How Does Income Growth Reported on a Financial Statement Increase Net Worth?
The concept of "net worth" is a cardinal term in modern-day economic activities. Whether assessing the financial health of a company or the solvency of a borrower, financial analysts and lenders pay attention to corporate or individual net worth. Net worth refers to what you possess after you pay all your debts.
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Features
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To understand how an increase in income affects net worth, it's important to be familiar with two financial statements: a balance sheet and a statement of profit and loss, or P&L. A balance sheet, also known as a statement of financial position, indicates the assets, liabilities and equity capital of a firm or an individual. Equity capital, or net worth, equals assets minus liabilities. Assets represent what you own, and debts what you owe. A P&L indicates expenses, revenues and net income. Net income equals revenues minus expenses. At the end of an accounting period --- say, a month or quarter --- bookkeepers add net income to retained earnings, which is an equity item. As a result, an increase in income positively affects net worth.
Illustration
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At the end of the year, assume you have $1 million in assets and $700,000 in debts. Your equity capital, or net worth, equals $300,000 ($1 million minus $700,000). During the year, you earned revenues amounting to $200,000 and had $150,000 in expenses. Your net income for the year equals $50,000 ($200,000 minus $150,000). Consequently, your net worth at the end of the year is $350,000 ($300,000 plus $50,000).
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Significance
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Calculating net worth accurately is a key process to which business owners and organizations pay close attention. Incorrect equity numbers may result in adverse regulatory initiatives, such as Internal Revenue Service (IRS) penalties and U.S. Securities and Exchange Commission (SEC) fines. Both the IRS and SEC may levy hefty fines if amounts involved are high.
Expert Insight
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Accounting specialists help individuals and organizations calculate their net worth in accordance with U.S. generally accepted accounting principles and international financial reporting standards. These specialists include certified public accountants, tax advisers, chartered financial analysts and certified financial planners. Beyond the simple "assets minus liabilities" formula, net-worth calculation often has other implications, especially when it comes to long-term fiscal planning. For example, a company or business owner operating in multiple countries may need a specialist to calculate end-of-period net worth and tax liabilities.
Considerations
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Even though the concepts of net worth and income only concern corporate statements of income and balance sheets, accounting entries also impact other statements. For example, an increase in net income has an impact on the statement of cash flows, resulting in increased cash from operating activities. Accounting entries are debits and credits to financial accounts, such as assets, liabilities, equity items, expenses and revenues.
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