Financial Statements and their Relationships

While we process business events at the transaction level, there may be too many transactions to evaluate when making business decisions. Therefore, at the end of each accounting period, we aggregate transactions into financial statements. Financial statements summarize the impact of economic events on a business's financial condition. Because of the interrelationship between the financial statements, they are prepared in a sequence. The income statement, which is a financial statement that is a summary of the business's revenues and expenses over a period of time, is prepared first. That is followed by the statement of owner's equity, a financial statement that is a summary of changes in the business's equity over a period of time. Then the balance sheet, a financial statement that is a snapshot of the assets, liabilities, and equity of a business at a point in time, is prepared. Finally, the statement of cash flows is prepared as a financial statement that is a summary of inflows and outflows of cash over a period of time, and draws upon the previous three financial statements.

As a summary of a business's operations during a period, the income statement reports revenues and total expenses and the resulting net income. This statement aims to adhere to the matching principle, which attempts to match expenses incurred during a period with the revenues earned during that same period. The difference of revenues less expenses is net income if revenues were greater than expenses. If expenses are greater than revenues, then the result is a net loss. Net income is used to determine the changes in owner's equity over a period. The income statement is also referred to as the P&L, or profit-and-loss statement. As a summary of changes in the owner's equity during a period, the statement of owner's equity should be prepared next. Changes in owner's equity are determined by adding net income or subtracting net loss (expenses greater than revenues) to the beginning balance in the owner's equity account. Then add additional investments and subtract withdrawals. The ending balance in the owner's equity is used to compile the balance sheet. Considered as a statement of a business's financial position, the balance sheet is a snapshot at a point in time that lists the assets, liabilities, and owner's equity and then the resulting balance. The balance sheet lists the assets first, followed by the liabilities and owner's equity, reflecting the accounting equation. As the last statement to be prepared, the statement of cash flows is a summary of the inflows and outflows of cash for the period of the income statement, statement of owner's equity, and balance sheet. The statement of cash flows has three sections: operating activities, investing activities, and financing activities. The operating section summarizes the cash received and cash paid for normal business operations. The investing activities section reports the cash received or paid for the sales or purchase of fixed assets or other investments outside of the day-to-day operations. The financing activities section accounts for the cash received or cash paid from the issuance or purchase of the company's equity or debt. The ending cash balance computed on the statement should equal the cash balance reported on the balance sheet.

The income statement, statement of owner's equity, balance sheet, and statement of cash flows are all interrelated. The income statement for a period shows how assets and liabilities were used, and relates to the statement of owner's equity. The statement of owner's equity relates to the balance sheet. This last relationship between the statement of owner's equity and the balance sheet allows the balance sheet to balance. The statement of cash flows then details the company's cash inflow and outflow during the period, and the amount of cash the company has. That amount should match the cash reported on the balance sheet.

The four financial statements relate to each other and correlate to provide external users, such as creditors, customers, lenders, and government agencies, an accurate and important financial picture of a business entity. By examining all the financial statements, which reveal both strengths and weaknesses, good investment and credit decisions can be made by external users, such as stockholders, lenders, and others. Managers can also use the financial statements' information for effective financial planning and decision-making.