1.4: Financial Statements
The goal of journalizing, posting to the ledgers, and preparing the trial balance is to gather the information necessary to produce the financial statements . The time period concept requires companies produce the financial statements on a regular basis over the same time interval, such as a month or year. Most of the amounts on these statements are copied directly from the trial balance, and then appropriate calculations and summary amounts are also displayed. The first of the four financial statements will be discussed here.
1.4.1 Income Statement
The net income from a business’s operations for a period of time is so important to business people and investors that one financial statement—the income statement—is dedicated to showing what that amount is and how it was determined.
The income statement is a report that lists and summarizes revenue, expense, and net income information for a period of time, usually a month or a year. It is based on the following equation: Revenue - Expenses = Net income (or Net loss). Revenue is shown first; a list of expenses follows, and their total is subtracted from revenue. If the difference is positive, there is a profit, or net income. If the difference is negative, there is a net loss that is typically presented in parentheses as a negative number.
The income statement answers a business’s most important question: How much profit is it making? It is limited to a specific period of time (month or year) from beginning to end. The income statement relies on the matching principle in that it only reports revenue and expenses in a specified window of time. It does not include any revenue or expenses from before or after that block of time.
FORMATTING TIPS
Complete heading: Company Name, Name of Financial Statement, Date
Two Columns of numbers—left one for listing items to be sub-totaled; right one for results
Dollar signs go at the top number of a list of numbers to be calculated
Category headings for revenue and expenses only if there is more than one item listed in the category
Expenses listed in order of highest to lowest dollar amounts, except for Miscellaneous Expense, which is always last
The word “Expense” on expense account names
Single underline just above the result of a calculation (two of these)
Dollar sign on final net income number
Double underline below the final net income result
You have just learned about the income statement—the accounts it displays and its format. We will hold off for now on the other three financial statements— the retained earnings statement, the balance sheet, and the statement of cash flows —and learn about those later.
1.4.2 The Accounting Cycle
Accounting is practiced under a guideline called the time period assumption, which allows the ongoing activities of a business to be divided up into periods of a year, quarter, month, or other increment of time. The precise time period covered is included in the headings of the income statement, the retained earnings statement, and the statement of cash flows.
Therefore, the accounting process is cyclical. A cycle is a period of time in which a series of accounting activities are performed. As was just stated, the typical accounting cycle is a year, a month, or perhaps a quarter. Once the current cycle is completed, the same recording and reporting activities are then repeated in the next period of time of equal length.
In accounting, journalizing and posting transactions to the ledgers are done every day in the cycle. Financial statements are typically prepared only on the last day of the cycle. Once the financial statements are complete, the process continues on into the next accounting period, where again the financial statements are the goal of the recordkeeping process.
1.4.3 Temporary Accounts
The accounts on the income statement are called temporary accounts. They are used to record operational transactions for a specific period of time. Once the income statement is prepared to report the temporary account balances at the end of the period, these account balances are set back to zero by transferring them to another account. When the next accounting period begins, the beginning balances of the temporary accounts are zero, for a fresh start.
1.4.4 Closing Entries
The financial statements are the goal of all that is done in the accounting cycle. However, there are some steps that need to be taken once those reports are completed to set up the ledgers for the next cycle. These steps involve closing entries.
Closing entries are special journal entries made at the end of the accounting period (month or year) after the financial statements are prepared but before the first transaction in the next month is recorded in the journal. The purpose of closing entries is to set the balances of income statement accounts back to zero so you can start fresh and begin accumulating new balances for the next month. This process ensures that the balances on the second month’s income statement do not include amounts from transactions in the first month.
Profit at the end of the accounting period is transferred into a new account called Retained Earnings when the revenue and expense accounts are closed out. The Retained Earnings account is only used for closing entries.
Closing entries transfer the balances from the revenue and expense accounts into Retained Earnings in preparation for the new month . Retained Earnings is an account where profit is “stored.” Think of the retained earnings balance as “accumulated profit,” or all the net income that the business has ever generated since it began operations.
Assume a business’s accounting period is a month. For the first month in which the business operates, the beginning retained earnings balance is zero since there were no previous periods and therefore no previous profits. At the end of the first month, the retained earnings balance equals the net income for the month.
After the first month, when closing entries for the current month are journalized and posted, the additional net income for the next month is added to any net income already in Retained Earnings from previous months. Since Revenue - Expenses = Net Income , moving revenue and expense balances into Retained Earnings is the same as moving the net income.
