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 the income and expenses of an organization during a particular period. Historically, this was the first report that the user of financial statements looked at (if not the only report), to establish whether the company is worth investing in.
For many non-financial people, the balance sheet does not make sense in any case, so they gravitate towards the only easy-to-read report, namely the income statement. Assets and liabilities are too complex to understand.
In the last ten years or so, this has changed, so much so that readers and users are encouraged to give the balance sheet much more credit than the income statement. This “discrimination” imposed on the income statement is so serious that some investors are encouraged to ignore the income statement as a whole.
Why is this so? It could be the tinkering with the revenue figures of many now defunct corrupt corporations, which reported highly profitable figures, while these companies were heavily in debt (liabilities) or technically insolvent. Also, high income is no guarantee against bankruptcy.
Historically, an income statement was prepared first and a balance sheet second. The balance became the “garbage can” for all the items that books could not balance. IFRS now implements the opposite, first the balance sheet is drawn up and the income statement now becomes the “dustbin”.
The balance first method is more about accurate reporting than anything else, and it is endorsed by many accounting experts. The accounting equation, Assets-Liabilities = Equity, is the true bottom line, not the “earnings.” Capital growth is what any investor should be interested in. Any new business is actually built from your “balance sheet” in the first place. Capital is invested, loans are obtained, inventory is acquired and a bank account is opened. Only after all of the above has been established does the business begin to generate income and incur expenses.
Balance sheet audit
Balance sheet items are thoroughly reviewed and prepared first. Accountants will audit fixed assets, current assets, current liabilities, loans, and investments. Applying the asset-liability formula, a quick equity assessment is carried out. If the equity balance is divided into equity or shareholder funds, minus 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 gain or loss must then be adjusted (added) to expenses, and an income figure will be determined. If any variation is identified, at this juncture, it is a problem with the income statement, not the balance sheet. Balance sheet information is sacrosanct.
Accounting income is not always accurate and a properly prepared balance sheet will reveal this fact. If the income figures seem accurate, but variations are still identified, investigate the funds accumulated or withheld from previous years. Most errors can be isolated on this account. The balance method is magic. It can not only show you where you went wrong in the current year, but in previous years as well!
Do I need to say more? No further explanation is needed. Balance is king!