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How are three annual financial statements interlinked with each other?
In corporate accounting, the information found on a company’s financial statements is at the heart of the process.
People use information from a company’s balance sheet, income statement, and cash flow statement to figure out critical financial ratios that show how well the company is doing financially and what might need to be done to fix to sustain in the industry.
These three financial statements are interlinked with each other. The component of one helps prepare the other.
As a whole, the three financial statements provide investors with an overview of how financially strong a company is.
Let’s enlighten about the components that act as a bridge between these three statements.
Companies have to prepare a series of statements to follow the rules of accounting standards. Ultimately, a fairly presented financial statement at the year-end can justify all the transactions made during the whole year.
Sequential stages of data recording preparation of statements-
- Journal Entry
- Ledger posting
- Trail Balance
- Profit and loss account/income statement
- Balance sheet
- Cash flow statement
Although only income statements, balance sheets and cash flow statements are part of financial statements, journal entries are the first step in recording transactions. Then, we transfer the amounts recorded in journal entries into relevant ledger accounts. Ledger balancing is the essential part of the accounting process needed at the end of the relevant financial year. Balances of ledges accounts are to be transferred to the trail balance to recognize mistakes and errors during the process.
Trail balance has to be tallied as debit, and the credit side of the statement must be the same. Sometimes, it is impossible to identify the mistake because of the time horizon or lack of resources. The balance amount must be transferred to a suspense account, which needs to be verified by the auditor.
This is how the initial three stages of recording transactions are done and interlinked with each other. Similarly, the remaining three are interconnected with each other.
Let’s understand with examples and discuss components that act as a bridge between them-
How is the income statement interlinked with others?
The income statement is used to calculate net income earned by the company during the relevant financial year. It is prepared as per accrued income or expenses approach.
How is an income statement linked with a balance sheet?
Balance sheets are the part of annual financial statements with two sides, assets and liabilities, which need to be equated.
- The amount of net income calculated from the income statement should be added to the retained earnings under the head of the reserve surplus, which changes the amount of listed equity on the balance sheet.
- Items like prepaid expenses or incomes, outstanding expenses, accrued incomes are transferred only from the income statement to the balance sheet.
- Depreciation or amortization and gain or loss from the sale of assets can only be calculated in the ledger accounts and transferred to the income statement. The amount derived from the income statement under the said head must be transferred to the balance sheet.
Let’s understand with the example of the impact of depreciation in income statements and balance sheets.
Income statement
Net profit before depreciation and tax = 1,50,000
Depreciation = 15,000
Fixed assets = 15,00,000
- In the income statement, depreciation should be shown on the debit side, which reduces the net profit by 15,000. Now profit will be 135000 (1,50,000-15,000)
- In the balance sheet, depreciation of the same amount taken from the income statement is shown under the head of tangible assets by reducing the gross amount of fixed assets by 15,000. Fixed assets will now be shown as 14,85,000 (15,00,000-15,000)
How is an income statement linked with cash flow statements?
Cash flow statements are also a part of the annual financial statements that show the net cash available to the company after paying off all the cash expenses.
- The net income calculated in the income statement is useful in calculating net cash inflow or outflow generated from operating activities. To calculate net cash inflow/outflow from operating activities, we need to deduct non-cash expenses like depreciation and adjust the amount of the outstanding and prepaid expenses or incomes.
- Income or gain on sale of fixed assets derived from income statements becomes helpful in calculating net cash inflow/outflow from investing activity. We need to deduct gains on the sale of fixed and add loss on the sale of fixed assets.
- The interest paid in the income statement is taken to the cash flow statement under the head of cash flow from financing activities.
- On the other hand, the interest received is taken to the cash flow statement under the head of the cash flow from investing activities.
- By referring to the same example as above, the impact of depreciation on the cash flow statement is shown in the income statement.
- Depreciation shown in the income statement is a non-cash expense; adding depreciation to net income from the income statement to calculate net cash flow from the operating activity is necessary. Now net income will be increased by 15,000.
How is the balance sheet interlinked with the cash flow statement?
The sum of all the heads of cash flow statements, cash flow from investing activity, cash flow from operating activity, and cash flow from financing activity adds to the previous year’s closing cash balance. The results derived will be equal to the closing cash balance of the current year.
Let’s understand with an example.
Cash flow from operating activity = 10,000
cash flow from investing activity = 15,000
Cash flow from financing activity = 17,000
Closing cash balance of 31/3/2020 (previous year) = 16,000
Closing cash balance of 31/3/2021 (current year) must be-
= 10,000+15,000+17,000+16,000
= 58,000
The whole accounting process is interlinked. We won’t be able to prepare one without the other one. It is necessary to clarify each part of accounting concepts to form a full-fledged financial statement of a company. Accurate and fair financial statement representation, notes to accounts, and material disclosure are necessary. Financial statements are the basis for making financial decisions by the investors and management itself. Accounting principles are the reason behind the interlinking process, which helps companies and stakeholders make sound decisions.
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