The four statements and how they connect
A complete set of financial statements has four parts. They are prepared in a fixed order because each one feeds the next.
| Statement | Question it answers | Covers | Feeds |
|---|---|---|---|
| Income statement | Did the business make a profit? | A period of time | Net income goes to the statement of equity |
| Statement of owner's equity (or retained earnings) | How did the owner's stake change? | A period of time | Ending equity goes to the balance sheet |
| Balance sheet | What does the business own and owe? | A single date | Cash balance is checked against the cash flow statement |
| Statement of cash flows | Where did cash come from and where did it go? | A period of time | Ending cash must match the balance sheet |
The examples below use the adjusted figures from Bright Lawn Services in our guide to journal entries and the accounting cycle. The business is hypothetical, and its first month is June.
Step 1: the income statement
The income statement reports revenue, subtracts expenses and arrives at net income for the period. List revenue first, then expenses, then the difference. Use a heading with the business name, the statement title and the period covered, such as For the month ended June 30.
| Bright Lawn Services: income statement for June | Amount |
|---|---|
| Service revenue | 4,300 |
| Wages expense | 1,400 |
| Supplies expense | 250 |
| Depreciation expense | 80 |
| Total expenses | 1,730 |
| Net income | 2,570 |
Larger businesses split the statement into sections: revenue, cost of goods sold, gross profit, operating expenses, operating income, interest and tax, then net income. The same principle applies. Each subtotal tells the reader something: gross profit shows whether the product is profitable before overhead, and operating income shows whether the core business is profitable before financing costs.
Step 2: the statement of owner's equity
This statement bridges the income statement and the balance sheet. It starts with opening equity, adds investments and net income, subtracts drawings or dividends and arrives at closing equity.
| Bright Lawn Services: statement of owner's equity for June | Amount |
|---|---|
| Owner's capital, June 1 | 0 |
| Add: investment by owner | 10,000 |
| Add: net income for June | 2,570 |
| Less: drawings | (500) |
| Owner's capital, June 30 | 12,070 |
For a company, this becomes a statement of retained earnings or changes in equity, adding share issues and subtracting dividends. The logic is identical. Net income taken from the income statement is the link, so the order of preparation matters.
Step 3: the balance sheet
The balance sheet is a snapshot at one date. List assets, liabilities and equity so that assets equal liabilities plus equity. Classify assets and liabilities as current (expected to be used or settled within a year) or non-current. Present assets in order of liquidity, starting with cash.
| Bright Lawn Services: balance sheet at June 30 | Amount |
|---|---|
| Cash | 6,700 |
| Accounts receivable | 800 |
| Supplies | 350 |
| Total current assets | 7,850 |
| Equipment | 4,800 |
| Less: accumulated depreciation | (80) |
| Equipment, net | 4,720 |
| Total assets | 12,570 |
| Accounts payable | 300 |
| Wages payable | 200 |
| Total liabilities | 500 |
| Owner's capital | 12,070 |
| Total liabilities and equity | 12,570 |
Check the central rule: total assets of 12,570 equal total liabilities and equity of 12,570. If they do not match, the error is usually an arithmetic slip, a missing adjustment or equity that was not rolled forward correctly.
Step 4: the statement of cash flows
The statement of cash flows explains the change in cash, classified into three activities: operating (the day-to-day business), investing (buying and selling long-term assets) and financing (owner and lender funds).
| Bright Lawn Services: cash flows for June | Amount |
|---|---|
| Cash received from customers (2,500 + 1,000) | 3,500 |
| Cash paid for wages | (1,200) |
| Cash paid to suppliers | (300) |
| Net cash from operating activities | 2,000 |
| Purchase of equipment | (4,800) |
| Net cash used in investing activities | (4,800) |
| Owner investment | 10,000 |
| Owner drawings | (500) |
| Net cash from financing activities | 9,500 |
| Net increase in cash | 6,700 |
| Cash at June 1 | 0 |
| Cash at June 30 | 6,700 |
Closing cash of 6,700 matches the balance sheet, which is the check. The statement above is the direct method, showing actual cash received and paid. Most companies use the indirect method, which starts from net income and adjusts for items that did not involve cash.
