Relationship Between Financial Statements

Relationship Between Financial Statements

Understanding the relationship between financial statements enable you to manage business operations better. These relationships stem from the accounting information system and the way double-entry accounting is setup. The accounting cycle makes continuous utilization of this system to output four standard financial statements at the end of each accounting period. Those statements are :

(1) The Income Statement (2) Statement of Owner’s (Shareholder’s) Equity (3) The Balance Sheet (4) The Statement of Cash Flows

While each statement tells its own story, there are specific links and relationships between them that provide insights into the “bigger picture”. Moreover, a thorough comprehension of  the relationship between financial statements will make you feel more confident about the information you are looking at and in your ability to analyze the numbers.

Relationship Between Financial Statements:

relationship between financial statements

Know where the numbers and financial statements are coming from

Relationship Between Financial Statements - Accounting Cycle

Relationship Between Financial Statements – Accounting Cycle

  • Every business transaction with a financial implication first enters the process through journal entries. Each entry carries with it, a debit and credit balance. This is the first step to ensuring a “balanced book” . 
  • Towards the end of the accounting period, before any financial statements are generated and the books are closed, a trial balance is put together outlining all the debit and credit balances .
  • Adjustments to the trial balance are made to correct erroneous entries and include adjusting entries for the period. Adjusting entries are those that have to be made when the business has made prepayments or has accrued expenses.
  • Once the trial balance is balanced for both debit and credit entries, financial statements are prepared.
  • Closing entries are made to transfer the balances from Temporary Accounts (i.e., income and expense accounts) to Permanent Accounts (i.e., balance sheet accounts).
  • The process starts all over when the Temporary Accounts are opened up for a new period.
relationship between financial statements

Know what the financial statements represent

  • The Income Statement is a summary of all the revenue and expense transactions that took place for the period. Revenue and expenses are reported on an accrual basis – meaning that they are reported as those transactions are incurred. This doesn’t mean that there was always a cash transaction.
  • The Statement of Shareholders’ Equity outlines the changes in equity that have taken place during the period. This statement provides detailed information about how the business is capitalized through common and preferred shareholders. It includes summaries of  changes in retained earnings, stock issuance, stock buybacks and dividends.
  • The Balance Sheet, also referred to as the Statement of Financial Position, is a snapshot of what the company owns and owes at a given point in time. It’s important to note that unlike the other financial statements, which are reported for a Period, the Balance Sheet only represents the position of the company on the day it was generated. All the company’s Assets (what the company owns) are grouped together on one side and all the company’s financial obligations (what it owes) are grouped on the other side. The total figure for Assets MUST equal the total figure for Liabilities + Shareholders’ Equity.
  • The Statement of Cash Flows , reported on a period basis, reconciles between the accrual basis of accounting with actual sources and uses of cash for the period. This is done by making adjustments to the Net Income figure to account for non-cash transactions and includes changes in Balance Sheet accounts between reporting periods.
relationship between financial statements

Know what the relationship between financial statements are

Diagram and worksheet for understanding relationship between financial statements:

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relationship between financial statements

Complete an exercise to master your understanding of the relationship between financial statements

There is no better way to understand the underlying relationship between financial statements than to go through a simple exercise from the point of view of a business owner. In the following exercise, pay special attention to highlighted numbers as they indicate where there is a relationship between financial statements. Assume that you are an entrepreneur who has decided to start your own consulting practice and are starting to prepare your first financial statements after being in business for a month. At the end of the month, you are sitting with the following business events and transactions in front of you and are ready to compile those first statements.

March 1, 2009 – Opened a business bank account and deposited $50,000.
March 1, 2009 – Moved into your new office for which rent is due on the 15th of the month for March.
March 1, 2009 – 3 new employees started to work for you.
March 2, 2009 – Bought office supplies from a vendor on account for $2,500
March 12, 2009 – Earned fees of $25,000 for services rendered – check in hand.
March 15, 2009 – Paid rent expenses of $10,000
March 15, 2009 – Paid $14,785 in salaries
March 17, 2009 – Paid $1,500 to vendor for the supplies bought on account
March 21, 2009 – Billed a client $ 32,750 for consulting services your firm provided
March 22, 2009 – Paid $4,950 for travel, lodging and entertainment expenses.
March 25, 2009 – Determined that the value of supplies you have left amounts to $1,250 (cost of supplies used was $1,250).
March 28, 2009 – Withdrew $4,000 from the business bank account for personal use.

