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How are the balance sheet and income statement connected?

The balance sheet reports a company's assets, liabilities, and owner's equity as of the last instant of an accounting year. Generally, the amount of the owner's equity will have changed from the previous balance sheet amount due to

  • the company's net income
  • the owner's additional investments in the business
  • the owner's withdrawals of business assets

If the owner did not invest or withdraw, the change in owner's equity is likely to be the amount of net income earned by the business. The revenues, expenses, gains, and losses that make up the net income are reported on the company's income statement.

To illustrate, let's assume that a company's balance sheets had reported owner's equity of $40,000 as of December 31, 2012 and $65,000 as of December 31, 2013. If during the year 2013 the owner did not invest or withdraw business assets, the $25,000 increase in owner's equity is likely to be the net income earned by the business. The details for the $25,000 of net income will appear on the company's income statement for the year 2013. (If the owner had withdrawn $12,000 of business assets for personal use, the net income must have been $37,000 since the net increase in owner's equity was $25,000.)

The connection between the balance sheet and the income statement results from the use of double-entry accounting or bookkeeping and the accounting equation Assets = Liabilities + Owner's Equity.