The Financial Statements & their Relationship / Connection | Explained with Examples

Summary

This lesson delves into the intricacies of financial statements, highlighting their interconnections. It explains the income statement, which reflects a company's financial performance over a period, the balance sheet, offering a snapshot of the company's financial position at a specific time, and the cash flow statement, detailing cash movements. The lesson clarifies how net profit from the income statement impacts equity on the balance sheet and how non-cash items like depreciation link the two. It also illustrates how the cash flow statement reconciles cash movements with the other financial statements, providing a comprehensive understanding of financial reporting.

Takeaways

• 📊 The income statement (statement of comprehensive income) shows a company's financial performance over a specific period, detailing income earned and expenses incurred.
• 💼 The balance sheet (statement of financial position) provides a snapshot of an entity's financial position at a given point in time, including assets, equity, and liabilities.
• 💧 The cash flow statement (statement of cash flows) illustrates the movement of cash within an entity over a specific period, focusing solely on cash transactions.
• 🔗 There is a direct relationship between the income statement and the balance sheet, where net profit affects equity and expenses and income that are not yet paid or received appear as liabilities or assets respectively.
• ⏱ The balance sheet and income statement are based on the accrual principle, recognizing income and expenses when they are earned or incurred, not necessarily when cash is exchanged.
• 💹 The cash flow statement is prepared to reconcile the accrual-basis net profit with actual cash movements, taking into account non-cash items and changes in working capital.
• 📈 The preparation of financial statements can vary between entities, with some differences in how items like depreciation or finance costs are categorized.
• 🌐 The indirect method of cash flow statement preparation starts with net profit from the income statement and adjusts for non-cash items and changes in working capital to determine cash generated.
• 🏦 The cash or bank balance on the balance sheet corresponds to the final cash balance calculated in the cash flow statement, reflecting the entity's cash position at a specific date.
• 🔄 Changes in working capital, such as inventory, receivables, and payables, are derived from the balance sheet and are crucial in the indirect method of preparing the cash flow statement.

Q & A

What is the primary purpose of the income statement?

The income statement, also known as the statement of comprehensive income, shows the financial performance of a company over a specific period and includes income earned and expenses incurred.

How does the balance sheet differ from the income statement?

The balance sheet, or statement of financial position, provides a snapshot of an entity's financial position at a specific point in time, showing assets, equity, and liabilities, unlike the income statement which covers a period.

What does the statement of cash flows represent?

The statement of cash flows illustrates the movement of cash within an entity over a specific period, focusing solely on cash transactions and excluding non-cash items.

Why might the net profit not match the cash balance in the balance sheet?

The net profit might not match the cash balance because the income statement and balance sheet are prepared on the accrual basis, which recognizes income and expenses when they are earned and incurred, not necessarily when cash is exchanged.

What is the accrual principle and how does it affect financial statements?

The accrual principle recognizes income and expenses when they are earned and incurred, respectively, rather than when cash is received or paid. This principle affects the income statement and balance sheet by recognizing revenue and expenses even if there is no immediate cash movement.

How is depreciation accounted for in both the income statement and balance sheet?

Depreciation is an expense recognized in the income statement that reduces net income. It is also recorded in the balance sheet as a reduction in the carrying value of the related non-current assets, shown as accumulated depreciation.

What is the relationship between the net profit on the income statement and the equity section of the balance sheet?

The net profit from the income statement is transferred to the retained earnings or accumulated profits in the equity section of the balance sheet, reflecting the change in net assets of the company.

How does the statement of cash flows connect with the income statement and balance sheet?

The statement of cash flows starts with the net profit from the income statement and adjusts for non-cash items like depreciation. It also considers changes in current assets and liabilities from the balance sheet to determine the actual cash generated or used during the period.

Why is the indirect method used to prepare the cash flow statement?

The indirect method starts with net profit and adjusts for non-cash items and changes in working capital to arrive at cash generated from operations. This method shows how operating activities affect cash flow and is useful for analyzing a company's liquidity.

What are working capital changes and how do they appear in the cash flow statement?

Changes in working capital include modifications in current assets and current liabilities that affect cash. These changes are derived from the balance sheet and are included in the cash flow statement to show the impact on cash flows from operating activities.

How is the final cash balance on the cash flow statement related to the balance sheet?

The final cash balance on the cash flow statement, which results from the addition of cash generated during the year and the beginning cash balance, is carried forward to the balance sheet as either cash or bank under current assets.