How the Balance Sheet and Income Statement Are Connected

The account Retained Earnings provides the connection between the balance sheet and the income statement.

How revenues affect retained earnings

When revenues and gains are earned by a corporation, they have the effect of immediately increasing the corporation’s retained earnings. This is true even though they are not directly recorded in the Retained Earnings account at the time they are earned.

To illustrate, let’s examine what occurs when a company earns revenues by providing services on credit:

• The asset account Accounts Receivable is increased.
• An income statement account such as Revenues Earned is increased. However, when revenues are earned, they have the immediate effect of increasing the corporation’s retained earnings. This is true, even if the balance in the Revenues Earned account is transferred to the Retained Earnings account only at the end of the accounting year.

How expenses affect retained earnings

When a corporation incurs expenses and losses, they have the effect of immediately decreasing the corporation’s retained earnings. This is true, even though they are not directly recorded in the Retained Earnings account at the time the expenses or losses occurred. To illustrate, assume a corporation issues monthly income statements and it pays each month’s rent on the first day of the month. Here is what occurs:

• The asset account Cash is decreased.
• The income statement account Rent Expense is increased. However, as the expense is occurring, the immediate effect is to decrease the corporation’s retained earnings. This is true, even if the balance in the Rent Expense account is transferred to the Retained Earnings account only at the end of the accounting year.

Notes To the Financial Statements

The notes to the financial statements are an integral (essential) part of the balance sheet. To communicate this, there will be a notation on the face of the balance sheet that states “See notes to the financial statements.” or “The accompanying notes to the financial statements are an integral part of this statement.”

The notes to the financial statement are required by the accounting principle known as the full disclosure principle and will include the following:

• Summary of significant accounting policies is the first note. It describes the use of estimates, revenue recognition, inventories, property and equipment, goodwill and other intangible assets, effects of recent accounting rules from the FASB, and more.

• Schedules of amounts and other details for inventories, accrued liabilities, income taxes, employee benefit plans, leases, stock options, commitments, contingencies, related party transactions, assets pledged as collateral, and more.

NOTE: U.S. corporations whose common stock is traded on a stock exchange are required to file an annual report with the Securities and Exchange Commission (SEC). The report known as Form 10-K contains the complete set of the corporation’s financial statements with notes plus it has additional information concerning the corporation’s financial position, liquidity, operations, risks, etc.

You can access a corporation’s Form 10-K by going to the Investor Relations section of the corporation’s website.

Making Sure Your Company’s Balance Sheet Is Accurate

Before issuing a balance sheet, it is wise to do a final review of the amounts being reported. Here are some steps we recommend:

• Compare the amounts to the amounts reported on earlier balance sheets.

• Make certain that the balance sheet amounts agree with the supporting workpapers and other documentation. Here are some examples along with links to the related topics found on AccountingCoach.com:

  • The amount of cash and cash equivalents should be supported by bank reconciliations for the company’s bank accounts. You can learn more by visiting our topic Bank Reconciliation.

  • Accounts receivable – net should be compared to an aging of accounts receivable. You can learn more by visiting our topic Accounts Receivable and Bad Debts Expense.

  • Inventory should be supported by a schedule of calculations to support the cost reported as inventory. You can learn more by visiting our topic Inventory and Cost of Goods Sold.

  • The amount of prepaid expenses should agree with workpapers showing the calculations of the amounts that had been paid in advance and are still prepaid as of the date of the balance sheet. You can learn more by visiting our topic Adjusting Entries.

  • Accounts payable should be supported by a listing of amounts owed. You can learn more by visiting our topic Accounts Payable.

  • Accrued liabilities should agree with workpapers showing the calculation of the amounts owed but have not yet been recorded. You can learn more by visiting our topic Adjusting Entries.

  • Deferred revenues should be supported by a workpaper documenting the amounts received from customers in advance but have not yet been earned. You can learn more by visiting our topic Adjusting Entries.