Describe the Nature of the Balance Sheet and the Income Statement

by Rose Johnson ; Updated September 26, 2017

The balance sheet and income statement are two of the three primary financial statements that companies are required to produce. Understanding the nature of the balance sheet and income statement is important for an organization's management, and companies and individuals desiring to invest in a company. Companies preparing financial statements must follow Generally Accepted Accounting Principles (GAAP).

Elements of a Balance Sheet

The balance sheet lists a company’s financial resources and business obligations. Elements of a balance sheet include assets, liabilities and shareholders’ equity. A firm’s liabilities and shareholders’ equity are thought of as the elements needed to acquire assets. The balance sheet is run for a specific date, not a period of time. When a balance sheet is produced, it will show in real time all of a company’s assets, liabilities and equity up to that date. Assets are listed on one side of the balance sheet and normally have a debit balance. Under assets are accounts known as contra assets, which have a credit balance. Contra assets include allowance for doubtful accounts and accumulated depreciation. Liabilities and shareholders’ equity is listed on the other side of the balance sheet. Liabilities normally have credit balances; contra liabilities have debit balances. Contra liabilities include discounts on notes payable and discounts on bonds payable.

Elements of an Income Statement

Sometimes referred to as the profit and loss statement, the income statement shows a company’s revenue and expenses. Net income is the last line on an income statement, hence the phrase “the bottom line.” The statement shows a company’s profitability for the time period listed, which is usually a three-month period (or financial quarter). Revenues from operating activities are listed first, then revenues from non-operating activities. Non-operating activities may include rental income and interest earned from investments. Next on the statement is the account called gains. Gains are derived from the sale of the company’s long-term assets. Expenses and losses are also listed on the income statement. Expenses are the cost associated with revenues and losses come from the sale of long-term assets below the original price paid by the company.

Relation Between the Statements

Investors usually analyze each of the three major income statements of a company before making an investment decision because they relate one to another. Retained earnings are profits retained by the company to further its operations, and these are calculated using information from the balance sheet and income statement. Data from the balance sheet and income statement are used together to calculate important financial ratios. These ratios include the accounts receivable turnover, inventory turnover, gross profit margin, return on assets and return on equity.

Notes on Financial Statements

The balance sheet and income statement include notes on the bottom made by the company to provide additional information, like footnotes in a book. These notes can run several pages, but comprise important information for investors to consider. Financial notes can include information about the accounting methodologies used to record data, and important information about the company’s stock options and pension plans.

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