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Financial Statements Linkage You Must Know

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How Financial Statements LinkedKnowing the linkage of numbers in a financial statements set is vital to anyone who attempts to understand the content of financial statements and accounting in general—not only the accounting students. Failure to understand it, consider you know nothing about financial statements, and accounting entirely. That is how I would like to express the important of knowing the linkage of numbers in the financial statements.

A complete set of financial statements generally includes a balance sheet, an income statement, a statement of stockholders’ equity, and a statement of cash flows. The statements present different types of information about the enterprise’s activities during a period of time and thus are not alternatives to each other. Let me summarize it in a quick way:

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1. Balance Sheet – Also called a statement of financial position, is the photograph of an enterprise at a point in time.  It is a listing of the quantifiable resources that an enterprise has to operate with as well as a listing of claims against those resources represented by both creditors and owners. In the report form of the statement, the quantifiable resources, called assets, are first listed, followed by the claims of creditors and owners. In the account form of the statement, the assets are typically presented on the left and the claims to the assets on the right side of the statement. An important relationship in the balance sheet is that the claims to the assets equal or “balance” exactly the amount of the assets presented.

2. Income Statement – Continuing the analogy of the balance sheet as a still photograph of an enterprise at a point in time, the income statement can then be described as a motion picture that identifies certain dimensions of the enterprise over a period of time. Income Statement is based on an accounting principle called matching. Revenues ordinarily can be readily associated with specific business activity that relates to specific periods of time. Once the revenues for a period of time have been identified, the accountant then attempts to associate with those revenues all expenses that relate to (1) that same period of time and/or (2) the generation of those specific revenues. These amounts are then “matched,” meaning that the expenses are subtracted from the revenues, to determine the results of operations for the period. The result is called net income if revenues exceed expenses; it is called net loss if expenses exceed revenues.

3. Statement Of Stockholders’ Equity – A required disclosure in a complete set of financial statements of a corporation is an identification of the changes in stockholders’ equity in terms of dollars by major category and numbers of shares of stock. Like the income statement, the statement of stockholders’ equity covers a period of time rather than a specific point in time. The columns represent the major categories of stockholders’ equity: contributed equity—preferred stock, common stock, and additional paid-in capital—and retained earnings. The statement begins with the balance at the end of the period prior to that covered in the statement. The rows in the statement indicate activities that resulted in changes in the major categories of stockholders’ equity—sale of common stock, net income, and dividends. Net income and dividends affect only retained earnings. Net income increases the retained earnings balance, and dividends decrease that balance.

4. Statement Of Cash Flows – The statement of cash flows presents information about an enterprise’s cash receipts and payments during a period of time. This statement is similar in concept to the income statement and statement of stockholders’ equity in that it covers a period of time rather than a point in time, as does the balance sheet. In its simplest form, the statement of cash flows simply indicates the enterprise’s primary sources of cash and the primary ways the enterprise used that cash. These changes are presented in a manner that reconciles the change in cash from the beginning to the end of the accounting period. This statement is presented in three categories—cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. At the bottom of the statement, the net change in cash is presented as a reconciling figure to show how the cash balance either increased or decreased between the beginning and ending of the accounting period covered by the statement.

The four financial statements are derived from the same fundamental transactions and the same financial measurements of those transactions. All are necessary for the readers to get as complete an understanding as is possible through the medium of financial statements.

Attempting to demonstrate the linkage of the four financial statements in a single illustration is an impossible undertaking. For a quick reference, here is a simple (but handy) graph that illustrates several of the most important relationships that underlie the four financial statements—the balance sheet, the income statement, the statement of stockholders’ equity, and the statement of cash flows:

Financial Statements Linkage

These eight relationships identified by numbers in parentheses:

(1) Revenues and expenses, presented in the income statement, result in changes in assets and liabilities in the balance sheet.

(2) Net income flows into the statement of stockholders’ equity and is an important determinant of the end-of-period balance in retained earnings.

(3) The ending balances of contributed equity accounts in the statement of stockholders’ equity correspond to the same amounts in the stockholders’ equity section of the balance sheet.

(4) The ending balance of retained earnings in the statement of stockholders’ equity corresponds to the balance in retained earnings in the stockholders’ equity section of the balance sheet.

(5) The ending cash balance in the statement of cash flows corresponds to the amount of cash presented on the balance sheet.

(6) Cash flows from operating activities in the statement of cash flows reflects the cash effects of those transactions included in the determination of net income. A reconciliation of net income and net cash flows from operating activities is presented as part of the statement of cash flows.

(7) Investing activities in the statement of cash flows reflect positive and negative cash flows from changes in assets whose ending balances are included in the balance sheet.

(8) Financing activities in the statement of cash flows reflect positive and negative cash flows from debt and equity financing transactions. The end-of-period balances in debt and equity are presented in the balance sheet.

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