3.5: Preparing Financial Statements

Preparing Financial Statements

After the adjusted trial balance, we will prepare the financial statements. The financial statements are how a business communicates or publishes its story. We will be focusing on three financial statements:

1. Income Statement: Calculates net income or loss of a company by showing revenues – expenses. If revenues are greater than expenses, you have net income. If revenues are less than expenses, you have net loss.
2. Statement of Retained Earnings: Calculates an ending balance in the retained earnings account using net income or loss calculated on the income statement. This statement takes the beginning balance in retained earnings + net income (or – net loss) – dividends to get the ending retained earnings balance. The ending retained earnings balance is reported on the balance sheet.
3. Balance Sheet: Proves the accounting equation of Assets = Liabilities + Equity and uses ending retained earnings calculated on the statement of retained earnings in equity.

This video will review the basic financial statements after the adjusted trial balance.

The balance sheet shown in the video is the simplified version we learned at the beginning of the course. If you look at the balance sheets produced by companies now, they are a little more detailed. A classified balance sheet adds groupings and subtotals to make the balance sheet easier for investors to read and analyze. The balance sheet can be done in report form where assets are first and liabilities and equity are below. Or in a side-by-side presentation. The classified balance sheet still proves the accounting equation but it separates assets and liabilities into subgroups:

• Current Assets: Can be converted to cash within a year or the operating cycle whichever is longer. Current assets include cash, accounts receivable, interest receivable, supplies, inventory, and other prepaid expenses.
• Long Term Investments: Investments that do not come due for more than a year are reported in this section. Long term investments would include notes receivable or investments in bonds or stocks.
• Plant Assets: Plant assets (also called Property, Plant, and Equipment or Fixed Assets) refer to property that is tangible (can be seen and touched) and is used in the business to generate revenue. Plant assets include depreciable assets and land used in the business. The plant asset is recorded with its accumulated depreciation (if any) subtracted below it to get the asset’s book value.
• Intangible Assets: Intangible assets are items that have a financial value but do not have a physical form. These would be things like trademarks, patents, and copyrights.
• Current Liabilities: Like current assets, these are liabilities that are due to be paid within a year or the operating cycle whichever is longer. Current liabilities include accounts payable, salaries payable, taxes payable, unearned revenue, etc.
• Long Term Liabilities: Liabilities due more than a year from now would be reported here. These would include notes payable, mortgage payable, bonds payable, etc.

The Equity section of a classified balance sheet does not change. Using the information for MicroTrain, the financial statements would be:

MicroTrain Company
Income Statement
For Year Ended December 31
Revenues:
Service Revenue	$ 36,500
Interest Revenue	600
Total Revenues		$ 37,100
Expenses:
Salaries Expense	18,360
Rent Expense	1,200
Utilities Expense	500
Insurance Expense	200
Supplies Expense	7,000
Depreciation Expense	750
Total Expenses		28,010
Net Income (37,100 – 28,010)		$ 9,090

The net income gets carried over to the statement of retained earnings. We will also use the retained earnings balance from the adjusted trial balance as the beginning balance. There are no dividends listed on the adjusted trial balance so MicroTrain did not pay dividends.

MicroTrain Company
Statement of Retained Earnings
For Year Ended December 31
Beginning Retained Earnings	$ 6,100	from the adjusted trial balance
Net Income	9,090	from the income statement
	$ 15,190
Dividends	– 0	No dividends paid this year
Ending Retained Earnings	$ 15,190	goes to the balance sheet

The calculated ending balance will be reported as the Retained Earnings amount on the balance sheet. We are doing the Classified Balance Sheet showing the subgroups for assets and liabilities in report form.

MicroTrain Company
Classified Balance Sheet
December 31
Assets
Current Assets
Cash	$ 10,000
Accounts Receivable	25,000
Interest Receivable	600
Supplies	1,500
Prepaid Insurance	2,200
Total Current Assets		$ 39,300
Plant Assets
Trucks	40,000
Less: Accum. Depreciation – Trucks	( 750)
Total Plant Assets		39,250
TOTAL ASSETS		$ 78,550
Liabilities and Equity
Current Liabilities
Accounts Payable	25,000
Unearned Revenue	3,000
Salaries Payable	360
Total Current Liabilities		28,360
Equity
Common Stock	35,000
Retained Earnings	15,190
Total Equity		50,190
TOTAL LIABILITIES AND EQUITY		$ 78,550

Notice how accumulated depreciation, a contra-account, reduces the asset account it is related to in the plant asset section. Remember, the balance sheet proves the accounting equation (ASSETS = LIABILITIES + EQUITY) and must always be in balance. Why do we need these groupings? It makes it easier for investors to quickly calculate ratios, for example, the current ratio.

The current ratio measures how much in assets the company has available now to pay liabilities due in the next year. The current ratio uses current assets and current liabilities:

Current Ratio =	Current Assets
	Current Liabilities

We can calculate MicroTrain’s current ratio as follows:

Current Assets =	39,300 =	1.39
Current Liabilities	28,360

The current ratio has been rounded to 2-decimal places to get a current ratio of 1.39 or 1.39 to 1. This means MicroTrain has approximately $1.39 in current assets available to pay every $1 of current liabilities. Investors like to see a ratio of between 1.5 and 2 so MicroTrain’s current ratio is a little low but still good since we have more assets than liabilities.