How the Financial Statements Interact

Carl has survived learning about four financial statements: the balance sheet, income statement, statement of cash flows, and statement of retained earnings. His clock business (Carl’s Clockworks) is ticking along and he is finding that running a business requires a lot of work and a lot of knowledge. Carl is starting to realize that these financial statements are really a portrait of his business. Carl’s pretty sure he doesn’t want to be a full-time accountant but he’s very grateful for the knowledge he has picked up. Today Carl sets off to learn how all of these financial statements are connected.

Peter (Carl’s accountant buddy) sends Carl a funny email entitled, “A picture of your business for the year 20X2.” Carl opens up the email expecting to see a picture of himself sitting out in his front yard with all of his clocks on his brown table. To his surprise he finds the following picture:

Accountants find this fascinating.

Carl is pretty confused at first but he starts piecing things together. (Don’t get scared here; you have seen all of the financial statements in this image before; they are simply grouped together to show you how they work together.)

Starting from the left on the picture you will see that this is Carl’s Clockworks’ balance sheet for the end of last year. Well Carl wasn’t in business last year so all of his assets, liabilities, and owners’ equity are set to zero.

On the far right of the picture you will see Carl’s Clockworks’ balance sheet for the end of this year. We have seen this balance sheet before in a previous lesson. We are assuming that Carl hasn’t made any more sales since his last sale to the old lady.

Take some time to follow the arrows on the image and see how the financial statements interconnect with each other.

• The statement of cash flows shows how Carl’s Clockworks goes from $0 cash to $11,000 cash.
• The statement of retained earnings and the income statement show how Carl’s Clockworks goes from $0 retained earnings to $1,000 retained earnings.
  • This is an interesting relationship that is often placed into an equation.                (Beginning retained earnings) + (Net Income) – (Dividends) = (Ending retained earnings)
  • Note that the changes in the balance sheet from one year to the next are being described by the other financial statements. The balance sheet is the only financial statement that doesn’t get zeroed out at the end of the year. The numbers on it are a running total from the beginning of the business. In other words, whatever amounts are left over from last year’s assets, liabilities, and owners’ equity are carried over from last year’s balance sheet onto this year’s balance sheet.   The income statement and the statement of cash flows are not running totals. The numbers on the income statement and statement of cash flows are zeroed out at the end of every year. Each year these statements start from zero and they are used to describe the changes on the balance sheet. Pretty intense stuff right? If you don’t quite get it right now, don’t worry. We’ll be seeing plenty more examples of this in the future.

To further illustrate the last bullet point it is worth mentioning that the balance sheet is a look at the business as of a point of time. The income statement and statement of cash flows are different in that they represent the business for a period of time (usually a one year period).

That sums up the discussion on how the financial statements interact with each other. Carl is pretty excited because he is starting to see how this all comes together. Now that he knows what the financial statements are he is ready to start implementing an accounting system that will have all the ledgers, journal entries, and trial balances he needs to keep these financial statements up-to-date. We’ll learn about that in the coming lessons.

This is a huge mile stone for you as a learner. All the accounting software, bookkeeping, double-entry accounting, journal entries, ledgers, etc. that you hear about and associate with accountants are simply used in order to create financial statements. Now that you know what your end goal is, it is very easy to learn the rest. When you can see what you are trying to create (the financial statements) you are already more than half way there!

Next Lesson: Lesson 8 – Standard Formatting for Financial Statements