Once you have prepared the adjusted trial balance, you are ready to prepare the financial statements. Preparing financial statements is the seventh step in the accounting cycle. Remember that we have four financial statements to prepare: an income statement, a statement of retained earnings, a balance sheet, and the statement of cash flows. These financial statements were introduced in Introduction to Financial Statements and Statement of Cash Flows dedicates in-depth discussion to that statement.
To prepare the financial statements, a company will look at the adjusted trial balance for account information. From this information, the company will begin constructing each of the statements, beginning with the income statement. Income statements will include all revenue and expense accounts. The statement of retained earnings will include beginning retained earnings, any net income (loss) (found on the income statement), and dividends. The balance sheet is going to include assets, contra assets, liabilities, and stockholder equity accounts, including ending retained earnings and common stock.
Magnificent Adjusted Trial Balance
Go over the adjusted trial balance for Magnificent Landscaping Service. Identify which income statement each account will go on: Balance Sheet, Statement of Retained Earnings, or Income Statement.
Balance Sheet: Cash, accounts receivable, office supplied, prepaid insurance, equipment, accumulated depreciation (equipment), accounts payable, salaries payable, unearned lawn mowing revenue, and common stock. Statement of Retained Earnings: Dividends. Income Statement: Lawn mowing revenue, gas expense, advertising expense, depreciation expense (equipment), supplies expense, and salaries expense.
An income statement shows the organization’s financial performance for a given period of time. When preparing an income statement, revenues will always come before expenses in the presentation. For Printing Plus, the following is its January 2019 Income Statement.
Revenue and expense information is taken from the adjusted trial balance as follows:
Total revenues are $10,240, while total expenses are $5,575. Total expenses are subtracted from total revenues to get a net income of $4,665. If total expenses were more than total revenues, Printing Plus would have a net loss rather than a net income. This net income figure is used to prepare the statement of retained earnings.
The Importance of Accurate Financial Statements
Financial statements give a glimpse into the operations of a company, and investors, lenders, owners, and others rely on the accuracy of this information when making future investing, lending, and growth decisions. When one of these statements is inaccurate, the financial implications are great.
For example, Celadon Group misreported revenues over the span of three years and elevated earnings during those years. The total overreported income was approximately $200–$250 million. This gross misreporting misled investors and led to the removal of Celadon Group from the New York Stock Exchange. Not only did this negatively impact Celadon Group’s stock price and lead to criminal investigations, but investors and lenders were left to wonder what might happen to their investment.
That is why it is so important to go through the detailed accounting process to reduce errors early on and hopefully prevent misinformation from reaching financial statements. The business must have strong internal controls and best practices to ensure the information is presented fairly.3
Statement of Retained Earnings
The statement of retained earnings (which is often a component of the statement of stockholders’ equity) shows how the equity (or value) of the organization has changed over a period of time. The statement of retained earnings is prepared second to determine the ending retained earnings balance for the period. The statement of retained earnings is prepared before the balance sheet because the ending retained earnings amount is a required element of the balance sheet. The following is the Statement of Retained Earnings for Printing Plus.
Net income information is taken from the income statement, and dividends information is taken from the adjusted trial balance as follows.
The statement of retained earnings always leads with beginning retained earnings. Beginning retained earnings carry over from the previous period’s ending retained earnings balance. Since this is the first month of business for Printing Plus, there is no beginning retained earnings balance. Notice the net income of $4,665 from the income statement is carried over to the statement of retained earnings. Dividends are taken away from the sum of beginning retained earnings and net income to get the ending retained earnings balance of $4,565 for January. This ending retained earnings balance is transferred to the balance sheet.
Concepts Statements give the Financial Accounting Standards Board (FASB) a guide to creating accounting principles and consider the limitations of financial statement reporting. See the FASB’s “Concepts Statements” page to learn more.
The balance sheet is the third statement prepared after the statement of retained earnings and lists what the organization owns (assets), what it owes (liabilities), and what the shareholders control (equity) on a specific date. Remember that the balance sheet represents the accounting equation, where assets equal liabilities plus stockholders’ equity. The following is the Balance Sheet for Printing Plus.
Ending retained earnings information is taken from the statement of retained earnings, and asset, liability, and common stock information is taken from the adjusted trial balance as follows.
