Financial Accounting Basics

Question 1

Title: Three Financial Statements
Subtitle: How They Link Together

Answer 1

1. Income Statement:
   • Purpose: It shows a company’s revenue, expenses, and net income over a specific period.
   • Key elements: Revenue, cost of goods sold, operating expenses, net income.
   • Linkage: Net income from the income statement is transferred to the balance sheet as it gets added to shareholder equity
   
   2. Balance Sheet:
      • Purpose: It presents a snapshot of a company’s financial position at a specific point in time.
      • Key elements: Assets, liabilities, shareholders’ equity.
      • Linkage: Net income from the income statement is added to retained earnings, impacting shareholders’ equity.
   3. Cash Flow Statement:
      • Purpose: It tracks the inflow and outflow of cash from operating, investing, and financing activities.
      • Key elements: Cash from operating activities, cash from investing activities, cash from financing activities.
      • Linkage: Net income from the income statement affects the operating activities section of the cash flow statement.

Remember: The income statement captures a company’s performance, the balance sheet depicts its financial position, and the cash flow statement reveals its cash movements. These statements are interconnected and provide a comprehensive view of a company’s financial health.

Question 2

Why does net income increase your shareholder equity?

Answer 2

Net income increases shareholder equity because net income is a component of retained earnings, which is a subsection of shareholder equity on the balance sheet.

When a company generates net income, it represents the profit earned after deducting all expenses from the revenue. This net income is accumulated over time and contributes to the retained earnings of the company. Retained earnings reflect the cumulative earnings that have been retained within the company rather than distributed as dividends to shareholders.

Since shareholder equity is the residual interest in the company’s assets after deducting liabilities, an increase in retained earnings (which is part of shareholder equity) directly leads to an increase in overall shareholder equity. Retained earnings can be reinvested in the company’s operations, used to pay down debt, or distributed as dividends in the future, all of which can have an impact on the value of the shareholders’ ownership in the company.

In summary, net income contributes to retained earnings, which in turn increases shareholder equity. It represents the accumulated profits that the company has retained and reinvested to enhance its financial position and provide potential benefits to its shareholders.