Accounting: Statement Linkages and Recognition Rules
Accounting
The three statements are one system: net income flows to retained earnings and is the starting point of the cash flow statement; the cash flow statement explains the change in cash; the balance sheet must balance. Every balance sheet change therefore has two effects, and exam questions exploit this relentlessly.
Key linkages: a rise in accounts receivable reduces cash (revenue recognised but not collected); a rise in accounts payable increases cash; capex appears as an investing outflow and as growth in gross PP&E; depreciation reduces net income, is added back in operating cash flow, and reduces net PP&E. Because depreciation is non-cash, changing the depreciation estimate alters net income but not cash flow from operations (absent tax effects) - a favourite trick.
Revenue recognition under ASC 606 / IFRS 15 uses five steps: identify the contract, identify performance obligations, determine the transaction price, allocate the price, and recognise revenue as each obligation is satisfied. Expect questions on principal versus agent and on bill-and-hold arrangements.
Traps: capitalising a cost that should be expensed (overstating profit and assets in year one); confusing operating lease expense with a finance lease's interest-plus-amortisation split; and forgetting that an inventory write-down is non-cash but reduces taxable income.
Worked example: revenue of 500 with receivables rising by 80 means cash collected is 420. Operating cash flow shows net income of 500 less the 80 working capital build, giving 420. Omit the working capital line and cash is overstated by 80.