IB Technicals - Three-Statement Linkages and Transaction Accounting Scenarios

How are the three financial statements linked?

Net income from the IS feeds into the CFS as the starting point for operating cash flows. Second, it flows into the retained earnings section of shareholders’ equity on the balance sheet. Then, changes in BS items like accounts receivable or inventory show up as adjustments in the operating activities section on the CFS. Capital expenditures and debt issuances from the investing and financing sections of the CFS affect BS items like PP&E and debt. Finally, the ending cash balance ties directly back to the cash line on the BS.

Where does net income flow on the balance sheet and cash flow statement?

Net income flows becomes the top line on the cash flow statement and becomes the starting point for operating cash flows, while it also flows into retained earnings under the shareholders’ equity section of the balance sheet.

Walk me through how a $10 increase in depreciation impacts the financial statements?

Firstly, depreciation acts as a non-cash expense that a company incurs and reduces pre-tax income by $10. Then, since depreciation is tax-deductible, some of the depreciation expense can reduce taxable income. Assuming a 30% tax rate, tax expenses decrease by $3, so net income is reduced by $7. This $7 decrease flows into the top line of the cash flow statement, but since depreciation is a non-cash expense, $10 is added back, resulting in a net gain of $3. This change is reflected on the cash line of the balance sheet, but the $10 depreciation expense must be subtracted from PP&E, resulting in a net change of -$7 on the assets section. Lastly, net income in the retained earnings section is decreased by $7, so the balance sheet balances.

Walk me through how a $10 increase in capital expenditures impacts the financial statements?

Firstly, capital expenditures does not impact the income statement since it represents a purchase of long term assets. However, on the cash flow statement, $10 is subtracted from the investing activities section, resulting in a $10 decrease in net cash. This $10 decrease in cash is represented on the cash line on the balance sheet, but $10 is added to PP&E. The liabilities and equities side of the balance sheet remains unchanged, and the balance sheet balances.

Walk me through how a $10 increase in deferred revenue impacts the financial statements?

Since deferred revenue represents a cash increase before goods or services have been exchanged, there is no change on the income statement. However, on the cash flow statement, there is a $10 increase in the operating activities section, resulting in a $10 increase in net cash. This change is reflected in the cash line of the balance sheet, and on the liabilities side, deferred revenue increases by $10, so the balance sheet balances.

Walk me through how a $10 purchase of inventory (with cash) impacts the financial statements?

A $10 purchase of inventory does not immediately impact the income statement, since this expense is only recognized as cost of goods sold once the inventory is sold to the customer. However, this expense does reduce the operating activities of the cash flow statement by $10 since cash left the business to purchase an asset. This reduction is accounted for as a $10 decrease in the cash line on the balance sheet, but inventory increases by $10, so the balance sheet balances.

Walk me through how a $10 purchase of inventory (with credit) impacts the financial statements?

A $10 purchase of inventory does not immediately impact the income statement, since this expense is only recognized as cost of goods sold once the inventory is sold to the customer. On the cash flow statement, the company’s cash flow from operations increases by $10 because of the change in accounts payable, but decreases by $10 because of the change in inventory, resulting in no change on the final cash flow. On the balance sheet, accounts payable in the liabilities section increases by $10, but inventory increases by $10 so the balance sheet balance.

A company sells inventory with a $10 cost basis for $15 in cash. Walk through all three financial statements.

First revenue increases by $15, but COGS increases by $10, resulting in a $5 increase in pre-tax income. Assuming a 30% tax rate, the company is taxed $1.50 on the sale, resulting in a total increase in net income of $3.50. This flows into the cash flow statement, but since inventory decreases by $10, $10 dollars is added back to the CFO section, resulting in a net cash inflow of $13.50. This is reflected in the cash line of the balance sheet, as well as the $10 decrease in. The $3.50 from net income flows into retained earnings in the equity section, and since both sides of the balance sheet increased by $3.50, the balance sheet balances.

Accounts receivable increases by $10 because revenue is recognized but cash is not collected. Walk through all three financial statements.

The company records $10 of revenue, and assuming a 30% tax rate, produces $7 in net income. On the cash flow statement, net income increases by $7 but since no cash was received, $10 is subtracted from the CFO section. On the balance sheet, cash falls by $3, and accounts receivable rises by $10, so assets increase $7 which is balanced by a $7 increase in retained earnings.

How does a $10 increase in accounts payable impact the three financial statements?

The income statement is not immediately affected since there was no transaction. On the cash flow statement, there is a $10 increase in CFO because of the AP increase. This increases the cash line on the BS by $10, which is balanced on the liabilities and equities side of the equation by a $10 increase in AP.

How does a $10 increase in accrued expenses impact the three financial statements?

A $10 increase in accrued expenses increases operating expenses by $10, reducing pre-tax income by $10. Assuming a 30% tax rate, net income decreases by $7. On the CFS, net income decreases by $7, but $10 must be added back to CFO since no cash has left the bank yet. On the BS, the cash line increases by $3, and accrued expenses increases by $10 in the liabilities section. Under equity, retained earnings decrease by $7, so the balance sheet balances.

A company issues $100 of debt. Walk through all three financial statements.

There is no immediate change to the income statement since debt is a financing activity. On the cash flow statement, it shows up as a $100 increase in CFF. This is reflected as a $100 increase in cash on the balance sheet. On the liabilities side, debt, either short term or long term, increases by $100, so the balance sheet balances. Going forward, the debt would create interest expense, which would reduce pre-tax income, net income, cash, and retained earnings. The $100 debt balance would remain until the principal is repaid.

A company repays $100 of debt principal. Walk through all three financial statements.

There is no immediate change to the income statement since debt is a financing activity. On the cash flow statement, there is a $100 decrease in cash flow from financing activities, so net cash is down $100. On the balance sheet, cash is down by $100, and debt is down by $100, so the balance sheet balances.

Interest expense increases by $10. Walk through all financial statements.

First, interest expense reduces pre-tax income by $10. Since interest is tax-deductible, assuming a 30% tax rate, net income is down by $7. On the cash flow statement, net income is down by $7, so cash at the bottom is down $7. On the balance sheet, cash is down $7, and retained earnings are down $7, so the balance sheet balances.

A company issues $100 of common equity. Walk through all three financial statements.

The income statement is not immediately impacted since equity is a financing activity. On the cash flow statement, cash increases by $100. On the balance sheet, the cash line increases by $100, and common stock increases by $100, so the balance sheet balances.

A company repurchases $100 in stock. Walk through all three financial statements.

The income statement is not immediately affected since stock repurchases are not an operating item. On the cash flow statement, there is a $100 cash outflow in the CFF section, so net cash is down $100 on the balance sheet. There is also a $100 decrease in shareholder’s equity due to treasury stock increase of $100, so the balance sheet balances.

A company pays a $10 dividend. Walk through all three financial statements.

The income statement is not immediately impacted since dividends are a financing activity. On the cash flow statement, this decreases CFF by $10, which reduced the cash line on the balance sheet by $10. However, retained earnings decrease by $10, so the balance sheet balances.