When an accountant records a sale or expense entry using double-entry accounting, he or she sees the interconnections between the income statement and balance sheet. A sale increases an asset or decreases a liability, and an expense decreases an asset or increases a liability.
Therefore, one side of every sales and expense entry is in the income statement, and the other side is in the balance sheet. You can’t record a sale or an expense without affecting the balance sheet. The income statement and balance sheet are inseparable, but they aren’t reported this way!
To properly interpret financial statements, you need to understand the links between the statements, but the links aren’t easy to see. Each financial statement appears on a separate page in the annual financial report, and the threads of connection between the financial statements aren’t referred to.
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The following figure shows the lines of connection between income statement accounts and balance sheet accounts. When reading financial statements, in your mind’s eye, you should “see” these lines of connection. Because financial reports don’t offer a clue about these connections, it may help to actually draw the lines of connection, like you would if you were highlighting lines in a textbook.
Connections between income statement and balance sheet accounts.
Here’s a quick summary explaining the lines of connection in the figure, starting from the top and working down to the bottom:
- Making sales (and incurring expenses for making sales) requires a business to maintain a working cash balance.
- Making sales on credit generates accounts receivable.
- Selling products requires the business to carry an inventory (stock) of products.
- Acquiring products involves purchases on credit that generate accounts payable.
- Depreciation expense is recorded for the use of fixed assets (long-term operating resources).
- Depreciation is recorded in the accumulated depreciation contra account (instead decreasing the fixed asset account).
- Amortization expense is recorded for limited-life intangible assets.
- Operating expenses is a broad category of costs encompassing selling, administrative, and general expenses:
- Some of these operating costs are prepaid before the expense is recorded, and until the expense is recorded, the cost stays in the prepaid expenses asset account.
- Some of these operating costs involve purchases on credit that generate accounts payable.
- Some of these operating costs are from recording unpaid expenses in the accrued expenses payable liability.
- Borrowing money on notes payable causes interest expense.
- A portion (usually relatively small) of income tax expense for the year is unpaid at year-end, which is recorded in the accrued expenses payable liability.
- Earning net income increases retained earnings.
Download an Income Statement Template for Microsoft Excel®
An income statement or profit and loss statement is an essential financial statement where the key value reported is known as Net Income. The statement summarizes a company's revenues and business expenses to provide the big picture of the financial performance of a company over time. The income statement is typically used in combination with a balance sheet statement.
There are many ways to format an income statement. The two examples provided in the template are meant mainly for small service-oriented businesses or retail companies. (1) The simplified 'single-step' income statement groups all of the revenues and expenses, except the income tax expense. (2) The 'multi-step' income statement example breaks out the Gross Profit and Operating Income as separate lines. It first calculates the Gross Profit by subtracting Cost of Goods Sold from Net Sales. It calculates the Operating Income and then adjusts for interest expense and income tax to give the Income from Continuing Operations.
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Description
This income statement template was designed for the small-business owner and contains two example income statements, each on a separate worksheet tab (see the screenshots). The first is a simple single-step income statement with all revenues and expenses lumped together.
The second worksheet, shown on the right, is a multi-step income statement that calculates Gross Profit and Operating Income.
Income Statement Essentials
Net Income = Total Revenue - Total Expenses
Revenues
The income that is generated by providing a service, selling a product, earning interest on investments, renting extra office space, licensing technologies, selling advertising space, or licensing the use of your brand name. In the income statement template, there are categories for Sales revenue, Service revenue, Interest revenue, and Other revenue. You will likely want to customize the Revenue section to highlight your company's main sources of revenue.
Business Expenses
For a retail company, one of the main expenses is the cost of goods sold. For service businesses, this might not be such a large factor. Some of the other operating expenses may be advertising, salaries, rent, utilities, insurance, legal fees, accounting fees, supplies, taxes, etc.
Operating Income
In the multi-step income statement, the operating income is calculated as the Gross Profit minus the total Operating Expenses. In general, interest expense and income tax expense are not included as operating expenses, which gives rise to the term EBIT or 'earnings before interest and taxes' - another name for Operating Income.
Income from Continuing Operations
This is the 'bottom line', calculated as the Operating Income minus interest expense and income tax (and plus/minus non-operating revenues, expenses, gains, and losses, if there are any). If there are no 'below-the-line' items, then this is the same as the Net Income.
Below-the-line Items
Some forms of income, such as the sale of a building you are no longer going to be using, are included 'below-the-line' (i.e. below the reported Net Income from Continuing Operations) because they may not be expected to occur in the future. These include the effect of accounting changes, income from discontinued operations, and extraordinary items (gaines or losses that are unusual or highly abnormal).
Income Statement References:
- Financial Accounting: Reporting and Analysis by M.A. Diamond, E. K. Slice, and J.D. Slice., 2000.
- Income Statement, Net Income or 'Bottom Line' at wikipedia.org
Disclaimer: This spreadsheet and the information on this page is for illustrative and educational purposes only. We do not guarantee the results or the applicability to your financial situation. You should seek the advice of qualified professionals regarding financial decisions.