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Preparing financial statements

The previous chapter presented adjustments that might be needed at the end of each accountingperiod. These adjustments were necessary to bring a company's books and records current inanticipation of calculating and reporting income and financial position. This chapter begins byillustrating how such adjustments would be used to actually prepare financial statements. Assume that

England Tours Company began operation early in 2!". #n the process of preparing its financialstatements for the year ending $ecember "%& 2!"& England determined that various adjusting entrieswere needed. These adjusting journal entries are shown on the following page. The numbers are allassumed. (ut& if it is unclear as to why any one of these entries might be needed& definitely reviewthe detailed discussion in the previous chapter.

The illustration shows %) England's trial balance before the adjusting entries& 2) the adjusting journalentries& ") the posting of the adjusting journal entries to the general ledger& and *) the adjusted trialbalance. #f England attempts to prepare its financial statements based only on the unadjusted trialbalance& the reported information would be incomplete and incorrect.

THE ADJUSTING PROCESS

+ost of the time& a company will prepare its trial balance& analy,e the trial balance for potentialadjustments& and develop a list of necessary adjusting entries. -nowing what to adjust is notnecessarily intuitive. #t usually reuires hands/on review by someone who is very knowledgeableabout the business. As a practical matter& a company should not allow anyone and everyone to haveaccess to the accounting system for purposes of entering year/end adjustments0 too many errors androgue entries will appear. #nstead& a company will usually have a defined process where proposed

entries are documented on a form 1sometimes called a journal voucher). These forms are submitted toa chief accountantcontroller for review and approval. The approved journal vouchers then serve assupporting documents to authori,e data entry into the accounting system.


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FINANCIAL STATEMENTS

The adjusted trial balance is ordinarily sufficient to facilitate preparation of financial statements. Taketime to trace the amounts from England's adjusted trial balance to the following statements.


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ACCOUNTING SOFTWARE

The financial statement preparation process is mostly mechanical& and easily automated. once theadjusting entries have been prepared and entered& every accounting software package will racethrough the steps of processing the data to produce the financial statements. As such& one might beinclined to discount the need to understand how to move amounts from an adjusted trial balance intoa set of financial statements. #n some respects that is true& just as it is true that one does not need toknow how to add and subtract if they own a calculator. of course& there is value in understandingaddition and subtraction even with a calculator. #n the same light& please consider that understandingthe flow of transactions into financial statements is essential.

WORKSHEET APPROACH

3ccasionally& one may desire to prepare financial statements that take into account necessary

adjustments& but without actually updating journals and ledgers. 4hy5 A manager may desire monthlyfinancial reports even though the business may not formally prepare and book adjusting entries everymonth. A worksheet approach can be used for this purpose. or& an auditor may use a worksheet toprepare financial statements that take into account recommended adjustments& before proposing thatthe actual journalledger be updated.

The following illustrates a typical worksheet. The data and adjustments correspond to informationpreviously presented for England. The first set of columns is the unadjusted trial balance. The ne6t setof columns reveal the end/of/period adjustments. The information in the first two sets of columns is


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combined to generate the adjusted trial balance columns. The last three pairs of columns are theappropriate financial statement e6tensions of amounts from the adjusted trial balance columns.

7or e6ample& Cash is an asset account with a debit balance& and is appropriately e6tended from theadjusted trial balance columns to the debit column of the balance sheet pair of columns. 8ikewise&9evenue is an income statement account with a credit balance0 notice that it is e6tended to theincome statement credit column. This e6tension of accounts should occur for every item in theadjusted trial balance. look at the worksheet& and consider the additional comments that follow.

After all adjusted trial balance amounts have been e6tended to the appropriate financial statementcolumns& the income statement columns are subtotaled. #f credits e6ceed debits& the company hasmore revenues than e6penses 1e.g.& :"2&; vs. :"&2 < :2&= net income)). or& an e6cess ofdebits over credits would represent a net loss. To complete the worksheet& the amount of net incomeor loss is entered in the lower portion of the income statement columns in a manner which causestotal debits to eual total credits. England Tours had a :2&= net income& and a debit is needed tobalance the income statement pair. An offsetting credit is entered in the lower portion of the retainedearnings columns. This credit represents income for the year that must be added to retained earningsto complete the preparation of a formal statement of retained earnings. 4ithin the retained earnings

columns& the subtotal indicates that ending retained earnings is :%&= 1noted by the e6cess of credits1:2&=) over debits 1:%&))0 this amount is debited in the retained earnings columns and credited

in the balance sheet columns& thereby bringing both sets of columns into balance.


