Chapter 4
Financial
Statements
Preparation
It All Starts with the Trial Balance
4-1
How Do We Prepare Financial
Statements?
• The financial statements:
– Income statement:
• Reports revenues and expenses and calculates net
income or loss for the period.
– Statement of owner’s equity:
• Shows how capital changed during the period.
– Balance sheet:
• Reports assets, liabilities, and stockholders’ equity as
of the last day of the period.
It All Starts with the Trial Balance
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The financial
statements are
prepared from
the adjusted trial
balance.
It All Starts with the Trial Balance
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Relationships Among the Financial
Statements
• The financial statements relate to each
other.
– Net income or net loss from the income
statement flows to the statement of owner’s
equity.
– Ending Capital from the statement of owner’s
equity flows to the balance sheet.
It All Starts with the Trial Balance
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Exhibit 4-2 Smart Touch Learning
Financial Statements
Net income flows to
the statement of
owner’s equity.
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Exhibit 4-2 Smart Touch Learning
Financial Statements
The net income
from the income
statement flows to
the statement of
owner’s equity.
The ending
capital flows
to the balance
sheet.
It All Starts with the Trial Balance
4-6
Exhibit 4-2 Smart Touch Learning
Financial Statements
The ending
value of
Capital
from the
statement
of owner’s
equity
flows to the
balance
sheet.
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Classified Balance Sheet
• A classified balance sheet places each
asset and each liability into a specific
category.
– Assets are shown in order of liquidity.
– Liabilities are classified as current (due within
one year) or long term (due after one year).
• Liquidity measures how quickly and easily
an account can be converted to cash.
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Assets
Current assets
• Converted to cash or used within 12 months
or within the operating cycle.
Long-term assets
• Not converted to cash or used up within the
operating cycle or one year.
• Long-term investments
The operating cycle is the time
• Plant assets
span during which cash is paid
for goods and services, which
• Intangible assets
are then sold to customers,
from whom the business
collects cash.
It All Starts with the Trial Balance
4-9
Liabilities
• Current liabilities must be paid either with
cash or with goods and services within one
year or within the entity’s operating cycle.
– Examples:
• Accounts Payable
• Salaries Payable
• Unearned Revenue
• Long-term liabilities are all liabilities that
do not need to be paid within one year or
within the operating cycle.
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Owner’s Equity
• Owner’s equity represents the owner’s
claims to the assets of the business.
– Reflects the owner’s contributions to the
business, net income or net loss of the
business, and owner’s withdrawals.
– Represents the amount of assets left over after
the corporation has paid its liabilities.
It All Starts with the Trial Balance
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It All Starts with the Trial Balance
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How Could a Worksheet Help in
Preparing Financial Statements?
• The first four sections of the worksheet (see
Chapter 3) helped determine the adjusted
trial balance, from which we prepare financial
statements.
– Section 5—Income Statement
• Includes only revenue and expense accounts
– Section 6—Balance Sheet
• Includes asset, liability, and equity accounts except
revenues and expenses
– Section 7—Determine Net Income or Net Loss
• The balancing amount for the income statement and
balance sheet sections (will be the same amount)
It All Starts with the Trial Balance
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It All Starts with the Trial Balance
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What Is the Closing Process, and
How Do We Close the Accounts?
Temporary
Accounts
Permanent
Accounts
Revenues
Assets
Expenses
Liabilities
Owner’s
Withdrawals
Owner’s
Capital
It All Starts with the Trial Balance
The closing process
zeros out all
revenue and
expense accounts
in order to
measure each
period’s net income
separately from all
other periods.
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What Is the Closing Process, and
How Do We Close the Accounts?
• Closing entries
– Transfer revenues, expenses, and Owner,
Withdrawals balances to the Owner, Capital
account.
• Revenues and expenses may be
transferred first to an account titled
Income Summary.
– The Income Summary account summarizes the
net income (or net loss) for the period.
It All Starts with the Trial Balance
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What Is the Closing Process, and
How Do We Close the Accounts?
It All Starts with the Trial Balance
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Closing Temporary Accounts—Net
Income for the Period (Revenues)
It All Starts with the Trial Balance
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Closing Temporary Accounts—Net
Income for the Period (Expenses)
It All Starts with the Trial Balance
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Closing Temporary Accounts—Net
Income for the Period (Income
Summary)
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Closing Temporary Accounts—Net
Income for the Period
(Withdrawals)
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Closing Temporary Accounts—Net
Loss for the Period
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Closing Temporary Accounts—Net
Income for the Period
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Closing Temporary Accounts—Net
Income for the Period
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How Do We Prepare a Post-Closing
Trial Balance?
• The accounting cycle ends with a postclosing trial balance:
– A list of the accounts and their balances at the
end of the period, after journalizing and
posting the closing entries.
– Includes only permanent accounts.
It All Starts with the Trial Balance
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It All Starts with the Trial Balance
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What Is the Accounting Cycle?
It All Starts with the Trial Balance
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How Do We Use the Current Ratio
to Evaluate Business Performance?
• The current ratio measures a company’s
ability to pay its current liabilities with its
current assets.
• The formula is:
It All Starts with the Trial Balance
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What Are Reversing Entries?
• Special journal entries that ease the
burden of accounting for transactions in
a later period.
• The opposite of certain adjusting entries.
• Not required by GAAP.
• Used for convenience and to save time.
It All Starts with the Trial Balance
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Accounting for Accrued Expenses
To record accrued salaries of $1,200, Smart Touch
Learning recorded the following adjusting entry:
It All Starts with the Trial Balance
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Accounting Without a Reversing
Entry
To record the payment of total salaries of $2,400 on
January 15 without a reversing entry, Smart Touch
would:
It All Starts with the Trial Balance
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Accounting with a Reversing Entry
A reversing entry is a special journal entry that
eases the burden of accounting for transactions in
the next period.
It All Starts with the Trial Balance
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Accounting with a Reversing Entry
The credit balance in the Salaries Expense
account is eliminated on January 15, when
Smart Touch Learning pays the payroll and
debits Salaries Expense.
It All Starts with the Trial Balance
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