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Lesson 1: Introduction to Financial Statements
Relationships Among the Financial Statements
The information on the financial statements all comes from the same accounting system, and the four basic financial statements are all related to one another. Recall that the income statement calculates net income for the accounting period (usually a month, quarter, or year). The same net income is shown on the statement of owners’ equity, in the calculation of retained earnings for the period. For A & N Lawn Care, June net income of $1,270 is added to retained earnings in the June statement of owners’ equity. Also, the $200 distribution is subtracted from retained earnings, separately from net income. Total retained earnings and total owners’ equity are then shown on the balance sheet.
Remember that the balance sheet shown earlier had a date of June 1, 20xx, before A & N Lawn Care conducted business for the month of June. At the end of June, the balance sheet would look like Figure 1.7.
Please watch Video 1.5 to learn more about A & N's balance sheet on June 30.
Remember that the balance sheet shown earlier had a date of June 1, 20xx. That was before A&N Lawn Care conducted business for the month of June. At the end of June, the balance sheet would look like this. You've got your heading again with the name of the company and the title of this statement. For a balance sheet, it is at a particular point in time and this is at June 30, not June 1.
Now that they've done a month's worth of work and the different assets in the statement are a little bit different than they were before. We've got a cash account that now has $1,710. Accounts receivable is $50. That represents the amount that one customer still owes them at the end of June. We put it in an account called accounts receivable, which is self-explanatory. They are waiting to receive that particular amount of money.
Accounts receivable is an asset and it is listed under cash, because it is a little bit less liquid than cash. And yet, they will receive that amount in a short amount of time, so it is a fairly liquid asset. Next, equipment is listed, because it is the least liquid asset that they have on their balance sheet. Their equipment is still $8,310.
So total assets now are up to $10,070. Their note payable remains the same at $8,000. Contributed capital remains the same at $1,000. And now they have retained earnings of $1,070, which includes their net income for the month minus the dividends that they distributed to themselves, the owners. Total equity now is $2,070. So total liabilities in equity is $10,070, the same as assets. Again, the balance sheet is in balance.
At this point, it's a good idea to look at how the different financial statements are related to each other. So I'm going to erase all my marks here and go back to the income statement. So this is the income statement for the month ending June 30.
We calculated net income and that was $1,270. Net income is calculated first of all of the financial statements, because that carries over to the next statement, which is the statement of changes in owners' equity. And here we see net income on the statement of changes in owners' equity. So income statement is related to the owners' equity statement and it carries right over.
On the owners' equity statement, we calculate retained earnings. And remember, I said that was a very important calculation, because it increases retained earnings in the owners' equity section of the balance sheet. So with retained earnings, we added the net income and then we subtracted the distributions to the owners. So the total in retained earnings at the end of the month was $1,070.
That $1,070 can be seen on the balance sheet as the amount in retained earnings. So we'll skip ahead over the cash flow statement to get to the balance sheet. And you can see retained earnings is $1,070 on the balance sheet.
Now notice that the cash account on the bank balance sheet is $1,710. That is a number that matches the bottom line of the statement of cash flows. Because when we calculated cash flows, remember we were talking about just the cash that came into the company or went out of the company regardless of when expenses were paid or when revenues were earned. So with just the cash ins and outs, if you will, the cash inflows and the cash outflows, we divided them into the different sections but the total at the end of the month added up to the cash balance that we would expect to see on the balance sheet in the cash account. And that's what we have on the balance sheet.
We now have a complete picture of A & N Lawn Care’s financial information for the month of June, in the form of the four basic financial statements. Details of operating revenues and expenses are shown on the income statement and summarized in net income. Net income carries over to the statement of owners’ equity in the calculation of retained earnings. The final balance in retained earnings then carries over to the balance sheet, along with the balances of the other equity accounts.
The relationships among the income statement, owners’ equity statement, and the balance sheet are summarized in Figure 1.8.
In addition, the reconciliation of cash in the statement of cash flows agrees with the balance in the Cash account on the balance sheet. The four financial statements will always tie together in this manner. Another illustration of the financial statement relationships is shown on page 16 of your textbook.
The financial statements alone don't present enough information to enable investors and creditors to make informed decisions, because they're presented in a summary format. They don't contain any information about the characteristics of the company, its choices of accounting methods, or details of complex transactions. For this reason, companies also present notes to the financial statements to provide a more complete communication of financial data. FASB guidelines strive to ensure that companies provide transparency in their financial statements, meaning that they do not hide or disguise information, which might mislead the users of the financial statements. In this course, we will sometimes refer to the financial statement notes and their contents when covering certain topics.