Income statement and balance sheet logic in plain language

Understanding income statement and balance sheet logic is important for entrepreneurs because all company cash flows move within accounting through them. Accounting can include entries related to both income and balance sheet, or only internal balance sheet transfers. After internalizing the income statement and balance sheet, an entrepreneur can form a more comprehensive picture of their own or other companies' finances.

Income statement logic

The purpose of the income statement is to help the reader understand where the company's revenues and expenses for a specific period have originated. According to the most common accrual-based accounting method, for example, expected future revenues from sales invoices are recorded on the assets side of the balance sheet as accounts receivable. Instead, future expenses from purchase invoices are recorded on the liabilities side as accounts payable until the invoice is paid from cash.

Reflecting on personal life, the income statement can be thought of as describing daily revenues and expenses. A person's salary can be compared to turnover, and running costs such as electricity bills, rent, and insurance payments to business expenses. Note that rent paid for a rental apartment would be included in daily (business) expenses, while mortgage payments for an owned home are only recorded on the balance sheet.

The reason for balance sheet-based entries for fixed asset amortizations is that their costs are recorded in income according to a depreciation plan based on the estimated useful life of the fixed asset. Thus, recording amortizations on an income basis would cause a kind of double entry for depreciable items. The purpose of depreciation is therefore to deduct the acquisition cost of assets belonging to fixed assets during their useful life from the income obtained with the asset's contribution.

Balance sheet logic

The word 'balance sheet' is the equivalent of the previously commonly used term 'bilanssi' in Finnish. Balance sheet, like many other accounting terms (debit, credit, balance, etc.) came to Finnish accounting language from Italy, the homeland of accounting, where the term appears as 'bilancio'. Bilancio is derived from the original Latin word 'bilanx', where 'bi-' describes double and 'lanx' means scale pan. 'Bilanx' thus refers to a scale with two pans. That's exactly what a balance sheet is: a two-sided scale (assets-liabilities) where a company's financial quantities are compared at a specific point in time.

Reflecting on private life, one can think that on the assets side (what is owned), owned home, car, already earned vacation pay receivable, and a thousand euros in the bank account are recorded. On the liabilities side (how it's owned), the accumulated surplus (profit) from the difference between salary and expenses over time, home and car loans, and unpaid bills would be recorded.

Assets

The main purpose of the assets side of the balance sheet is to illustrate what is owned and what and what kind of receivables the company has at a specific point in time. On the assets side, property is divided into fixed assets, i.e., assets that generate income for more than one year, and assets and receivables that generate income within a year.

The items on the assets side are thus grouped in reverse liquidity order. At the top are assets that are hardest to convert to cash, and at the bottom is the easiest item to convert - cash and bank receivables. Other items on the assets side include various intangible and tangible assets, equipment, investments, inventory, receivables, and securities.

Liabilities

The main purpose of the liabilities side of the balance sheet is to help the reader understand how the assets on the assets side have been financed. On the liabilities side, sources of financing are divided into equity, accumulated appropriations, provisions, and liabilities. In practice, the liabilities side shows whether assets and receivables are financed with equity, such as invested funds or retained earnings from operations, or with debt.

On the liabilities side, debt is divided into long-term and short-term liabilities. Long-term liabilities include obligations payable in more than a year, such as loan installments due after more than a year, and short-term liabilities include obligations payable within a year, such as loan installments payable within a year from the review period.

The accumulated appropriations item appearing between equity and liabilities records unrealized but already expensed and tax-deducted expenses. Mandatory provisions such as pension liabilities are by nature debts. The difference between mandatory provisions and liabilities is that the amount or timing of the provision has had to be estimated.

Summary

As stated, the income statement and balance sheet contain all the company's cash flows. Understanding the financial situation, cash flow, and future forecast can be difficult just by examining their items. It's worth deriving KPI analyses and reports from the income statement and balance sheet that help evaluate the company's profitability, liquidity, solvency, and working capital. The cash flow statement, on the other hand, helps monitor the company's cash flows and understand future cash situations.