Accounting Basics: the Income Statement and Balance Sheet
This tutorial focuses on the two most important financial reports in accounting: the Income Statement (Profit & Loss Report) and the Balance Sheet. These reports provide information on a company's financial makeup and profitability. We'll also discuss running a Trial Balance to ensure our debits and credits balance before producing reports.
We will then learn which accounts the Income Statement and Balance Sheet report on, using a small set of sample transactions. This will help us understand the difference between these financial reports.
The Five Different Types of Accounts
To understand these financial reports, we must first understand the five account types. In Assets, Liabilities, Equity, Revenue, and Expenses, we learned that each account is defined as one of five account types. We recommend reading this tutorial before proceeding. As a brief summary, the five account types are.
- Assets: items of value the company owns. Examples: machinery, cash.
- Liabilities: money the company owes to others. Examples: vehicle loan, mortgage.
- Equity: the portion of assets the company owns outright.
- Revenue or Income: money earned from sales, plus dividends or interest on securities.
- Expenses: items or services the company pays for in order to run the business. Example: rent, advertising.
The Income Statement
The simpler of these two financial reports is the Income Statement, or Profit and Loss Report. The P & L lists only the income and expense accounts, and their balances. The income statement then calculates the difference to arrive at Net Income Before Taxes. A company can run a standard or detailed Profit and Loss Report any time during the fiscal year to determine its profitability. Net income before taxes is also referred to as earnings or profit.
Income and expense accounts are yearly or temporary accounts. At the end of each fiscal year, the accounts must be "zeroed out" ... their balances reset to zero. Then their sum - net income - is applied to Retained Earnings (Owner's Equity). Most Accounting programs perform these tasks automatically.
The Balance Sheet
The Balance Sheet is a financial snapshot of the business on any given date. It is called the Balance Sheet because it reports on Assets, Liabilities, and Equity, and the total account balances in these categories must balance according to the following formula:
Assets = Liabilities + Owner's Equity
The formula can be read as follows: The total assets of a company equal the portion of the assets that the creditors own (Liabilities), plus the portion of the assets that the owners or stockholders fully own (Equity).
The balance sheet equation can also be written as Equity = Assets - Liabilities, and is often better understood by beginners in this form.
How it All Works Together!
(How the Income Statement and Balance Sheet are Created)
Let's take some of the mystery out of Accounting and learn how the Income Statement and Balance Sheet are produced.
Our basis will be six transactions posted in the month of December - the first month of our business and the last month of our fiscal year. This keeps things simple. For each transaction, one account is debited and one account is credited. (If you do not have a clear understanding of debits and credits, see our tutorial Accounting: Making Sense of Debits and Credits.)
Sample Transactions and a Trial Balance
Our six transactions are shown in the first image below. Study the list of transactions. We discuss each transaction in detail below the images.
Also shown below is our Trial Balance. A Trial Balance Report totals the debits and totals the credits to ensure they are equal because they MUST be equal in double-entry bookkeeping!
Transactions (Debits and Credits)
Invested $ in the Business: We invested $3,000 in the business so our bank account (checking, cash) receives a debit, and we credit an equity account called Paid in Capital. Equity accounts normally maintain a negative balance, so a credit increases their negative balance. However, reports show the absolute value of equity accounts.
Invoices Created: Since our company uses the Accrual Method of accounting (vs. the Cash Method), invoice income is recognized as soon as an invoice is created, so our equity account called Income is credited. We debit Accounts Receivable - an asset account. [Companies using the Cash Method do not have A/R since income is not recognized until an invoice is actually paid.]
Equipment Loan: We borrowed $4,000 from the bank, so we debit cash because we deposited the money into our checking account. We create a liability account for the loan and it receives the credit. Liability accounts usually maintain negative balances, but reports show the absolute value of the account. [Tip: When we write a check for a loan payment, Cash will receive a credit and the Loan account will receive the debit - decreasing its value as we would expect.]
