Financial Statements: The Income Statement and the Balance Sheet

In one line

The income statement says how much you earned in a period; the balance sheet says what you are worth at the end of it.

In exam wording: financial statements comprise the income statement, which shows income and expenditure for a period and produces the profit or loss, and the balance sheet, which shows assets, liabilities and capital as at a date.

The two statements, and the difference between them

The link between them is the point students miss, and stating it earns marks: the profit from the income statement is added to capital in the balance sheet. That is why the balance sheet balances at all. A profit increases what the proprietor has in the business; a loss reduces it; and drawings, money taken out by the proprietor for himself, reduce it further.

The three forms of the first statement

For a professional practice the "income statement" takes one of three forms, and MU's syllabus expects the distinction.

Receipts and payments account

A summary of the cash book. Every receipt on the debit, every payment on the credit, whether or not it relates to the period, and whether it is capital or revenue.

It is on the cash basis, and it is the easiest to prepare because it copies the cash book.

Its weakness is that it mixes everything. The purchase of a laptop appears in it, though it is capital; a fee received this year for work done last year appears in it; and a fee earned but unpaid does not appear at all.

Income and expenditure account

The professional equivalent of a profit and loss account. It includes only revenue items and only those belonging to the period, and on the accrual basis it includes income earned and expenses incurred, whether or not money has moved.

Its result is called a surplus or deficit, or for a practice simply net profit.

Profit and loss account

The same thing under its business name. For an advocate's practice the substance is identical; many practitioners use "income and expenditure".

Which does an advocate use? Commonly the cash basis, because fees are often received late and a professional is taxed on what he receives. But the accrual picture is the truer one, and the difference matters when a practice is valued or a partner retires.