Connection between Balance Sheet and Income Statement
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
Basically, the income statement components have the following effects on owner's equity:
- Revenues and gains cause owner's (or stockholders') equity to increase
- Expenses and losses cause owner's (or stockholders') equity to decrease
Example of How the Balance Sheet and Income Statement Are Connected
To illustrate the connection between the balance sheet and income statement, let's assume that a company's owner's equity was $40,000 at the beginning of the year, and it was $65,000 at the end of the year. Let's also assume that the owner did not invest or withdraw business assets during the year. Therefore, the $25,000 increase in owner's equity is likely the company's net income earned for the year. The details for the $25,000 (revenues, expenses, gains, losses) will be reported on the company's income statement for the year.
Accountants refer to the income statement accounts (revenues, expenses, gains, losses) as temporary accounts because their balances will be closed and transferred to the owner's capital account at the end of the year.