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The companion website includes a linked animationthat presents the development of the worksheeton a step/by/step basis& and may further aid understanding of the worksheet's construction.

ADDITIONAL EXAMPLES

The illustration shown assumed England Tours was formed early in 2!". As such& there was no

beginning retained earnings balance. one may wonder how the worksheet would be influenced by abeginning retained earnings balance. The following is an illustration of England's 2!* worksheet&where the :%&= ending retained earnings from 2!" carries over to become the beginning balancefor 2!*. The other numbers for 2!* are all assumed.

2!* #llustration 4ith (eginning 9etained Earnings (alance

3ne may also be curious to see how a net loss situation would be handled in the worksheet. The ne6tillustration is for England's 2!> worksheet. #t is assumed that England lost :%& in 2!>. ?oticehow the e6penses of :"@&= e6ceed revenues of :";&= as evident in the income statementcolumns. The :%& balancing amount is reflected as a credit in the income statement and a debit tothe retained earnings column.
http://www.principlesofaccounting.com/ART/C4art/ws1.htmhttp://www.principlesofaccounting.com/ART/C4art/ws1.htm


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2!> #llustration 4ith ?et 8oss

The Accounting Cycle and closing process

9eflecting on the accounting processes thus far described reveals thefollowing typical steps

transactions are recorded in the journal

journal entries are posted to appropriate ledger accounts

a trial balance is constructed

adjusting entries are prepared and posted

an adjusted trial balance is prepared


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formal financial statements are produced 1perhaps with the assistance of a worksheet)

#t appears that the accounting cycle is completed // capturing transaction and event data andmoving it through an orderly process that results in the production of useful financial statements.#mportantly& one is left with substantial records that document each transaction 1the journal) and eachaccount's activity 1the ledger). #t is no wonder that the basic elements of this accounting methodologyhave endured for hundreds of years.

There remains one final process known as the closing process. Closing has two objectives

3(BECT#E % D$ATE 9ETA#?E$ EA9?#?FG

Closing is a mechanism to update the 9etained Earnings account in the ledger to eual the end/of/period balance. -eep in mind that the recording of revenues& e6penses& and dividends do notautomatically produce an updating debit or credit to 9etained Earnings. As such& the beginning/ of/period retained earnings amount remains in the ledger until the closing process updates the9etained Earnings account for the impact of the period's operations.

3(BECT#E 2 9EGET TE+39A9H ACC3D?TG

9evenues& e6penses& and dividends represent amounts for a period of time0 one must ,ero out theseaccounts at the end of each period 1as a result& revenue& e6pense& and dividend accounts are calledtemporary or nominal accounts). #n essence& by ,eroing out these accounts& they are reset tobegin the ne6t accounting period. #n contrast& asset& liability& and euity accounts are called realaccounts& as their balances are carried forward from period to period. 7or e6ample& one does notstart over each period reaccumulating assets like cash and so on0 their balances carry forward.

Closing involves a four/step process

This process results in all revenues and e6penses being corralled in Income Summary 1the net ofwhich represents the income or loss for the period). #n turn& the income or loss is then swept to9etained Earnings along with the dividends. 9ecall that beginning retained earnings& plus income& lessdividends& euals ending retained earnings0 likewise& the closing process updates the beginningretained earnings to move forward to the end/of/period balance.


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7ollowing are the closing entries for England Tours for 2!". Compare the accounts and amounts tothose that appeared in the 2!" adjusted trial balance

The effect of the above entries is to update the 9etained Earnings account and cause a ,ero balance tooccur in the temporary accounts. The #ncome Gummary account is also ,eroed out 1:"2&; 1cr.) & 2!*& when :>& was paid to employees. The entry on that date reuired a debit to Galariesayable 1for the :2& accrued at the end of 2!") and Galaries E6pense 1for :"& earned byemployees during 2!*).

The ne6t e6ample revisits the same facts using reversing entries. The adjusting entry in 2!" torecord :2& of accrued salaries is the same as above. Jowever& the first journal entry of 2!*simply reverses the adjusting entry. on the following payday& january %>& 2!>& the entire payment of:>& is recorded as e6pense.

