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r Practice LINKAGES BETWEEN THE FINANCIAL STATEMENTS

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Learning Outcome
j Game Center describe how the cash flow statement is linked to the income statement and the balance sheet

e Discussions Primary Financial Statements

B Search Recall that the four primary financial statements are interrelated and each provides specific information to
analysts about an entity. The primary financial statements are as follows:

1. Balance Sheet—shows the financial position of an entity at a point in time, reporting the balances of
“permanent” or “stock” accounts showing the entity’s assets and how those assets are financed.
2. Income Statement—provides information about a company’s financial performance between balance
sheet dates. The income statement is made up of revenue, expense, gain, and loss accounts. In contrast
to the balance sheet, the income statement is a “flow” statement as it captures income activity between
two balance sheet dates. Income statements prepared under IFRS or US GAAP are based on accrual
accounting, so they do not necessarily reflect cash inflows and outflows.
3. Statement of Cash Flows—reports the change in an entity’s cash, cash equivalents, and restricted cash
between balance sheet dates. The statement classifies cash inflows and outflows during the period as
operating, investing, or financing activities. Because the cash flow statement reports performance over a
period of time, it is also a “flow” statement, like the income statement.
4. Statement of Shareholder’s Equity—provides information about how a company’s equity has changed
between balance sheet dates. The statement identifies the significant components of shareholders equity
that are reported on the balance sheet (e.g., common stock and retained earnings) and the activities that
occurred during the period that impacted these accounts (e.g., share issuance, net income or loss). Like
the income statement and statement of cash flows, the statement of shareholders equity is also a “flow”
statement.

Relationship between Financial Statements

As illustrated in Exhibit 1, the income statement, cash flow statement and statement of shareholders’ equity
link the balance sheet from one period to the next.

Exhibit 1: Relationship between the Financial Statements

For example, the beginning and ending balances of cash are shown on the company’s 20X1 and 20X2
balance sheets, and the bottom of the 20X2 cash flow statement reconciles 20X1 cash to 20X2 cash. The
relationship, stated in general terms, is as shown in Exhibit 2.

Exhibit 2: Beginning and Ending Balances

Balance Sheet Balance Sheet

at at
31 December Statement of Cash Flows for Year 31 December
20X1 Ended 31 December 20X2 20X2

Beginning cash Plus: Cash inflows (from Less: Cash outflows (for Ending cash
(as of Year-end operating, investing, and operating, investing, and (as of Year-end
31 December financing activities) financing activities) 31 December
20x1) 20x2)

Exhibit 3 adds greater detail to Exhibit 1, tracing specific linkages through the four financial statements.

Exhibit 3: Interaction of Financial Statement Accounts

For example, the 20X2 statement of shareholders’ equity reconciles the equity accounts reported on 20X1
balance sheet to the equity accounts reported on the 20X2 balance sheet, including additions (or
subtractions) resulting from net income or loss reported on the income statement and dividends paid that are
also reported on the statement of cash flows if made in cash.

Linkages Between Current Assets and Current Liabilities

The income statement and statement of cash flows also provide key linkages between the current assets
and current liabilities sections of the balance sheet. Differences between the accrual and cash accounting
recognition of operating activities result in an increase or decrease in a current asset or liability on the
balance sheet. For example, accrual basis revenue in excess of cash collections will be accompanied by an
increase in accounts receivable. If expenses reported using accrual accounting are lower than cash actually
paid, the result will typically be a decrease in accounts payable or another accrued liability account. Finally,
in situations in which a company is paid in advance for the delivery of a service or product in the future, it will
recognize the cash received as an asset, but it also must recognize a liability for its obligation to deliver
service or product in the future, typically referred to as deferred revenue. A deferred revenue liability account
is derecognized upon the recognition of revenue when the entity satisfies its performance obligations.

If an analyst knows beginning accounts receivable, revenues, and cash collected from customers, they can
compute ending accounts receivable, as the accounts are linked as shown in Exhibit 4.

Exhibit 4: Ending Accounts Receivable

Income Statement
Beginning Balance for Year Statement of Cash Flows
Sheet at Ended 31 December for Year Ending Balance Sheet at
31 December 20X1 20X1 Ended 31 December 20X1 31 December 20X2

Beginning accounts Plus: Revenues Minus: Cash collected from Equals: Ending accounts
receivable customers receivable

Understanding the interrelationships among the balance sheet, income statement, and cash flow statement
is useful not only in evaluating the company’s financial health but also in detecting accounting irregularities.
Recall the extreme illustration of a hypothetical company that makes sales on account without regard to
future collections and thus reports healthy sales and significant income on its income statement yet lacks
cash inflow. Such a pattern would occur if a company improperly recognized revenue.

Example 1–Example 4 demonstrate how common business transactions affect a company’s balance sheet,
income statement, and statement of cash flows. Notice how all three financial statements are needed to fully
account for the transactions.