Purchased Equipment: Our cash decreased when we wrote a check for the equipment (credit), but we did acquire a company asset, so the asset account receives the debit. Asset accounts usually maintain a positive balance.
Utilities: Cash is credited (decreased in value) when we paid the bills, and an expense account called Utilities receives the debit. Expense accounts usually maintain a positive balance.
Office Supplies: Another example of crediting cash and debiting an expense account.
To learn more about the different account types, see Assets, Liabilities, Equity, Revenue, and Expenses.)
The right-most image below is our Trial Balance. A Trial Balance Report checks to see if the sum of the debits equals the sum of the credits. If not, transactions in error must be corrected or the financial reports will be inaccurate.
Because our example scenario is simple, our Trial Balance repeats the debits and credits in our transaction list except for Cash. Cash received both debits and credits, and was involved in five of the six transactions. The Trail Balance sums its debits and credits to arrive at a debit for Cash of $1,700. [$3,000 + $4,000 - $4,000 - $1,000 - $300 = $1,700].
Also, because this was our company's first year in business, we have no Retained Earnings as Retained Earnings tracks Net Income accumulated from previous years.
Naturally, a Trial Balance should be run before producing the year-end reports, but it is highly-recommended that a Trial Balance be run periodically so problems can be identified and resolved as they occur.
How Our Sample Income Statement is Created
Our abbreviated Chart of Accounts and our Income Statement are shown below. Notice that the accounts included in a Profit & Loss Report are just income and expense accounts. If our income exceeds our expenses, we make a profit. If not, we have a loss. This is why it is called the Profit and Loss Report!
In most accounting software programs, an Income Statement can be produced for any chosen time period.
How Our Sample Balance Sheet is Created
The Balance Sheet is a bit more complicated than the P & L, but stay with us! Look at our Balance Sheet below. It is dated January 1st of the following year.
The Balance Sheet is divided into two main categories: Assets and Liabilities & Equity. Remember the Accounting formula we learned above? Assets = Liabilities + Owner's Equity. As the Balance Sheet design mirrors this formula, we can easily see if our Assets do indeed equal the sum of Liabilities and Equity.
Review the Balance Sheet carefully, and we'll make a few more important observations below. Notice that our income and expense accounts are not included in the Balance Sheet.
First, did you notice that we now have a value for Retained Earnings? Our Net Profit on December 31st was $3,700 as shown in the Income Statement above. On January 1st of the next year, Net Income is posted to Retained Earnings (Owner's Equity). This is done every year, so Retained Earnings is the accumulation of Net Income over the years.
Secondly, your company's Balance Sheet will be longer and contain more accounts no doubt. Also, the Assets section may be divided into Current Assets and Fixed Assets. These are also discussed in our tutorial about the five Account Types that we referenced above.
In most Accounting programs, you can select the end date for the Balance Sheet, but the report always starts with the date of the first posted transaction of the company.
We hope this article has been helpful. Cheers!
Disclaimer: Keynote Support is providing general information in a highly readable format as a service to the visitor. We have made every effort to provide information accurate as to the date of this article. Every customer environment and each transaction is unique, so please use the information and examples in this article only as a guide. In addition, the reader cannot infer from this article that Keynote Support is providing financial or accounting advice. Consult with a financial or accounting professional for assistance with your unique requirements.
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- » ACCOUNTING OVERVIEW: Chart of Accounts, Double-Entry Bookkeeping, General Ledger, and Account Types
- » MAKING SENSE OF DEBITS AND CREDITS
- » SUPER SAMPLE ACCOUNTING TRANSACTIONS
- » THE ACCOUNT TYPES: Assets, Liabilities, Equity, Revenue, and Expenses
- » ACCOUNTING REPORTS: The Income Statement and Balance Sheet
- » USING ITEMS AND COGS IN ACCOUNTING
- » DEFINITIONS: Accounting - Bookkeeping Terms A-C
- » DEFINITIONS: Accounting - Bookkeeping Terms D-L
- » DEFINITIONS: Accounting - Bookkeeping Terms M-Z
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