relates to the statement of retained earnings

and then how that statement of retained earnings

flows in or relates to the balance sheet.

So first of all let’s just define quickly what an income statement is. An income

statement is…

you take all the revenues

of the business for the year in this example is year 1

which is $1,000

and from the revenues you subtract

all the expenses.

That's the $950

in advertising, telephone and other expenses we've identified here.

So whatever is left over is something called net income

or net profit.

There are different ways to call it. But in this example let’s just stick with net income.

So the

1,000 minus 950 gives us the net income of $50.

Now the second statement here…and you'll see here that the

$50 from the income statement

flows in here to the

statement of retained earnings.

So retained earnings…all retained earnings is – is the accumulation of profits

or losses in the business over time.

So in year 1

which we’re in now,

we have a profit of $50.

So the retained earnings at the end of the period is $50. Now let's

assume for a second that

we’re at the end of year 2

and we had another net income or profit of $25. So at

the end of year 2

our retained earnings would be $75.

Now let’s say in year 3 we had a net loss

of $25.

So at the end of year 3 our retained earnings would be $50.

So again retained earnings is just the accumulation of profits and

losses

from day 1 of the of the business to whatever point in time you’re at.

So right now in our example we’re at the end of year 1.

I just wanted to show you what

happens to retained earnings when future

net incomes and future net losses

are factored in.

Now the balance sheet.

The balance sheet

keeps track of all the

assets, liabilities,

and shareholders equity of the business.

So first of all, just to show you how the statement of retained earnings

ties into the balance sheet you'll see that the $50 here

ties into the balance sheet

through the shareholder’s equity section

under the

name retained earnings.

So that $50 flows right through from the income statement

to the statement of retained earnings right into the balance sheet.

So to wrap up here. To

define what a balance sheet is. A balance sheet is…

and we mention it…

you look at all the assets of the business. So assets of the business

can be anything that the business owns. That could be cash, that can be

...

amounts on account that customers owe them,

it could be tables, chairs, equipment - that sort of stuff.

Liabilities,

or items that the company owes money for. So if they bought supplies on account from

Staples. Then if

they haven’t paid that bill yet

that would be an accounts payable.

Other types of

liabilities would be if they borrowed money and they owe money to the bank.

So assets are things they own and

liabilities are things they owe.

And finally you have something called the shareholders equity section.

And there's a couple of components in this section. I just wanted to

put in retained earnings - that's the main one. There’s

something called capital stock but won’t put that in here right now.

So retained earnings is the shareholder’s equity in this example.

By definition the balance has to balance. So the equation I just did

here assets equals liabilities plus equity.

You can see that here the $100 in assets is equal to the $50

in liabilities plus the $50

in shareholder’s equity.

Another way to state this formula that some people

prefer it this way

is assets minus liabilities

equals equity.

And in this example,

think about a house. If you owned a house – the asset

was $100,000 dollars

and you owed $50,000 in the mortgage

your equity would be $50,000. The same things applies in a

business on a balance sheet.

So those are just…

What I wanted to accomplish here is was

show you how the income statement, the statement of retained earnings, and balance sheet are all tied to one another

and to give you a quick overview of what each financial statement does. And one last thing I forgot to

mention on the statement of retained earnings there is something else called dividends that

factors into this calculation, but

we’ll leave this for another time.

No sense complicating it here.

That summarizes things for now. We’ll talk to you next time. Thanks for stopping by.