A track star is practicing running a lap at a time around the track. He has a timekeeper with a stopwatch timing each lap. The timekeeper clicks “Start” and the runner takes off. He crosses the finish line in 50 seconds, the time elapsed as shown on the stopwatch when “Stop” was clicked.
The runner rests, drinks, and decides to try again to see if he can do better. The timekeeper clicks “Start” and the runner takes off, running even faster. He crosses the finish line in 95 seconds, the time elapsed as shown on thestopwatch when “Stop” was clicked.
What is wrong with this picture? Was he so much slower? He did not have a poor sprint; he had a poor timekeeper! This person did not reset the stopwatch to zero for the second run, so the 50 seconds from the first run was includedwith the 45 seconds from the second run. The runner can subtract the 50 from the 95, but who wants to do math on the track? That is what the reset button is for, and it enables the results of both runs to be easily compared.
Similarly, income statements include revenue and expense amounts for a period of time—a month or a year. After one month is reported, the ledger balances of these accounts must be reset to zero so that the next month’s income statement does not include amounts from the previous month. This is done by closing out the revenue and expense ledger balances and resetting their balances to zero.
The Retained Earnings account is not closed out; instead, revenue and expense accounts are closed out into it. The effects are that the credit balance in Retained Earnings increases each month by the month’s net income amount, and the balances of Fees Earned and all the expense accounts become zero.
Closing entries are entered in the same journal that was used for the general entries during the month. The first closing entry is journalized right after the last general entry. Closing entries must be posted to the ledgers to impact the revenue, expense, and Retained Earnings account balances.
As an example, assume that on 6/30 Fees Earned has a credit ledger balance of $2,100 and Rent Expense (the only expense account) has a debit ledger balance of $500. Net income is therefore $1,600. The closing entry process would be as follows:
-
Zero out the Fees Earned account
(and any other revenue accounts, if there are others.)
Debit Fees Earned for its credit balance of $2,100 to close it out and bring its balance to zero.
Credit Retained Earnings for the same amount.
Date Account Debit Credit 6/30 Fees Earned 2,100 ▼ Fees Earned is a revenue account that is decreasing . Retained Earnings 2,100 ▲ Retained Earnings is an equity account that is increasing . -
Zero out the Rent Expense account
(and any other expense accounts, if there are others.)
Credit Rent Expense for its debit balance of $500 to close it out and bring the balance to zero.
Debit Retained Earnings for the same amount.
Date Account Debit Credit 6/30 Retained Earnings 500 ▼ Retained Earnings is an equity account that is decreasing . Rent Expense 500 ▼ Rent Expense is an expense account that is decreasing.
EXAMPLE
One month to the next WITHOUT closing entries on 6/30
The following journal shows five June transactions. (There would be more, but we will just use five for the example.) These are posted to the ledgers on the right. The running balance in Fees Earned as of 6/30 is a $2,100 credit. The running balances of Rent Expense and Wages Expense as of 6/30 are a $500 debit and a $300 debit, respectively. These three amounts would be reported on the income statement in arriving at a net income of $1,300 for June.
Then July begins and the journal also shows the first three July transactions. Once again Rent Expense on the first of the month is $500, the first Fees Earned transaction is $900, and Wages Expense is $300. Both amounts are posted to their respective ledgers, as is shown in the following example.
| Date | Account | Debit | Credit | |
| 6/1 | Rent Expense | x | 500 | |
| Cash | x | 500 | ||
| 6/5 | Cash | x | 600 | |
| Fees Earned | x | 600 | ||
| 6/8 | Wages Expense | x | 300 | |
| Cash | x | 300 | ||
| 6/20 | Cash | x | 700 | |
| Fees Earned | x | 700 | ||
| 6/29 | Cash | x | 800 | |
| Fees Earned | x | 800 | ||
| 6/29 | Cash | x | 800 | |
| Fees Earned | x | 800 | ||
| 7/1 | Rent Expense | x | 500 | |
| Cash | x | 500 | ||
| 7/2 | Cash | x | 900 | |
| Fees Earned | x | 900 | ||
| 7/7 | Wages Expense | x | 300 | |
| Cash | x | 300 | ||
LEDGERS (EXCEPT CASH)
| Date | Item | Debit | Credit | Debit | Credit |
| Date | Item | Debit | Credit | Debit | Credit |
| 6/5 | 600 | 600 | |||
| 6/20 | 700 | 1,300 | |||
| 6/29 | 800 | 2,100 | |||
| 7/2 | 900 | 3,000 | |||
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 500 | 500 | |||
| 7/1 | 500 | 1,000 | |||
| Date | Item | Debit | Credit | Debit | Credit |
| 6/8 | 300 | 300 | |||
| 7/1 | 300 | 600 | |||
Now there is an inconsistency. When the 7/1 Rent Expense debit is posted, the running balance becomes $1,000. According to procedure, that final balance would be copied to July’s income statement. That report would indicate that it cost the company $1,000 in rent during July, which is clearly not true. It only cost $500 for rent in July. The problem is that the $500 in June became a part of the July running total.
