Recently I was asked a question that goes to the crux of the title question. Accounting is a way to track, measure, and report information. Accounting does this by producing financial statements. Accounting is actually quite brilliant and there is a good argument that it spurred the Renaissance and thus the modern world.

But that’s a story for another post. Suffice it to say one of the greatest thinkers and writers Johann Wolfgang von Goethe called double entry accounting,

“among the finest inventions of the human mind.”

Everyone should know a little about accounting and how it functions. Your investments and retirement depend on it. If you have studied accounting and still don’t get it, read on.

By the end of this post you will all be able to read and understand financial statements.

The question that acts as the launching pad is a bit technical and geeky so hold your nose and just power through it.

Why do net losses reduce retained earnings?

The question is a perfect one because it straddles the three financial statements and their impact on each other.

The impact of the Income Statement on the Balance Sheet is a great question that goes to the heart of accounting, financial statements, and financial reporting.

Net profits and net losses are recorded at the end of the period to the Balance Sheet in the Retained Earnings account. That is what retained earnings means. The bottom line of the Income Statement impacts the equity section of the Balance Sheet via Retained Earnings.

Below is a description of how accounting numbers flow through the three financial statements and how they are interconnected.

The Big Picture of Financial Statements

The three Financial Statements: Balance Sheet, Income Statement, and Cash Flow Statement are interconnected, and the accounting numbers flow through them. They are the measure of a company’s performance and health.

The interconnection starts with a Balance Sheet showing the financial position at the beginning of the period (usually a year); next, you have the Income Statement that shows the operations during the year, and then a Balance Sheet at the end of the year.

The Cash Flow Statement is necessary to reconcile the cash position starting from the Net Income number at the bottom of the Income Statement.

The cash number calculated from the Cash Flow Statement is added to the cash reported on the beginning Balance Sheet in the Cash account. This number needs to match the actual money in the bank at the end of the period. These steps represent the reconciliation process where you reconcile the cash account number in your accounting software to the actual balance in your bank account.

The reconciled amount is recorded as the Cash account balance at the top right (Asset column) of the end of year (EOY) Balance Sheet.

The Net Income number from the Income Statement (profit or loss) is then added, or subtracted in the case of a loss, to the Retained Earnings number in the Equity section (lower left-hand side) of the end of year (EOY) Balance Sheet. A profit increases retained earnings, and a loss decreases retained earnings. (This addresses the specific question.)

Changes in non-cash accounts like Accounts Receivable and Accounts Payable and Depreciation and Amortization will make up the difference between the Cash Flow number added on the right side of the Balance Sheet and the Net Income number added on the left-hand side.

When these steps are performed correctly, all the numbers should reconcile. The Assets will be equal to the Liabilities and Equity (remember the Accounting Equation A = L + E) on the EOY Balance Sheet.

Financial Statement Interconnections and Flow

Think of it as a system of two Balance Sheets acting as bookends for the Income Statement. The Cash Flow Statement reconciles the Net Income (or Loss) at the bottom of the Income Statement with the amount of cash actually in the bank.

This process accounts for every penny that has come in, gone through, and gone out of a company during the period.

Understanding the three financial statements and how they knit together will allow you to assess the financial health, viability, and prospects of any company, and help you make rational fact-based investment decisions. It’s the basis of Value Investing, and this is how Warren Buffett does it.

This post ties together the functionality of the financial statements. I hope this might be an “aha” moment for you. It was for me when I finally realized how this all fit and worked together.

Understanding how to read and understand financial statements is the basis of Financial Literacy and Capitalism. Following this big conceptual picture of accounting will provide a context to keep you from ever getting lost in the details like specific debits and credits.

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