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.
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.