The same issue is true for Fees Earned. Only $900 was earned in July so far as of 7/2, but the running balance is showing $3,000. That is because the running total to date in July also includes the $2,100 that was earned in June.
The matching principle in accounting states that the revenue earned in a period must be reported in conjunction with the expenses incurred in that same period. The period we are now referring to is the month of July in this example. However, June’s revenues and expenses are still included in the balances in the ledgers. Closing entries on 6/30 here would have avoided this situation but were omitted, so the July balances erroneously contain amounts from June as well.
EXAMPLE
One month to the next WITH closing entries on 6/30
The following journal has similar transactions to the previous example PLUS it has the necessary closing entries in red for the three income statement accounts. It also shows how posting the closing entries impact the ledger account balances: revenue and expense balances are now zero on 6/30, and the Retained Earnings balance has increased from zero. Closing entries are shown in red in the following example. It is a good idea to enter the word “Closing” in the Item column in the ledgers to indicate that a closing entry has been posted.
| Date | Account | Debit | Credit | |
| 6/1 | Rent Expense | x | 500 | |
| Cash | x | 500 | ||
| 6/5 | Cash | x | 600 | |
| Fees Earned | x | 600 | ||
| 6/8 | Wages Expense | x | 300 | |
| Cash | x | 300 | ||
| 6/20 | Cash | x | 700 | |
| Fees Earned | x | 700 | ||
| 6/29 | Cash | x | 800 | |
| Fees Earned | x | 800 | ||
| 6/30 | Fees Earned | x | 2,100 | |
| Retained Earnings | x | 2,100 | ||
| 6/30 | Retained Earnings | x | 500 | |
| Rent Expense | x | 500 | ||
| 6/30 | Retained Earnings | x | 300 | |
| Wages Expense | x | 300 | ||
| 7/1 | Rent Expense | x | 500 | |
| Cash | x | 500 | ||
| 7/2 | Cash | x | 900 | |
| Fees Earned | x | 900 | ||
| 7/7 | Wages Expense | x | 300 | |
| Cash | x | 300 | ||
LEDGERS (EXCEPT CASH)
| Date | Item | Debit | Credit | Debit | Credit |
| 6/30 | Closing | 2,100 | 2,100 | ||
| 6/30 | Closing | 500 | 1,600 | ||
| 6/30 | Closing | 300 | 1,300 | ||
| Date | Item | Debit | Credit | Debit | Credit |
| 6/5 | 600 | 600 | |||
| 6/20 | 700 | 1,300 | |||
| 6/29 | 800 | 2,100 | |||
| 6/30 | Closing | Closing | 0 | ||
| 7/2 | 900 | 900 | |||
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 500 | 500 | |||
| 6/30 | Closing | 500 | 0 | ||
| 7/1 | 500 | 500 | |||
| Date | Item | Debit | Credit | Debit | Credit |
| 6/8 | 300 | 300 | |||
| 6/30 | Closing | 300 | 0 | ||
| 7/1 | 300 | 300 | |||
Notice when the first July transactions are posted to the income statement accounts, the amounts are added to previous balances of zero. When the first July transaction is recorded in these accounts, it becomes the beginning balance for the new accounting period.
By doing this, the income statement for June reports only June transactions, and the income statement for July reports only July transactions. The income statements for the two months can then easily be compared.