The same operating figure, indirect method
Net income 2,570, plus depreciation 80 (a non-cash expense), minus the 800 increase in receivables (revenue earned but not yet collected), minus the 350 increase in supplies (bought but not yet used), plus the 300 increase in accounts payable (expenses not yet paid), plus the 200 increase in wages payable. That is 2,570 + 80 - 800 - 350 + 300 + 200 = 2,000, the same operating cash flow as the direct method.
A useful rule: an increase in an operating asset is cash tied up, so subtract it. An increase in an operating liability is cash kept in the business, so add it.
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Get an instant quoteA practice problem with solution
Here is an adjusted trial balance for a small business at the end of its first year. Prepare the income statement, the statement of owner's equity and the balance sheet.
| Account | Debit | Credit |
|---|---|---|
| Cash | 5,000 | |
| Accounts receivable | 2,000 | |
| Equipment | 9,000 | |
| Accumulated depreciation | 1,500 | |
| Accounts payable | 1,800 | |
| Owner's capital (opening) | 11,200 | |
| Owner's drawings | 1,000 | |
| Service revenue | 12,000 | |
| Wages expense | 6,000 | |
| Rent expense | 2,000 | |
| Depreciation expense | 1,500 | |
| Totals | 26,500 | 26,500 |
Solution
Income statement: revenue 12,000, less wages 6,000, rent 2,000 and depreciation 1,500, which total 9,500. Net income is 2,500.
Statement of owner's equity: opening capital 11,200, plus net income 2,500, minus drawings 1,000, gives closing capital of 12,700.
Balance sheet: total assets are cash 5,000 + receivables 2,000 + equipment 9,000 less accumulated depreciation 1,500, which is 14,500. Liabilities are accounts payable of 1,800 and equity is 12,700, which total 14,500, so the balance sheet balances.
The important habit is the order: net income first, then equity, then the balance sheet. A quick check that total assets equal liabilities plus equity confirms the work.
Presentation and classification
Markers look for professional presentation as well as correct numbers. Follow these conventions.
- Headings Three lines: business name, statement title, date or period.
- Currency and units Show the currency on the first and total lines, and state units if in thousands.
- Underlines and totals A single line under a list before a subtotal, a double line under a final total.
- Order of accounts Assets by liquidity, liabilities by due date, expenses in a consistent order.
- Negative numbers Use brackets for deductions and keep the same format throughout.
- Comparative columns If given two years, show the current year first unless told otherwise.
US GAAP and IFRS: differences to know
Your course will follow one framework. Some well-known differences affect how statements look.
| Area | US GAAP | IFRS |
|---|---|---|
| Inventory costing | LIFO permitted | LIFO not permitted |
| Writing inventory back up after a write-down | Not permitted | Permitted up to original cost |
| Revaluing property, plant and equipment | Cost model only | Revaluation model permitted |
| Development costs | Generally expensed | Capitalized if criteria are met |
| Statement layout | Prescribed more detail in places | More flexibility in format |
State the framework in your answer if your assignment is unclear, and apply it consistently.
Cross-checks that catch errors
- Net income matches. The figure on the income statement equals the figure used in the equity statement.
- Equity matches. Closing equity on the equity statement equals the equity on the balance sheet.
- Balance sheet balances. Assets equal liabilities plus equity.
- Cash matches. Ending cash on the cash flow statement equals cash on the balance sheet.
- Sign check. Increases in operating assets reduce cash, and increases in operating liabilities raise it.
When you have all four, you can analyze them. Our guide to financial ratio analysis shows how. If you need help with a full set of statements, you can order accounting assignment help.