EXAMPLE 1

Inventory Purchase and Sale Impact on Financial Statements

Assume fictional company ABC, a retailer, purchases USD100 of inventory on 1 January 1, 20X1 on
credit with payment due to its supplier in 30 days. On 1 February, ABC sells the product to Customer X
for USD150 with payment due by 16 February, 20X1. Customer X pays for the product on 15 February,
20X1.

This series of transaction would affect ABC’s financial statements as follows shown in Exhibit 5.

Exhibit 5: ABC’s Financial Statements

Date Balance Sheet Income Statement Statement of Cash Flows

1 Inventory (asset) increases by N/A N/A

January USD100
Accounts Payable (liability)
increases by USD100
30 Cash (asset) decreases by N/A Cash flows from operating activities
January USD100 decreases by USD100
Accounts Payable (liability)
decreases by USD100
1 Accounts Receivable (asset) Revenue increases N/A
February increases by USD150 by USD150
Inventory (asset) decreases by Cost of sales
USD100 increases by
USD100
15 Cash (asset) increases by Cash flows from operating activities
February USD150 increases by USD100
Accounts receivable (asset)
decreases by USD150

Note the statement of cash flows is affected only when the company pays or receives cash, which
differs from recognition on the income statement.

EXAMPLE 2

Depreciation Impact on Financial Statements

On 1 January, fictional company Notion Ltd, a manufacturing company, owns USD100 of equipment
used in the production of a product that is sold to wholesale customers. The equipment has a 10-year
life and no salvage value. Notion uses straight-line depreciation, so the annual depreciation expense is
USD10. On 1 July, Notion Ltd. makes a new capital investment for a different piece of equipment with a
purchase price of USD200 and annual depreciation expense of USD50. Notion Ltd. pays for the
equipment in cash upon receipt. Depreciation expense is recorded at the end of the fiscal year. The
impact on Notion Ltd.’s financial statements is summarized in Exhibit 6.

Exhibit 6: Notion Ltd. Financial Statement

Date Balance Sheet Income Statement Statement of Cash Flows

1 January Equipment (asset) of USD100 N/A N/A

1 July Equipment (asset) increases by N/A Cash flows from investing
USD200 activities decreases by
Cash (asset) decreases by USD200
USD200
31 Accumulated Depreciation Depreciation expense N/A
December (contra asset) increases by increases by USD35
USD35

EXAMPLE 3

Borrowing Impact on Financial Statements

On 31 March, fictional Geneva Company borrows USD500 from Stockholm Bank (also fictional). The
terms of the loan are interest accrues at 10 percent and payment is due along with principal upon
maturity of the loan on 30 September. Accordingly, Geneva is to pay USD525 to Stockholm Bank on 30
September consisting of USD500 in loan principal and USD25 of interest (USD500 loan × 10% × ½
year.) The impact on Geneva’s financial statements is summarized in Exhibit 7.

Exhibit 7: Geneva Financial Statement

Date Balance Sheet Income Statement Statement of Cash Flows

31 March Cash (asset) increases by N/A Cash flows from financing activities
USD500 increases by USD500
Loans payable (liability)
increases by USD500
30 Cash (asset) decreases Interest expense Cash flows from financing or operating
September by USD525 increases by USD25 activities decreases by USD25
Loans payable (liability) Cash flows from financing activities
decreases by USD500 decreases by USD500

EXAMPLE 4

Equipment Purchase Impact on Financial Statements

Assume Mountain Company, a fictional manufacturer, agrees to produce a custom-made piece of
equipment for Cirrus Corp. (another fictional company) in two months for a sales price of USD1,000.
On 1 October, Cirrus provides Mountain with a down payment of USD300 from Cirrus and agrees to
pay the balance of USD700 when the equipment is delivered on 30 November. Mountain Company
recognizes deferred revenue when it receives the USD300 on 1 October, which will be derecognized
when Mountain fulfills its obligation and delivers the equipment. The impact on Mountain Company’s
Rate Your Confidence
financial statement is summarized in Exhibit 8.
High

Exhibit 8: Mountain Company Financial Statement Medium

Low
Date Balance Sheet Income Statement Statement of Cash Flows

1 October Cash (asset) increases by N/A Cash flows from operating activities
USD300 increases by USD300 Continue !
Deferred revenue (liability)
increases by USD300 Category
30 Cash (asset) increases by Revenue increases Cash flows from operating activities Analyzing Statements of Cash
September USD700 by USD1,000 increases by USD700 Flows I
Deferred revenue (liability)
decreases by USD300 r Related Questions:
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Discussion

Exhibit 5 example 1 15th February,

HJ

Why does cash from operating activities only increase by 100 when they sold it to customer for 150 and received payment on 15th Feb for 150?

Created 8 days ago by Hwan Jung 1 reply | Last Activity: 4 days ago
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in example 4, second entry must be on 30th November rather than 30th september
AA

Created 9 days ago by Ansh Agarwal 1 reply | Last Activity: 5 days ago
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In this example 2, under Exhibit 6: on 31 December : Accumulated depreciation (contra asset) increase by USD35. How this depreciation increased by USD35 is came?
VA

Created 2 months ago by Vishwa Ajaydeepsinh Gohil 2 replies | Last Activity: 23 days ago
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