There are four basic financial statements: the income statement, the statement of changes in equity (often called the statement of retained earnings in intro courses), the balance sheet, and the cash flow statement. They have to be prepared in that order, because each one feeds the next. Most mistakes come from building them out of order or from losing track of where a number came from.
What each statement shows
- Income statement — revenues minus expenses equals net income, over a period of time.
- Statement of changes in equity — beginning equity plus net income, minus dividends, equals ending equity.
- Balance sheet — assets equal liabilities plus equity, at a single point in time. Some textbooks call it the statement of financial position.
- Cash flow statement — explains the change in cash through operating, investing, and financing activities.
Step-by-step order
- Start from the adjusted trial balance. Every number you need is on it.
- Prepare the income statement using the revenue and expense accounts to get net income.
- Prepare the statement of changes in equity, starting with beginning retained earnings, adding net income, and subtracting dividends.
- Prepare the balance sheet using the ending retained earnings from step 3.
- Prepare the cash flow statement last. It should end at the same cash figure shown on the balance sheet.
Worked example
Income statement: Revenue 50,000 − Expenses 32,000 = Net income 18,000
Retained earnings: Beginning 12,000 + Net income 18,000 − Dividends 5,000 = Ending 25,000
Balance sheet: Cash 30,000 + Accounts receivable 15,000 + Equipment (net) 35,000 = Total assets 80,000
Accounts payable 20,000 + Notes payable 15,000 = Liabilities 35,000. Common stock 20,000 + Retained earnings 25,000 = Equity 45,000.
Liabilities 35,000 + Equity 45,000 = 80,000, which matches total assets.
A quick word on the cash flow statement
It has three sections: operating activities (cash from running the business), investing activities (buying or selling long-term assets), and financing activities (borrowing, issuing stock, paying dividends). Most intro courses use the indirect method, which starts from net income and adjusts for non-cash items and changes in working capital.
Common mistakes
Building the balance sheet before the retained earnings. The balance sheet needs ending retained earnings, which needs net income. If assets don’t equal liabilities plus equity, retained earnings is the first place to look.
Treating dividends as an expense. Dividends reduce retained earnings directly. They never appear on the income statement.
Mixing up current and long-term items. Balance sheet classification matters, because the ratios in the next topic depend on it.
If you’re working on an accounting assignment that has you prepare all four statements from a trial balance, walking through the order with a tutor makes the connections between them much easier to see.
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