Before I answer this question, I will take 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 organizations income and expenses for a particular period. Historically this was the first report the user of financial statements looked at (if not the only report), to establish if the business is worth investing in.
To many non-financial people, the balance sheet does not make sense in any case, so they gravitate to the only report that is an easy read, namely, the income statement. Assets and liabilities are just too complex, to grasp.
In the last ten years or so, this has changed, so much so that readers and users are advised to lend substantially more credence to the balance sheet than the income statement. This “discrimination”, exacted on the income statement is so severe that some investors are encouraged to even ignore the income statement as a whole.
Why is this so? It could be the fiddling with revenue figures by many, now defunct corrupt corporations, which reported highly profitable figures, whilst these businesses were heavily indebted (liabilities), or technically insolvent. Moreover, high revenues are no guarantee against bankruptcy.
Historically, an income statement was drawn up first, and the balance sheet, second. The balance sheet became the “rubbish bin”, for all items that could not balance the books. IFRS now implemented the converse, the balance sheet is drawn up first, and the income statement now becomes the “rubbish bin”!
The balance sheet first, method has more to do with accurate reporting, than anything else, and is supported by many accounting experts. The accounting equation, Assets-Liabilities=Equity, is the true bottom line, not “profits”. Capital growth is what any investor should be interested in. Any new business, in reality is constructed from its “balance sheet”, first. Capital is invested, loans are sourced, inventory is acquired, and a bank account is opened. Only after all of the aforementioned has been established do the business start to generate revenue, and incur expenses.
Balance sheet auditing
Balance sheet items are reviewed meticulously and prepared first. Accountants will audit fixed assets, current assets, current liabilities, loans and investments. Applying the asset-liability formula, a quick assessment is made of equity. If the equity balance is broken up in stockholders funds or capital, less retained income, a current profit is swiftly established before even looking at income or expense items!
An income statement should then be preferably be build from “the bottom, up”. The profit or loss should then be adjusted (added), to expenses, and a revenue figure will be determined. If any variances are identified, at this juncture, it is an income statement problem, not the balance sheet. Balance sheet information is sacrosanct.
Book revenues are not always accurate, and a properly prepared balance sheet will reveal this fact. If revenue figures appear accurate, but variances are still identified, investigate the accumulated or retained funds from prior years. Most mistakes can be isolated to this account. The balance sheet method is magical. Not only can it show you where you have gone wrong in the current year, but also in prior years!
Need I say more? No further explanations necessary. The balance sheet is king!
