and expenses that are not part of the operating environment of the business. Indeed, there are expenses that the business must meet whether it is involved in business operations or not, and there are incomes that do not form part of the operating income. All the entries in an income statement must satisfy the matching principle. According to this principle, expenses are realized when accrued and revenues are realized when gained.
The balance sheet
This is simply a statement of the net worth or the book value of the business at a certain trading period. It shows the assets and the liabilities of the company. All entries in a balance sheet must satisfy the accounting equation: Capital= Assets-Liabilities. This is perhaps the most important financial statement of a company, because it can give an idea of how long the company can sustain its operations using its assets. Entries of a balance sheet.
Assets and liabilities
Assets, just like liabilities can be fixed (non-current) or current. Fixed assets include land, buildings and machinery. They are simply the assets that are bought for long-term use and are not easily convertible into cash. Some long term assets depreciate with time, and a provision for this depreciation is noted as a liability but not an expense to the business.
Long term liabilities on the other hand are those that are supposed to be settled after a relatively long period of time, compared to the short-term liabilities. For instance, a short term liability can be a short-term loan that is payable within 5 years, and a long term liability can be a debt that is repayable in 40 years. Current assets are those that can easily be converted into cash. They include cash at hand, cash at bank, inventories, prepayments and account receivables, among others.
Shareholders’ equity. This is the capital of the business. If the company is wholly financed using shareholder’s equity, then the total value of the shares currently held by shareholders is shown. In some cases, the company may have other sources of capital, and these other sources are shown as well. For instance, a private company may have 20% financing from the owner’s and 80% financing from shareholders. The sum of the assets must be equal to the sum of liabilities and capital, since the double entry rule is followed.
Income statement versus the balance sheet
The income statement is prepared before the balance sheet, because the profit gained over a certain period of time is reflected on the balance sheet. Both the income statement and the balance sheet are used by employees, investors, suppliers, the government and the public as a whole in making decisions. For instance, a company that has a healthy income statement for instance is likely to have a strong balance sheet, and this may lure investors to buy its shares. The balance sheet can also be analyzed using several rations. These include the working capital ratio, the acid test ratio and the gearing ratio, among others. These ratios give very important information to the stakeholders of the company, allowing them to make decisions that are likely to affect the company’s operations over a period of time. The management may use these ratios for instance to determine the company’s dividend sharing policy.
As noted earlier, the balance sheet is a statement of the book value of a business at a certain time while the income statement shows how expenses were used to generate revenues during a given trading period. The entries in a balance sheet are grouped into assets, liabilities and shareholders’ equity while in the income statement, entries are mainly sales, expenses and the earnings per share.
Cash and accrual basis
The balance sheet is mainly prepared under the cash basis while the income statement is prepared under the accrual basis. Cash-based accounting entails recognition of expenses and revenues only when money changes hands. A case on point, when goods are sold on credit, the amount of money that will be paid on the agreed future date is not recognized as revenue but as an asset. On the other hand, accrual basis accounting recognizes only the expenses and revenues that satisfy the matching principle.
In most countries, public limited companies and corporations are required to disclose their statement of net worth to the public. The income statement is not a mandatory requirement in most cases, though some companies require that both statements are made public. Whatever is the policy of the company, it is clear that both of these statements are crucial in decision making.
In a nut shell, the income statement and the balance sheet go hand in hand. Though they analyze different aspects of the business, the information they give at the end is useful in determining the efficiency of the business.