Business accounting is an ancient practice that dates all the way back to 1494 with Luca Pacioli’s development of double-entry bookkeeping. But even though accounting practices have permeated our personal and professional lives for centuries, there are still some common misconceptions that need some clearing up! Whether you’re a small business owner managing your own accounting, or just an inquiring mind — understanding balance sheets and income statements is important for everyone!
Knowing what’s on a balance sheet vs. income statement can help you better manage your business’ finances, help you identify areas for improvement, and give you the financial foundation and know-how you need to become a better business owner. In this article we’re breaking down the differences between balance sheets and income statements, and providing you some helpful bookkeeping tips to improve your business accounting operations.
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- A Brief History of Balance Sheets and Income Statements
- What is a Balance Sheet?
- What is an Income Statement?
- What Goes on a Balance Sheet and Income Statement?
- How To Create a Balance Sheet and Income Statement
- Small Business Accounting Starter Pack
A Brief History of Balance Sheets and Income Statements
Business accounting in general can be traced back to Italian mathematician Luca Pacioli’s book, Summa de arithmetica, geometria, proportioni et proportionalita written in 1494. The book detailed Pacioli’s philosophies for tracking and analyzing a business’ operational costs and revenue — now known as double-entry bookkeeping. This method became popular with Italian merchants during the Renaissance, and is still used today, often with the help of accounting software and technology. Like today’s representation of balance sheets, Pacioli’s method accounted for a merchants assets, liabilities, capital, income, and expenses to capture a well-rounded picture of the business’ financial standing. Pacioli then used this information to develop financial documents for annual end-of-year records and financial forecasts.
What is a Balance Sheet?
A balance sheet is a type of financial statement that captures a business’ current financial standing at any given time. A balance sheet includes the business’ assets, liabilities, and net worth/equity to account for both internal assets and outgoing funds. Balance sheets don’t represent a company’s financial status long term, but rather present a snapshot of its financial health for a shorter period of time. This makes balance sheets a good medium to check in on how your business is doing at a specific time, and help you identify areas of improvement or recent success. While you wouldn’t rely solely on a balance sheet to make financial projections, balance sheets are part of the process businesses use to plan their budgets and predict the next year’s revenue.
What is an Income Statement?
An income statement is a report of a company’s profits and losses over a period of time. This report is calculated by taking all avenues of the company’s revenue and subtracting total business expenses to determine both profit and loss over a specific stretch of time. Income statements can be divided into whatever time periods make sense for company operations, but monthly or quarterly reporting is a standard way to go. These reports can be aggregated to create quarterly and annual reports that can also be used (in part) to forecast business finances.
Why Are Income Statements and Balance Sheets Important?
Picture running a lemonade stand when you were a kid. Maybe your mom or dad gave you a few bucks to go to the store to buy some lemons and sugar. But, the cash was on loan and they had you write an IOU with your total from your shopping trip (maybe they even charged you interest — yikes!). Let’s say you owed $10 and you sold $25 worth of lemonade. If you decided not to account for that IOU or even the cost of building your lemonade shack — the cash that ends up in your pocket later might be a little disappointing by the time you pay back your debts. Or worse, you could end up mishandling your lemonade budget by buying a fancy new umbrella before you’ve made any profit — putting you into more debt before you ever see the fruits of your labor, pun intended.
Now, put this on a larger business scale where you really have to focus your budget, replenish inventory, and pay employees— and maybe even shareholders. If you’re not tracking your revenue and comparing it with your expenses, things could get pretty messy and result in some financial consequences if you ignore these details.
Income statements and balance sheets are important to help owners and accountants monitor a business’ financial standing. While each functions differently, they both play equally important parts in telling a business’ financial story and help business owners and accountants to initiate improvements, make budgets, and predict business growth (or loss). These financial statements are used to manage small business finances and corporations alike — so if you haven’t implemented these basic financial reports, it’s time to start now!
What Goes on a Balance Sheet and Income Statement?
As you know, there are some key differences between balance sheets and income statements since they measure different parts of a business’ finances. Let’s go over what details are included on each to give you a better understanding of how these reports work.
There are three main components that go into creating a balance sheet: company assets, liabilities, and equity. These three elements can encapsulate a number of different variables that can fluctuate the business’ financial standing from month to month. Let’s discuss what each of these categories are and what items might fit into each.
- Cash: Cash assets can be an actual stack or Ben Franklins in your business safe — or, they can be other kinds of liquid cash equivalents like U.S. Treasuries and bonds, mutual funds, and money-market funds. These cash equivalents can easily be liquidated for cash funds. Non-liquid assets can also be considered cash assets, but they often take longer to sell, such as real estate property.
- Accounts Receivable: This number is the amount your business collects in relation to sales. As you collect accounts receivable funds and turn them into cash, your cash account balance increases.
- Inventory: Inventory refers to the value of what you have in your shop to offer customers. This number is a sensitive balance that could throw your business into trouble — or could help you see a return in profits if you’re able to achieve the right symmetry.
Think about a sandwich shop for example — if the owner buys too much meat and cheese and doesn’t end up selling the inventory to customers, the cost of the ingredients outweighs the return. On the other hand, if they don’t have enough sandwich making materials, the sandwich shop could lose sales. Creating a balance sheet with this information could help the business owner determine just the amount they need to keep business functioning at its best.
- Plant, Property & Equipment (PP&E): PP&E assets are items of value that are important to business operations and aren’t easily converted into cash — and won’t likely be sold in the long term. Just as the name indicates, examples of these assets include plant, property, and equipment.
