Before answering this question, I’ll walk you through common perceptions of the income statement versus the balance sheet, as well as recent developments in
International Financial Reporting Standards (IFRS).
The income statement provides a summary of an organization’s income and expenses for a particular period. Historically, this was the first report the financial statement user looked at (if not the only report), to establish whether the business is worth investing in.
For many non-financial people, the balance sheet makes no sense at all, so they gravitate towards the only report that is easy to read, namely the income statement. Assets and liabilities are too complex to understand.
In the last ten years, this has changed, so much so that readers and users are advised to lend much more credibility to the balance sheet than to the income statement. This “discrimination” exercised on the income statement is so serious that some investors are even encouraged to ignore the income statement as a whole.
Why is this so? It could be the tinkering with revenue figures by many corrupt, now-defunct corporations that reported highly profitable figures, while these companies were heavily in debt (liabilities) or technically insolvent. Also, high income is not a guarantee against bankruptcy.
Historically, an income statement was prepared first and the balance sheet second. The balance sheet became the “garbage can,” for all the items that couldn’t balance the books. IFRS now implemented the opposite, the balance sheet is drawn up first and the income statement now becomes the “garbage can”!
The first balance sheet method is more about accurate reporting than anything else, and is endorsed by many accounting experts. The accounting equation, Assets-Liabilities=Equity, is the true bottom line, not “earnings.” Capital growth is what any investor should be interested in. Any new business is actually built on your “bottom line” first. Capital is invested, loans are obtained, inventory is purchased, and a bank account is opened. Only after all of the above have been established does the business begin to generate income and incur expenses.
balance sheet audit
Balance sheet items are meticulously reviewed and prepared first. Accountants will audit fixed assets, current assets, current liabilities, loans, and investments. Applying the asset-liability formula, a quick valuation of assets is carried out. If the principal balance is divided into shareholder funds or equity, less retained income, a current profit is quickly established even before income or expense items are considered!
So, an income statement should preferably be built from the “bottom up”. The profit or loss must then be adjusted (added) to the expenses and an income figure will be determined. If any variance is identified, at this point, it is an income statement issue, not a balance sheet issue. Balance sheet information is sacrosanct.
Countable income is not always accurate, and a properly prepared balance sheet will reveal this fact. If the income figures seem accurate, but variances are still identified, investigate funds accumulated or withheld from prior years. Most errors can be isolated to this account. The balance method is magical. It can not only show you where you have gone wrong in the current year, but also in previous years!
Need I say more? No further explanations are necessary. Balance is king!