Based on the above summary, here are the financial reports you can prepare as you learn the relationship between financial statements.

Your Consulting Service Inc.
Income Statement
Month Ended March 31, 2009
$          57,750
Salaries Expense
 $               14,785
Rent Expense
Travel & Entertainment
Supplies Expense
Total Expense
Net Income (Loss)
$          26,765

  Using your Net Income and some specific events that occurred during the month, you can now prepare the Statement of Owner’s (Shareholder’s) Equity.

Your Consulting Service Inc.
Statement of Owner’s Equity
Month Ended March 31, 2009
You (sole proprietor), Beginning Capital
 $                    -  
Investment during month
 $               50,000
Net Income (Loss) for month
 $               76,765
Less Withdrawal by Owner
Increase (Decrease) in Owner’s Equity
You (Sole proprietor), Capital, March 31, 2009
 $          72,765

Having gone through the exercise of figuring out what the ending owner’s equity is, you’ve already figured out one third of the balance sheet content. But before preparing the balance sheet, it helps to figure out what the cash position is at the end of the period since Cash is reported as a current asset line item on the balance sheet. (Note: Normally, it’s better to complete the Balance Sheet before the Cash Flow statement since in more complicated situations, the cash flow statement takes changes in the balance sheet accounts into consideration. Being that this is a simple exercise with only a few transactions, preparing the cash flow statement before the balance sheet is purely out of convenience.)

Your Consulting Service Inc.
Statement of Cash Flows
Month Ended March 31, 2009
Beginning cash balance As of April 30, 2009
 $          -  
Cash flows from operating activities:
Cash received from customers
 $  25,000
Deduct Cash Payments for operating expenses*
Net cash flow from operating activities
 $ (6,235)
Cash flows from investing activities:
 $          -  
Cash flows from financing activities:
Cash received as owner’s investment
 $  50,000
Deduct cash withdrawal by owner
Net cash flow from financing activities
Net cash flow and March 31, 2009 cash balance
* Salaries + Rent + Travel & Entertainment + Payment to Vendor for supplies
= 14,785 + 10,000 + 4,950 + 1500 = $31,235

With the 3 statements in hand, preparing the balance sheet becomes very easy and it will be easy to verify if the calculations used to prepare the first three statements are correct since the Statement of Owner’s Equity and Statement of Cash Flows provided a specific amounts that gets plugged in to the balance sheet.

Your Consulting Service Inc.
Balance Sheet
 $  39,765
Accounts Payable
 $    1,000
Accounts Receivable
Owner’s Equity
You (Sole proprietor), Capital, March 31, 2009
 $  72,765
Total Assets
 $  73,765
Total Liabilities and Owner’s Equity
 $  73,765

So as you can see all the calculations leading up to the preparation of the balance sheet were correct as indicated by independently derived figures like Net Income, Cash and Owner’s Capital. The books are balanced and Assets indeed = Liabilities + Owner’s (Shareholder) Equity. Now that you have a better understanding of the relationship between financial statements , check out the following tutorials on doing ratio / financial statement analysis.

Key Financial Ratios – Profitability

Key Financial Ratios – Asset Productivity

Cash Flow Analysis

Please share if you found this tutorial on relationship between financial statements useful.

5 Responses to Relationship Between Financial Statements

  1. sslux says:

    The information you have provided makes the links between the financial statements very clear…thank you…it has really helped with my assignment!!!

  2. waseem says:

    where is the info of accounts payable given above which was used to balance the BS.

  3. SSB says:

    March 2, 2009 – Bought office supplies from a vendor on account for $2,500

    So for this transaction the entry would be
    Debit – Office Supplies $2,500, Credit Accounts Payable $2,500

    March 17, 2009 – Paid $1,500 to vendor for the supplies bought on account

    For the above transaction on the 17th:
    Debit – Accounts Payable for $1,500 and Credit – Cash for $1,500.

    At this point, your Accounts Payable balance after the Debit (which lowers the liability) is only $1,000 … Hope this was helpful!

  4. SSB says:

    @sslux … you are welcome! I am glad you found it useful!

  5. Lisa NC says:

    I really appreciate the share and having the chance to learn from you.

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