Which of the following statements correctly describes how items on the income statement and balance sheet are connected?

• A. Net income from the income statement (after dividends) is added to retained earnings; debt on the balance sheet is used to calculate interest expense on the income statement; PPE is used to calculate depreciation expense.
• B. Net income increases cash on the balance sheet; debt has no effect on interest expense.
• C. Retained earnings are decreased by net income; depreciation affects the balance sheet directly but not the income statement.
• D. Interest expense on the income statement is determined by equity, not debt.

Answer: (A)

When you connect the statements, profits become part of the balance sheet through retained earnings. Net income increases retained earnings in shareholders’ equity, while dividends reduce retained earnings since they are distributions of accumulated profits. The amount of interest expense on the income statement comes from the company’s debt on the balance sheet—the more debt (and the higher the interest rate), the higher the interest expense. Long-lived assets shown as property, plant, and equipment on the balance sheet drive depreciation expense on the income statement, and depreciation also lowers the asset’s book value on the balance sheet through accumulated depreciation. These links—net income to retained earnings, debt to interest expense, and PPE to depreciation—explain how items on the income statement and balance sheet are connected.