- Intangible Assets: Intangible assets are fixed assets that could include items like patents, licenses, and secret formulas. It can also include broader items like the brand as a whole or goodwill.
- Accounts Payable: Accounts Payable, otherwise known as AP, is the amount a business owes to another company for goods and service purchased on credit — something you get an invoice for, for example. So, if you had a painting company repaint your office kitchen and you got an invoice for it, that expense would be attributed to accounts payable. As your accounts payable balance decreases when you pay off your expenses, so does the cash account you withdraw those payments from.
- Current Debts: Current debts are non-AP dues that must be completed within a one-year operation cycle.
- Current Portion for Long Term Debts: A long term debt will likely require monthly payments to be made in order to eventually satisfy the debt. The amount that is due in that particular month when the balance sheet is being created, would be considered the current portion that is due, as part of a larger long term debt.
- Bonds Payable: If your company has issued any bonds, you’ll need to take note of those IOUs in your balance sheet so that you can plan to pay that borrowed money back.
- Long Term Debt: The long term debt line on a balance sheet refers to the total amount of long term debt (a loan for example) that a business might owe, minus the current portion that is due at the time the balance sheet was created. This gives the business a bigger picture of their expenses down the line, not just for the current month or quarter.
- Share Capital: Share capital is the value of shareholder funds that have been invested in the business by investors. When an investor puts money into share capital, the cash asset amount rises in line with the amount that was invested.
- Retained Earnings: Retained earnings is the amount that is leftover at the end of the day — this capital might be used to reinvest in the business, or to repay debts, and hopefully, some is still left to function as the business owner’s paycheck.
Income statements use the following formula to give businesses a high level idea of what their net profit looks like: Revenue – Expenses = Net Profit / Loss.
Alternatively, if there are issues within these areas, the income statement could reflect this as a loss for the business. Just like for balance sheets, there are a few different subcategories that are part of the equation. Let’s take a closer look at the different types of revenue and business expenses you might expect to see on an income statement.
Operating revenue is the incoming cash flow from activities associated with the business’ primary operation — including the sales of goods and services.
Non-operating revenue is any incoming funding that is outside of the business’ standard goods and services — such as interest earned on business capital in a bank account, or rental payments from an income property.
Gains cover additional income that is outside of normal business operations and non-operating revenue. Examples of gains could include the sale of assets such as equipment or property.
Expenses: Primary Activities
These are expenses directly associated with the cost of running your business. This could include the costs of goods and services (relative to inventory), general and administrative expenses, and research and development costs.
Expenses: Secondary Activities
Expenses from secondary activities are costs that the business incurs that are outside the realm of their core business operations. This amount might include things like interest owed on a business loan or a late fee for an unpaid invoice.
Losses are typically one-time costs that are not charged regularly. Expenses associated with a lawsuit might be an example of a loss.
How To Create a Balance Sheet and Income Statement
Before you can access all of the important financial indicators provided by balance sheets and income statements, you’ll have to set your business up for reporting early on. As we mentioned before, income statements and balance sheets are typically generated on a monthly or quarterly basis. Since these statements account for a number of different variables, you’ll need to have a process to track this information daily, so that when the month rolls up or the quarter comes around, you’ll have accurate data to work with.
Let’s discuss how to create a balance sheet and income statement for your business.
- Use T-accounts to track your daily debit and credit balances so that you can easily keep tabs on your income and expenses. Separate T-accounts into income statement and balance sheet paperwork.
- For income statement, divide the T-accounts into operating and non-operating. For example, direct revenue from your sales would go into the operating revenue category, while revenue from interest on a company bank account would be considered non-operating revenue.
- Create the income statement by writing a list of operating revenues and expenses, then subtract the operating expenses from operating revenue to find the operating net profit. Do the same for the non-operating revenue and expenses.
- Make three categories for the balance sheet — assets, liabilities, and equity.
- Create the balance sheet by detailing each section with the accounts and total balances. After you’ve listed all of the accounts, the amount of assets should equal the amount of liabilities plus equity.
Keep in mind, this data is very sensitive. So don’t be afraid to check and re-check your work — it could help you catch a big error or missed opportunity!
Small Business Accounting Starter Pack
Managing your finances effectively involves more than just using income statements and balance sheets. In order to glean information from these reports to grow your business, you’ll have to understand the specifics of balance sheets vs. income statements, use these documents, and also take advantage of other insights.
Whether you decide to handle business finances on your own, or enlist the help of an accounting expert or bookkeeper, you’ll find that income statements and balance sheets will require you to track financial data daily — not just during reporting season. Here are some examples of forms you might need to help you fill out your income statements and balance sheets.
- General Ledger
- Cash Flow Form
- Depreciation Form
- Accounts Payable Ledger
- Stock Inventory Sheet
- Job Estimate Form, Quote Form
- Statement of Account
- Purchase Order Form
- Petty Cash Vouchers
- Cashbook Template
- Petty Cash Log
Maintaining your business’ financial health is simply part of being a responsible business owner. Without cash flowing in and out of your business, you probably wouldn’t see any growth — but you already knew that. The important thing to note is that if you’re diligent about monitoring your business’ finances, you’re more likely to catch red flags sooner, identify opportunity, and ultimately, become a better business owner. And if you’re more confident in your crafting, cooking, sewing, or coffee slinging skills than crunching numbers — talk to one of our financial experts about our small business accounting services so you can focus your expertise on what you love, and we’ll handle the rest.