The financial statements of a company are developed from the bookkeeping process of the business firm. As the firm records the financial transactions of the firm over an accounting time period, the financial statements begin to appear. They are developed through recording the transactions in the accounting journal and the general ledger. The financial statements come together from those records. The financial statements are based on the accounting equation.
The Income Statement and the Accounting Equation
The income statement (statement of profit and loss) shows how profitable the firm is. A positive net income means the firm is making money. A negative net income means the firm is losing money. The income statement is developed from the accounting entries for revenues and expenses over the accounting period.
The accounting equation is stated as:
Assets = Liabilities + Owner's Equity
In the accounting equation, owner's equity is made up of revenue and expenses. Revenue increases owner's equity and expenses decrease owner's equity (the money the owner's have invested in the company). Since the firm's balance sheet is based on the accounting equation, with owner's equity a component of the left side of the balance sheet, this is the tie to the income statement.
The Statement of Retained Earnings
The Statement of Retained Earnings is developed after the Income Statement because it uses data from the Income Statement. The net income from the income statement is either retained by the firm or paid out as dividends or a combination of both.
The Balance Sheet and the Accounting Equation
The business firm's balance sheet shows how much money the firm is worth -- its net worth. The balance sheet items are stated in terms of book value. The two sides of the accounting equation mirror the format of the balance sheet. The two sides of the balance sheet have to balance since every asset has to be purchased with either a liability, like a bank loan, or owner's equity, such as a portion of the retained earnings.
The balance sheet is an indicator of net worth while the income statement or statement of profit and loss is an indicator of profitability.
The Statement of Cash Flows
The Statement of Cash Flows uses data from both the income statement and balance sheet. It is the financial statement that is developed last due to this fact.