Looking at the asset section of the balance sheet, Accumulated Depreciation–Equipment is included as a contra asset account to equipment. The accumulated depreciation ($75) is taken away from the original cost of the equipment ($3,500) to show the book value of equipment ($3,425). The accounting equation is balanced, as shown on the balance sheet, because total assets equal $29,965 as do the total liabilities and stockholders’ equity.
There is a worksheet approach a company may use to make sure end-of-period adjustments translate to the correct financial statements.
Both US-based companies and those headquartered in other countries produce the same primary financial statements—Income Statement, Balance Sheet, and Statement of Cash Flows. The presentation of these three primary financial statements is largely similar with respect to what should be reported under US GAAP and IFRS, but some interesting differences can arise, especially when presenting the Balance Sheet.
While both US GAAP and IFRS require the same minimum elements that must be reported on the Income Statement, such as revenues, expenses, taxes, and net income, to name a few, publicly traded companies in the United States have further requirements placed by the SEC on the reporting of financial statements. For example, IFRS-based financial statements are only required to report the current period of information and the information for the prior period. US GAAP has no requirement for reporting prior periods, but the SEC requires that companies present one prior period for the Balance Sheet and three prior periods for the Income Statement. Under both IFRS and US GAAP, companies can report more than the minimum requirements.
Presentation differences are most noticeable between the two forms of GAAP in the Balance Sheet. Under US GAAP there is no specific requirement on how accounts should be presented. However, the SEC requires that companies present their Balance Sheet information in liquidity order, which means current assets listed first with cash being the first account presented, as it is a company’s most liquid account. Liquidity refers to how easily an item can be converted to cash. IFRS requires that accounts be classified into current and noncurrent categories for both assets and liabilities, but no specific presentation format is required. Thus, for US companies, the first category always seen on a Balance Sheet is Current Assets, and the first account balance reported is cash. This is not always the case under IFRS. While many Balance Sheets of international companies will be presented in the same manner as those of a US company, the lack of a required format means that a company can present noncurrent assets first, followed by current assets. The accounts of a Balance Sheet using IFRS might appear as shown here.
Review the annual report of Stora Enso which is an international company that utilizes the illustrated format in presenting its Balance Sheet, also called the Statement of Financial Position. The Balance Sheet is found on page 31 of the report.
Some of the biggest differences that occur on financial statements prepared under US GAAP versus IFRS relate primarily to measurement or timing issues: in other words, how a transaction is valued and when it is recorded.
The 10-column worksheet is an all-in-one spreadsheet showing the transition of account information from the trial balance through the financial statements. Accountants use the 10-column worksheet to help calculate end-of-period adjustments. Using a 10-column worksheet is an optional step companies may use in their accounting process.
Here is a picture of a 10-column worksheet for Printing Plus.
There are five sets of columns, each set having a column for debit and credit, for a total of 10 columns. The five column sets are the trial balance, adjustments, adjusted trial balance, income statement, and the balance sheet. After a company posts its day-to-day journal entries, it can begin transferring that information to the trial balance columns of the 10-column worksheet.
The trial balance information for Printing Plus is shown previously. Notice that the debit and credit columns both equal $34,000. If we go back and look at the trial balance for Printing Plus, we see that the trial balance shows debits and credits equal to $34,000.
Once the trial balance information is on the worksheet, the next step is to fill in the adjusting information from the posted adjusted journal entries.
The adjustments total of $2,415 balances in the debit and credit columns.
The next step is to record information in the adjusted trial balance columns.
To get the numbers in these columns, you take the number in the trial balance column and add or subtract any number found in the adjustment column. For example, Cash shows an unadjusted balance of $24,800. There is no adjustment in the adjustment columns, so the Cash balance from the unadjusted balance column is transferred over to the adjusted trial balance columns at $24,800. Interest Receivable did not exist in the trial balance information, so the balance in the adjustment column of $140 is transferred over to the adjusted trial balance column.
Unearned revenue had a credit balance of $4,000 in the trial balance column, and a debit adjustment of $600 in the adjustment column. Remember that adding debits and credits is like adding positive and negative numbers. This means the $600 debit is subtracted from the $4,000 credit to get a credit balance of $3,400 that is translated to the adjusted trial balance column.