#llustration 4ithout 9eversing Entries

#llustration 4ith 9eversing Entries


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The net impact with reversing entries still records the correct amount of salary e6pense for 2!*1:2& credit and :>& debit& produces the correct :"& net debit to Galaries E6pense). #t mayseem odd to credit an e6pense account on january %& because& by itself& it makes no sense. The creditonly makes sense when coupled with the subseuent debit on january %>. ?otice from the followingdiagram that both approaches produce the same final results


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(H C3+A9#?F TJE ACC3D?TG A?$ A+3D?TG& ?3T#CE TJAT TJE GA+E E?$ 9EGD8T #G 93$DCE$K

#n practice& reversing entries will simplify the accounting process. 7or e6ample& on the first paydayfollowing the reversing entry& a normal journal entry can be made to record the full amount ofsalaries paid as e6pense. This eliminates the need to give special consideration to the impact of anyprior adjusting entry. 9eversing entries would ordinarily be appropriate for those adjusting entries thatinvolve the recording of accrued revenues and e6penses0 specifically& those that involve future cashflows. #mportantly& whether reversing entries are used or not& the same result is achievedK

Classified Balance Sheets

The balance sheet reveals the assets& liabilities& and euity of a company. #n e6amining a balancesheet& always be mindful that all components listed in a balance sheet are not necessarily at fair value.Gome assets are carried at historical cost& and other assets are not reported at all 1such as the valueof a company's brand name& patents& and other internally developed resources). ?evertheless& carefule6amination of the balance sheet is essential to analysis of a company's overall financial condition. Tofacilitate proper analysis& accountants will often divide the balance sheet into categories orclassifications. The result is that important groups of accounts can be identified and subtotaled. Guch

balance sheets are called classified balance sheets.

The asset side of the balance sheet may be divided into as many as fiveseparate sections 1when applicable) Current assets0 long/term investments0 roperty& plant andeuipment0 #ntangible assets0 and other assets. The contents of each category are determined basedupon the following general rules

Current Assetsinclude cash and those assets that will be converted into cash or consumed ina relatively short period of time0 specifically& those assets that will be converted into cash orconsumed within one year or the operating cycle& whichever is longer. The operating cycle


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for a particular company is the period of time it takes to convert cash back into cash 1i.e.&purchase inventory& sell the inventory on account& and collect the receivable)0 this is usuallyless than one year. #n listing assets within the current section& the most liuid assets should belisted first 1i.e.& cash& short/term investments& and receivables). These are followed withinventories and prepaid e6penses.

ong-term Investments include land purchased for speculation&funds set aside for a plant e6pansion program& funds redeemablefrom insurance policies 1e.g.& cash surrender value of life insurance)&and investments in other entities.

Property! Plant! and E"uipmentincludes the land& buildings& and euipment productively inuse by the company.

Intangible Assets lack physical e6istence& and include items like purchased patents andcopyrights& goodwill 1the amount by which the fair value of a purchased business e6ceedsthat entity's identifiable net assets)& rights under a franchise agreement& and similar items.

#ther Assets is the section used to report asset accounts that just don't seem to fit

elsewhere& such as a special long/term receivable.

LIABILITIES

Bust as the asset side of the balance sheet may be divided& so too for the liability section. The liabilitysection is customarily divided into

Current iabilities are those obligations that will be liuidated within one year or theoperating cycle& whichever is longer. ?ormally& current liabilities are paid with current assets.

ong-term iabilitiesrelate to any obligation that is not current& and include bank loans&mortgage notes& certain deferred ta6es& and the like. #mportantly& some long/term notes maybe classified partially as a current liability and partially as a long/term liability. The portion

classified as current would be the principal amount to be repaid within the ne6t year 1oroperating cycle& if longer). Any amounts due after that period of time would be shown as along/term liability.

EQUITY

The appropriate financial statement presentation for euity depends on the nature of the businessorgani,ation for which it is prepared. (usinesses generally may be organi,ed as sole proprietorships&

partnerships or corporations. The illustrations in this book generally assume that the business isincorporated. Therefore& the euity section consists of

Capital Stoc$includes the amounts received from investors for the stock of the company. Theinvestors become the owners of the company& and that ownership interest is represented by

shares that can be transferred to others 1without further involvement by the company). #nactuality& the legalese of stock issues can become uite involved& and one is apt to encountere6panded capital stock related accounts 1such as preferred stock& common stock& paid/in/capital in e6cess of par& and so on). Those advanced issues are covered in subseuentchapters.

Retained Earnings should be familiar& representing the accumulated income less thedividends. #n essence& it is the profit that has been retained and plowed back 1reinvested) intoe6pansion of the business.