The following table summarizes information about the accounts you know so far:
| ACCOUNT TYPE | ACCOUNTS | TO INCREASE | TO DECREASE | NORMAL BALANCE | FINANCIAL STATEMENT | CLOSE OUT? |
| Asset | Cash | debit | credit | debit | Balance Sheet | NO |
| Stockholders’ Equity | Retained Earnings | credit | debit | credit | Balance Sheet | NO |
| Revenue | Fees Earned | credit | debit | credit | Income Statement | YES |
| Expense |
Wages Expense
Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense |
debit | credit | debit | Income Statement | YES |
1.4.5 Revenue Transactions on Account
EXAMPLE
6/1 Provide a service to a customer for $100 and receive cash.
| Date | Account | Debit | Credit | ||
| 6/1 | Cash | 100 | ▲ Cash is an asset account that is increasing . | ||
| Fees Earned | 100 | ▲ Fees Earned is a revenue account that is increasing . | |||
The 6/1 transaction is complete on that day. The company provided the service, and the customer paid cash in full for that service.
A second possibility involves the business sending a bill, or invoice, to the customer and typically giving the customer thirty days to pay. This is a revenue transaction on account .
The business records earnings and credits Fees Earned when it provides the service, regardless of when it receives the payment. When Fees Earned is credited because revenue is earned, there are now two possible debit accounts: Cash (paid on the spot), or Accounts Receivable (to be paid in the future).
Accounts Receivable is an asset account that keeps track of how much customers owe because a business sent invoices for goods or services to the customers rather than immediately receiving cash from them. This account is used as a substitute for a debit to Cash when a company provides services to customers and bills them on account rather than receiving cash right away.
When the customer pays the invoice and the business receives the cash payment, Cash is debited and Accounts Receivable is credited. The customer’s Accounts Receivable balance becomes zero now that they have paid in full.
The rules of debit and credit for Accounts Receivable are the same as they are for Cash since both are asset accounts.
| Debit ACCOUNTS RECEIVABLE when you invoice a customer | Accounts Receivable increases |
| Credit FEES EARNED when you provide a service to a customer | Fees Earned increases |
| Debit CASH when the customer pays the invoice | Cash increases |
| Credit ACCOUNTS RECEIVABLE when the customer pays | Accounts Receivable decreases |
The journal and the Accounts Receivable ledger below illustrate a revenue transaction on account for a business.
EXAMPLE
6/1 Provide a service to a customer for $200 on account and send the customer an invoice.
6/30 Receive payment on account from the customer for the service provided on 6/1.
| Date | Account | Debit | Credit | ||
| 6/1 | Accounts Receivable | x | 200 | ▲ Accounts Receivable is an asset account that is increasing . | |
| Fees Earned | x | 200 | ▲ Fees Earned is a revenue account that is increasing . | ||
| 6/30 | Cash | x | 200 | ▲ Cash is an asset account that is increasing . | |
| Accounts Receivable | x | 200 | ▼ Accounts Receivable is an asset account that is decreasing . | ||
| Accounts Receivable | |||||
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 200 | 200 | |||
| 6/30 | 200 | 0 |
In the 6/1 transaction, the company has received the product or service but has not paid for it yet. When the company does pay on 6/30, both parties in the 6/1 transaction have now received what they are due.
Stated another way, the company credited Accounts Payable when it received the product or service and later debited it when it paid the cash to the vendor. By 6/30, the two Accounts Payable entries negate one another (one credit and one debit to the same account for the same amount), resulting in a zero balance in that account on 6/30. If the Accounts Payable lines are crossed out in the journal since they wash out to zero, notice you are ultimately left with a debit to Supplies Expense and a credit to Cash. Both parties have received what they are due from the transaction by 6/30. The company received product or service and the vendor received cash.
The following table summarizes information about the accounts you know so far:
| ACCOUNT TYPE | ACCOUNTS | TO INCREASE | TO DECREASE | NORMAL BALANCE | FINANCIAL STATEMENT | CLOSE OUT? |
| Asset |
Cash
|
debit | credit | debit | Balance Sheet | NO |
| Liability | Accounts Payable | credit | debit | credit | Balance Sheet | NO |
| Stockholders’ Equity | Retained Earnings | credit | debit | credit | Balance Sheet | NO |
| Revenue | Fees Earned | credit | debit | credit | Income Statement | YES |
| Expense |
Wages Expense
Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense |
debit | credit | debit | Income Statement | YES |
All accounts are reported on one of three financial statements. The balances of two of the five types of accounts—revenue and expenses—are reported on the income statement at the end of each accounting period. The summary number on the income statement is net income, which is revenue minus expenses.