Reporting Financial ResultsThe Accounting Cycle
The Trial Balance
Articulation in Financial Statements
Closing the books at the end of the year
Chapter 5 brings together what you have learned in the previous chapters. In this chapter we review the overall accounting process and accounting cycle and learn to prepare financial statements.
Preparing Financial Statements
The ultimate purpose of the accounting process is to prepare financial statements. Everything else, all the routine journal entries & posting, corrections and adjusting entries finally culminate in an organized set of information that follows a set of rules known as GAAP.
GAAP gives us guidance as to what should be included in the financial statements, and how things should be reported and disclosed. The financial statements must include three specific reports, and notes that describe and disclose certain additional information.
The required elements of financial statements:
The Income Statement
The Balance Sheet
The Statement of Cash Flows
Notes to the Financial Statements
Optional (but recommended) financial statements:
The Statement of Retained Earnings
The Statement of Stockholders’ Equity
[Only one optional statement will be included in a set of financial statements]
Although GAAP gives us guidance, it also allows for a considerable amount of flexibility in presenting financial information. The Notes must accompany the other financial information, and includes disclosure about accounting principles, lawsuits, lease obligations, concentrations of receivables, and other information the FASB considers necessary for adequate disclosure of important information.
The Accounting Cycle
1) Capture and Record business transactions,
2) Classify transactions into appropriate Accounts,
3) Post transactions to their individual Ledger Accounts,
4) Summarize and Report the balances of Ledger Accounts in financial statements.
5) Post adjusting and closing journal entries.
6) Prepare a post-closing trial balance
The Trial Balance (TB)
The Trial Balance is a list of the balance in all accounts. The balances are separated into debit and credit columns, and the columns are totaled (footed) to be sure the financial system is in balance. Just because the system is in balance doesn't mean everything is correct, or that financial statements can be prepared. First we must make any necessary adjusting entries to bring our books into alignment with GAAP.
The Trial Balance Worksheet
The TB Worksheet provides accountants with a tool to organize the process of preparing adjusting entries and financial statements. A completed worksheet is presented on p. 192 of your text. It lets us organize the entire set of books on one or two pages of paper, so we can easily see all the balances and calculate the net profit for the year.
After completing the TB Worksheet, all that is left to
do is transfer the information from the Income Statement and Balance Sheet
columns to their respective financial statements, in the correct format.
The worksheet greatly simplifies the process of preparing financial statements.
It is also used by auditors when conducting an examination or review of
a company's books.
Articulation and Preparing the Financial Statements
The textbook shows how information flows back and forth between the Income Statement and Balance Sheet. This is called articulation. There are some very important articulations to watch when preparing financial statements. The financial statements should be prepared in the correct order, so the information articulates (flows) correctly.
The Income Statement should be prepared first. Net Income or Net Loss flows to the Statement of Retained Earnings (or Statement of Stockholders’ Equity). The ending balance of Retained Earnings flows to the Stockholder’s Equity section of the Balance Sheet.
How information articulates between financial statements
Closing the books at the end of the year
At the end of each year, the books are closed. What this means is that certain account balances are reset to zero, in preparation of a new year. Since the Income Statement reports information on a yearly basis, the income statement accounts are the ones that will be closed.
Have you ever seen an automobile odometer that had a trip odometer, with a button you can push to set the trip odometer to zero? When you want to measure your mileage you can press the button, reset the odometer to zero, then drive to your destination. The trip odometer will tell you how far you've driven. Then you can reset it again for the next trip.
Closing the accounts is very similar. We close the income
statement accounts so we can start counting again for a new year. These
accounts are all the revenue and expense accounts, and they make up the
total we call Net Income.
How to close an account
You close an account by looking at its balance, then entering a journal entry that is the exact opposite of its account balance. For instance, if an account has a $1000 debit balance, we would enter a $1000 credit to bring the account to zero.
||year end balance||
||year end closing entry||
Here we see the Insurance Expense ledger account. It has a debit balance of $1000. The closing entry credits the account, and brings the balance to zero. The account is now ready to begin entering transactions for the new year.
We will close all revenue and expense accounts. We will leave all balance sheet accounts alone, except for the dividend accounts, which closes directly to Retained Earnings.
The Income Summary Account
Income Summary is an account used for a single purpose to close the books at the end of the year. All income statement accounts are closed to the Income Summary account.
All revenues accounts are debited, and the Income Summary account is credited for the total of the debits. Then all expense accounts are credited, and the Income Summary account is debited for the total of all credits. At this point all revenue and expense accounts have a zero balance. The balance in Income Summary is equal to the Net Income or Net Loss for the year.
Finally the Income Summary account has to be closed. We make the entry necessary to bring that account to zero, and post the opposite side of the entry to the Retained Earnings account. The last entry is to close all dividend accounts to Retained Earnings. And we are done for the year.
We usually prepare a Post-Closing Trial Balance to make sure all revenue and expense accounts were closed out to zero, and none remain with a balance. We also check to see that all the account balances are correct, and match with the TB Worksheet and financial statements we have just prepared. If all is well, we are done for the year, and can begin entering transactions for the new year.
At this point I usually tell my students about life as an accountant. Since many companies close their books on December 31, all accountants have to stay and work late on New Year's Eve, and make sure all the adjusting and closing entries have been made so business can start up on January 1. And if you believe that story I have a bridge located right on the Mississippi river I’d like to sell you.
Actually, most accountants like to take New Year's Eve off, and they are usually sleeping in late on January 1 as well. In the real world, financial statements are prepared after the close of the year, often several months later. It is a time consuming process, and many things need to be done before financial statements can be prepared.
Inventories must be counted and valued. Missing information has to be found. Depreciation and various other accruals and deferrals must be calculated. Companies with many branches, or those that do business on a global scale, must gather up the information from all parts of their company, before financial statements can be prepared. So don't worry, you won't have to work late on New Year's Eve if you become an accountant. Now, tax season.... well, that's another story. And we'll save it for another day.
The textbook gives some good illustrations that show the basic mechanics of the closing process, and the final outcome. All that's left to do is analyze the financial information, and see what kind of year the company had.
Your text shows a few financial ratios on p. 189. Most chapters from now on will show some financial ratios, that relate to the specific chapter topics. Chapter 14 of the text recaps all the financial ratios presented in the text. you can see them all on pp 628-29.
These ratios are used by investors and financial analysts
on a daily basis. These are nothing new, and are not difficult to use.
All you have to do is carefully follow the instructions and formula. Financial
ratios can help you understand how your business is doing from year to
year, and can also help you compare one business to another.
Financial statements have these elements:
- A proper heading, consisting of
- Company Name
- Title of Statement
- Time Period or Date of Statement
- The body of the statement presenting financial information, in correct format.
- Totals and subtotals, specific to each financial statement.
- Articulation of balances and totals between statements.
- Notes disclosing additional information according to GAAP