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OTHER ENTITY FORMS

There is nothing that reuires that a business activity be conducted through a corporation. A soleproprietorship is an enterprise owned by one person. #f the preceding classified balance sheetillustration was instead being prepared for a sole proprietorship& it would look the same e6cept thatthe euity section would consist of a single owner's capital account 1instead of capital stock andretained earnings). #f several persons are involved in a business that is not incorporated& it is likely apartnership. Again& the balance sheet would be unchanged e6cept for the euity section0 the euitysection would be divided into separate accounts for each partner 1representing each partner's residualinterest in the business). 9ecent years have seen a spate of legislation creating variants of theseentity forms 1limited liability companiesllC& limited liability partnershipsll& etc.)& but the overallbalance sheet structure is relatively unaffected. The terminology used to describe entity forms and

euity capital structure also varies considerably around the world& but there is very little substantivedifference in the underlying characteristics or the general appearance and content of the balancesheet.

NOTES TO THE FINANCIAL STATEMENTS

7inancial statements& by themselves& may not tell the whole story. +any important details about acompany cannot be described in money on the balance sheet. ?otes are used to describe accountingpolicies& major business events& pending lawsuits& and other facets of operation. The principle of full


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disclosuremeans that financial statements result in a fair presentation and that all facts which wouldinfluence investors' and creditors' judgments about the company are disclosed in the financialstatements or related notes. oftentimes& the notes will be more voluminous than the financialstatements themselves.

Business i"uidity and the #perating Cycle

#nvestors and creditors must be mindful of a company's liuidity. i"uidityis the ability of a firm tomeet its near/term obligations as they come due. #nadeuate liuidity can spell doom& even for acompany with bright long/term prospects and significant noncash assets.

WORKING CAPITAL

%or$ing capital is the difference between current assets and current liabilities. The illustration forClassy Company revealed current assets of :*>& and current liabilities of :%>&. Thus&working capital is :"& 1:*>& / :%>&). 7or obvious reasons& one would hope to find apositive amount of working capital. #f not& it may be an indication of financial stress.

3f course& care should be taken in drawing blanket conclusions about a firm's condition based solelyupon an e6amination of a single number. Could a firm have negative working capital& and still be ingreat shape5 HesK 7or instance& the firm may have a standby letter of credit at a bank that enables itto borrow money as needed to meet near/term obligations. or& some companies are in great shapeeven though they have negative working capital. Consider a fast food restaurant that has virtually noreceivables 1most sales are for cash) and a very low inventory 1bread and milk don't store well). Theonly current assets may consist of cash& nominal inventories& and some prepaid items. ?evertheless&they may have current liabilities in the form of significant accounts payable and short/term debt. Jowdo they survive5 The velocity of their cash flow may be very fast& as they hopefully turn large volumesof business at high profit margins. This enables the spinning of enough free cash flow to pay

obligations as they come due and have money left over to reinvest in growing other businesslocations. Go& working capital is important to monitor. Bust be careful about blanket conclusions basedon any single measure.

CURRENT RATIO

#s :%&& of working capital a lot5 +aybe& maybe not. :%&& is but a drop in the bucket to acorporate giant& and that amount of working capital could signal the end. on the other hand& a momand pop business could be doing grand with far less than :%&&. Go& it really depends on theratio of current assets to current liabilities. The current ratiois used to e6press the relative amountof working capital. #t is calculated by dividing current assets by current liabilities

Current Ratio & Current assets 'Current iabilities

Classy Company has a current ratio of "% 1:*>&:%>&). (e advised that ratios can bemanipulated. #f Classy wished to increase its current ratio& it could just pay off a little debt. 7orinstance& if it paid off :>& of accounts payable with cash& then current assets and current liabilitieswould each decline by :>&& and the revised current ratio would improve to *% 11:*>& /:>&)1:%>& / :>&)).

A company could possess a large amount of inventory that is not easily sold. Thus& the current ratio1which includes inventory) could signal no problem& all the while the company is struggling to pay itsbills. A tougher ratio is the "uic$ ratio. This ratio provides a more stringent test of debt/paying ability


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by dividing only a firm's uick assets 1cash& short/term investments& and accounts receivable) bycurrent liabilities

(uic$ Ratio & )Cash * Short-term Investments * AccountsReceivable+'Current iabilities

Classy Company has a uick ratio of %.>% 11:%& I :>& I :L>&):%>&).

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