Service Revenue had a $9,500 credit balance in the trial balance column, and a $600 credit balance in the Adjustments column. To get the $10,100 credit balance in the adjusted trial balance column requires adding together both credits in the trial balance and adjustment columns (9,500 + 600). You will do the same process for all accounts. Once all accounts have balances in the adjusted trial balance columns, add the debits and credits to make sure they are equal. In the case of Printing Plus, the balances equal $35,715. If you check the adjusted trial balance for Printing Plus, you will see the same equal balance is present.
Next you will take all of the figures in the adjusted trial balance columns and carry them over to either the income statement columns or the balance sheet columns.
Income Statement and Balance Sheet
Take a couple of minutes and fill in the income statement and balance sheet columns. Total them when you are done. Do not panic when they do not balance. They will not balance at this time.
Every other account title has been highlighted to help your eyes focus better while checking your work.
Looking at the income statement columns, we see that all revenue and expense accounts are listed in either the debit or credit column. This is a reminder that the income statement itself does not organize information into debits and credits, but we do use this presentation on a 10-column worksheet.
You will notice that when debit and credit income statement columns are totaled, the balances are not the same. The debit balance equals $5,575, and the credit balance equals $10,240. Why do they not balance?
If the debit and credit columns equal each other, it means the expenses equal the revenues. This would happen if a company broke even, meaning the company did not make or lose any money. If there is a difference between the two numbers, that difference is the amount of net income, or net loss, the company has earned.
In the Printing Plus case, the credit side is the higher figure at $10,240. The credit side represents revenues. This means revenues exceed expenses, thus giving the company a net income. If the debit column were larger, this would mean the expenses were larger than revenues, leading to a net loss. You want to calculate the net income and enter it onto the worksheet. The $4,665 net income is found by taking the credit of $10,240 and subtracting the debit of $5,575. When entering net income, it should be written in the column with the lower total. In this instance, that would be the debit side. You then add together the $5,575 and $4,665 to get a total of $10,240. This balances the two columns for the income statement. If you review the income statement, you see that net income is in fact $4,665.
We now consider the last two columns for the balance sheet. In these columns we record all asset, liability, and equity accounts.
When adding the total debits and credits, you notice they do not balance. The debit column equals $30,140, and the credit column equals $25,475. How do we get the columns to balance?
Treat the income statement and balance sheet columns like a double-entry accounting system, where if you have a debit on the income statement side, you must have a credit equaling the same amount on the credit side. In this case we added a debit of $4,665 to the income statement column. This means we must add a credit of $4,665 to the balance sheet column. Once we add the $4,665 to the credit side of the balance sheet column, the two columns equal $30,140.
You may notice that dividends are included in our 10-column worksheet balance sheet columns even though this account is not included on a balance sheet. So why is it included here? There is actually a very good reason we put dividends in the balance sheet columns.
When you prepare a balance sheet, you must first have the most updated retained earnings balance. To get that balance, you take the beginning retained earnings balance + net income – dividends. If you look at the worksheet for Printing Plus, you will notice there is no retained earnings account. That is because they just started business this month and have no beginning retained earnings balance.
If you look in the balance sheet columns, we do have the new, up-to-date retained earnings, but it is spread out through two numbers. You have the dividends balance of $100 and net income of $4,665. If you combine these two individual numbers ($4,665 – $100), you will have your updated retained earnings balance of $4,565, as seen on the statement of retained earnings.
You will not see a similarity between the 10-column worksheet and the balance sheet, because the 10-column worksheet is categorizing all accounts by the type of balance they have, debit or credit. This leads to a final balance of $30,140.
The balance sheet is classifying the accounts by type of accounts, assets and contra assets, liabilities, and equity. This leads to a final balance of $29,965. Even though they are the same numbers in the accounts, the totals on the worksheet and the totals on the balance sheet will be different because of the different presentation methods.
Publicly traded companies release their financial statements quarterly for open viewing by the general public, which can usually be viewed on their websites. One such company is Alphabet, Inc. (trade name Google). Take a look at Alphabet’s quarter ended March 31, 2018, financial statements from the SEC Form 10-Q.
Frank’s Net Income and Loss
What amount of net income/loss does Frank have?
In Completing the Accounting Cycle, we continue our discussion of the accounting cycle, completing the last steps of journalizing and posting closing entries and preparing a post-closing trial balance.