ACCOUNTING FUNDAMENTALS 6: Financial Statements & Completion of the Accounting Cycle

Learning Objectives

• Understand the flow of data from unadjusted trial balance to adjusted trial balance, income statement, and balance sheet.

• Accurately prepare a ten-column worksheet.

• Appreciate the usefulness of financial statements.

• Develop skills in preparing financial statements.

• Explain interrelations among financial statements.

• Understand why temporary accounts are closed at period end.

• Recognize the necessity of post-closing trial balances and reversing entries.

• Prepare and post adjusting, closing, and reversing entries.

• Complete a post-closing trial balance.

The Worksheet

• Definition: A multi-column summary tool for data transfer from the trial balance to financial statements.

• Purpose: Helps adjust and close accounts; simplifies the preparation of financial statements; aids in error detection.

• Structure: Not a financial statement; works as a summary device.

Preparing the Worksheet (Step 5)

1. Entering the Unadjusted Trial Balance

   • Input balances from the ledger before adjustments.

   • Total debits must equal credits.

   • Identify accounts that require adjustments.

2. Adjusting Entries

   • Input adjustments in designated columns.

   • Adjustments are labeled with letters for clarity.

   • Not journalized until worksheet completion.

3. Compute Adjusted Balances

   • Combine unadjusted trial balance and adjustments to get adjusted balances using cross-footing.

   • Simple conventions: add when same type and subtract when different.

4. Extending to Financial Statements

   • Assets, liabilities, and owner's equity go to balance sheet columns.

   • Income and expenses extend to income statement columns.

   • Ensure each account appears in one statement column only.

5. Profit or Loss Calculation

   • Difference between total revenues and expenses.

   • Profit/loss is recorded in both the income statement and balance sheet columns.

Financial Statements Overview

• Essence: Addresses stakeholders' inquiries about earnings and financial condition.

• Complete Set: Includes:

  1. Statement of financial position (balance sheet)

  2. Statement of comprehensive income

  3. Statement of changes in equity

  4. Statement of cash flows

  5. Important notes on accounting policies

• Components: Each statement presents different financial aspects for informed decision-making.

Preparing Financial Statements (Step 6)

• Prepare financial statements using worksheet information.

• Income Statement Example:

  • Revenues, expenses, and profits summarized.

  • Shows performance over a specific time.

Statements of Changes in Equity

• Summarizes equity changes,

• Increases from investments/profits, decreases from withdrawals/losses.

Balance Sheet Characteristics

• Shows financial position at a point in time,

• Must include assets, liabilities, and owner's equity.

• Users analyze liquidity and solvency.

• Format: Can be report format or account format.

Statement of Cash Flows

• Purpose: Displays cash movement.

• Activities:

  • Operating: Cash from services, payments to employees.

  • Investing: Cash transactions involving assets.

  • Financing: Cash transactions with owners and creditors.

Relationship Among the Financial Statements

• Interrelated:

  • Income statement influences statement of changes in equity.

  • Ending equity from changes in equity appears on the balance sheet.

  • Cash flow statement influences balances in the balance sheet.

Adjustments and Closing Process (Steps 7 & 8)

• Adjustments identified and recorded in the worksheet become journal entries post-worksheet.

• Temporary accounts (income, expenses, withdrawals) must be closed each period.

Post-Closing Trial Balance (Step 9)

• Verifies equality of debits/credits post-closing.

• Only balance sheet items remain since all income statement items are closed.

Reversing Entries (Step 10)

• Optional entries to simplify transaction recording in the new period.

• Generally applied to accrued expenses or revenues.

Important Tips:

• Not every adjustment should be reversed.

• Common categories: prepaid expenses, unearned revenues, accrued expenses.

Review Questions

1. True/False: Worksheet pulls together current balances for statements.

2. Fact: Financial statements come from adjusted trial balance.

3. Clarification: Adjusting entries need journalization post-preparation of the worksheet.

ACCOUNTING FUNDAMENTALS 6: Financial Statements & Completion of the Accounting Cycle

Learning Objectives

• Understand the flow of data: Comprehend how data transitions from the unadjusted trial balance through to the adjusted trial balance, income statement, and balance sheet, playing a critical role in the accounting cycle.

• Accurately prepare a ten-column worksheet: Master the organization and preparation of a multi-column worksheet to facilitate adjustments and the summarization of financial data.

• Appreciate the usefulness of financial statements: Recognize the significance of financial statements for various stakeholders, including management, investors, and creditors, as tools for decision-making and assessing performance.

• Develop skills in preparing financial statements: Gain hands-on experience in compiling essential financial statements that reflect the organization’s performance and financial position accurately.

• Explain interrelations among financial statements: Understand the connections between different financial statements, including how changes in one affect the others.

• Understand why temporary accounts are closed at period end: Learn the necessity of closing temporary accounts (such as revenues, expenses, and dividends) to prepare for the next accounting period and prevent the carryover of results.

• Recognize the necessity of post-closing trial balances and reversing entries: Understand the role of post-closing trial balances in ensuring the accuracy of financial information and the function of reversing entries in simplifying accounting processes in the new period.

• Prepare and post adjusting, closing, and reversing entries: Develop the capability to analyze and accurately record necessary adjustments and closures within the accounting cycle.

• Complete a post-closing trial balance: Validate that all debits and credits balance after closing entries are made, ensuring the integrity of the financial records.

The Worksheet

Definition:

A multi-column summary tool that facilitates the transition of data from the unadjusted trial balance to the financial statements, allowing for meticulous adjustments and financial oversight.

Purpose:

• Adjustment and Closure: Aids in closing accounts and making necessary adjustments.

• Simplification: Streamlines the financial statement preparation process and can assist in identifying errors quickly.

Structure:

• It serves as a summary device rather than a comprehensive financial statement and organizes information across several columns for clarity.

Preparing the Worksheet (Step 5)

Entering the Unadjusted Trial Balance:

• Inputting Balances: Record the balances from the ledger prior to adjustments, ensuring total debits equate to total credits for accuracy.

• Identifying Required Adjustments: Recognize and delineate accounts that necessitate adjustments based on reviews of operations and activities.

Adjusting Entries:

• Input Adjustments: Document all adjustments in designated columns with appropriate labeling for clarity, ensuring these entries are correctly accounted for.

• Journalization Timing: Adjustments remain unjournalized until the worksheet is complete to avoid discrepancies.

Compute Adjusted Balances:

• Combining Balances: Utilize cross-footing to ascertain adjusted balances by summing unadjusted trial balances with corresponding adjustments, adhering to simple mathematical rules based on account types.

• Simple Conventions: Use addition for similar account types and subtraction for differing account types to calculate final balances.

Extending to Financial Statements:

• Classification of Accounts: Accurately extend balances of assets, liabilities, owner's equity to the balance sheet columns and revenues, expenses to the income statement columns.

• Exclusive Appearance: Each account is ensured to be represented in only one financial statement column for clarity.

Profit or Loss Calculation:

• Determine the profit or loss from the total revenues subtracting total expenses, recording the outcome in both the income statement and balance sheet columns for comprehensive reporting.

Financial Statements Overview

Essence:

• Financial statements respond comprehensively to inquiries from stakeholders regarding the organization's earnings and financial condition, providing insights into operational effectiveness.

Complete Set:

The full set of financial statements includes:

• Statement of Financial Position (Balance Sheet): Presents a snapshot of assets, liabilities, and equity at a specific point in time.

• Statement of Comprehensive Income: Shows the overall performance and profitability over a designated period.

• Statement of Changes in Equity: Summarizes how equity components change within the reporting period, detailing increases and decreases.

• Statement of Cash Flows: Illustrates the inflow and outflow of cash across operating, investing, and financing activities.

• Important Notes on Accounting Policies: Articulates the strategies the organization adopts in accounting standards, informing stakeholders of the financial practices employed.

Components:

• Each financial statement provides distinct insights, critical for informed decision-making by stakeholders, ranging from executives to investors and creditors.

Preparing Financial Statements (Step 6)

• Utilize the information from the worksheet to methodically prepare financial statements tailored to reflect the organization's financial condition accurately.

Income Statement Example:

• Summarizes revenues, expenses, and profits to illustrate the performance over a designated time period, offering insights into profitability and operational efficiency.

Statements of Changes in Equity:

• Detail changes to equity, highlighting increases due to investments and profits, and decreases resulting from withdrawals and losses, essential for shareholder understanding.

Balance Sheet Characteristics:

• Provides a brief but thorough overview of the company’s financial standing at a particular moment, must always include assets, liabilities, and equity.

• Users analyze the organization’s liquidity (ability to meet short-term obligations) and solvency (ability to meet long-term commitments).

• Can be formatted in either report format or account format depending on preference.

Statement of Cash Flows:

• Displays the movement of cash through three primary activities:

  • Operating Activities: Reflecting cash from services provided and payments made to employees.

  • Investing Activities: Demonstrating cash transactions involving the acquisition and disposal of long-term assets.

  • Financing Activities: Illustrating cash transactions with owners (equity financing) and creditors (debt financing).

Relationship Among the Financial Statements

Interrelated Components:

• The income statement directly influences the statement of changes in equity by affecting retained earnings.

• The ending equity reported in the changes in equity statement is then represented on the balance sheet, ensuring consistency across reports.

• Changes recorded in the cash flow statement provide significant insights that influence the balances reported in the balance sheet.

Adjustments and Closing Process (Steps 7 & 8)

• All adjustments identified and recorded within the worksheet transition to journal entries post-worksheet completion, streamlining the adjustment process.

• Temporary Accounts: Income statement accounts (revenues, expenses) and drawings must be closed at period-end to prepare for the next period’s accounting cycle.

Post-Closing Trial Balance (Step 9)

• A crucial element in the accounting cycle, it verifies the equality of debits and credits after closing entries are made, ensuring accuracy in final records.

• Only balance sheet items remain as all temporary accounts are closed, providing a clearer picture of the organization’s financial health.

Reversing Entries (Step 10)

• Optional but beneficial entries designed to simplify transaction recording in the upcoming accounting period.

• Often applied to accrued expenses or revenues to help ease the recording process in the new period and ensure smoother transitions.

• Important Tips:

  • Not every adjustment should be reversed; careful consideration is necessary to determine which entries will be beneficial to reverse.

  • Common categories for reversing entries include prepaid expenses, unearned revenues, and accrued expenses, requiring thoughtful analysis to apply effectively.

Review Questions

• True/False: The worksheet effectively aggregates current balances to formulate financial statements.

• Fact: Financial statements are generated directly from the adjusted trial balance, underscoring its ultimate role in reporting.

• Clarification: Adjusting entries must be journalized following the preparation of the worksheet to formalize the adjustments in the accounting records.