1.4: Financial Statements (2024)

Last updated
Save as PDF

Page ID: 43056

$ \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}}}$

$ \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash{#1}}} $

$ \newcommand{\id}{\mathrm{id}}$ $ \newcommand{\Span}{\mathrm{span}}$

( \newcommand{\kernel}{\mathrm{null}\,}\) $ \newcommand{\range}{\mathrm{range}\,}$

$ \newcommand{\RealPart}{\mathrm{Re}}$ $ \newcommand{\ImaginaryPart}{\mathrm{Im}}$

$ \newcommand{\Argument}{\mathrm{Arg}}$ $ \newcommand{\norm}[1]{\| #1 \|}$

$ \newcommand{\inner}[2]{\langle #1, #2 \rangle}$

$ \newcommand{\Span}{\mathrm{span}}$

$ \newcommand{\id}{\mathrm{id}}$

$ \newcommand{\Span}{\mathrm{span}}$

$ \newcommand{\kernel}{\mathrm{null}\,}$

$ \newcommand{\range}{\mathrm{range}\,}$

$ \newcommand{\RealPart}{\mathrm{Re}}$

$ \newcommand{\ImaginaryPart}{\mathrm{Im}}$

$ \newcommand{\Argument}{\mathrm{Arg}}$

$ \newcommand{\norm}[1]{\| #1 \|}$

$ \newcommand{\inner}[2]{\langle #1, #2 \rangle}$

$ \newcommand{\Span}{\mathrm{span}}$ $ \newcommand{\AA}{\unicode[.8,0]{x212B}}$

$ \newcommand{\vectorA}[1]{\vec{#1}} % arrow$

$ \newcommand{\vectorAt}[1]{\vec{\text{#1}}} % arrow$

$ \newcommand{\vectorB}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}}}$

$ \newcommand{\vectorC}[1]{\textbf{#1}}$

$ \newcommand{\vectorD}[1]{\overrightarrow{#1}}$

$ \newcommand{\vectorDt}[1]{\overrightarrow{\text{#1}}}$

$ \newcommand{\vectE}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash{\mathbf {#1}}}} $

1.4.1 Income Statement

The net income from a business’s operations for a period of time is so important to business people and investors that one financial statement—the income statement—is dedicated to showing what that amount is and how it was determined.

The income statement is a report that lists and summarizes revenue, expense, and net income information for a period of time, usually a month or a year. It is based on the following equation: Revenue - Expenses = Net income (or Net loss). Revenue is shown first; a list of expenses follows, and their total is subtracted from revenue. If the difference is positive, there is a profit, or net income. If the difference is negative, there is a net loss that is typically presented in parentheses as a negative number.

The income statement answers a business’s most important question: How much profit is it making? It is limited to a specific period of time (month or year) from beginning to end. The income statement relies on the matching principle in that it only reports revenue and expenses in a specified window of time. It does not include any revenue or expenses from before or after that block of time.

FORMATTING TIPS

Complete heading: Company Name, Name of Financial Statement, Date

Two Columns of numbers—left one for listing items to be sub-totaled; right one for results

Dollar signs go at the top number of a list of numbers to be calculated

Category headings for revenue and expenses only if there is more than one item listed in the category

Expenses listed in order of highest to lowest dollar amounts, except for Miscellaneous Expense, which is always last

The word “Expense” on expense account names

Single underline just above the result of a calculation (two of these)

Dollar sign on final net income number

Double underline below the final net income result

You have just learned about the income statement—the accounts it displays and its format. We will hold off for now on the other three financial statements— the retained earnings statement, the balance sheet, and the statement of cash flows —and learn about those later.

1.4.2 The Accounting Cycle

Accounting is practiced under a guideline called the time period assumption, which allows the ongoing activities of a business to be divided up into periods of a year, quarter, month, or other increment of time. The precise time period covered is included in the headings of the income statement, the retained earnings statement, and the statement of cash flows.

Therefore, the accounting process is cyclical. A cycle is a period of time in which a series of accounting activities are performed. As was just stated, the typical accounting cycle is a year, a month, or perhaps a quarter. Once the current cycle is completed, the same recording and reporting activities are then repeated in the next period of time of equal length.

In accounting, journalizing and posting transactions to the ledgers are done every day in the cycle. Financial statements are typically prepared only on the last day of the cycle. Once the financial statements are complete, the process continues on into the next accounting period, where again the financial statements are the goal of the recordkeeping process.

1.4.3 Temporary Accounts

The accounts on the income statement are called temporary accounts. They are used to record operational transactions for a specific period of time. Once the income statement is prepared to report the temporary account balances at the end of the period, these account balances are set back to zero by transferring them to another account. When the next accounting period begins, the beginning balances of the temporary accounts are zero, for a fresh start.

1.4.4 Closing Entries

The financial statements are the goal of all that is done in the accounting cycle. However, there are some steps that need to be taken once those reports are completed to set up the ledgers for the next cycle. These steps involve closing entries.

Closing entries are special journal entries made at the end of the accounting period (month or year) after the financial statements are prepared but before the first transaction in the next month is recorded in the journal. The purpose of closing entries is to set the balances of income statement accounts back to zero so you can start fresh and begin accumulating new balances for the next month. This process ensures that the balances on the second month’s income statement do not include amounts from transactions in the first month.

Profit at the end of the accounting period is transferred into a new account called Retained Earnings when the revenue and expense accounts are closed out. The Retained Earnings account is only used for closing entries.

Closing entries transfer the balances from the revenue and expense accounts into Retained Earnings in preparation for the new month. Retained Earnings is an account where profit is “stored.” Think of the retained earnings balance as “accumulated profit,” or all the net income that the business has ever generated since it began operations.

Assume a business’s accounting period is a month. For the first month in which the business operates, the beginning retained earnings balance is zero since there were no previous periods and therefore no previous profits. At the end of the first month, the retained earnings balance equals the net income for the month.

After the first month, when closing entries for the current month are journalized and posted, the additional net income for the next month is added to any net income already in Retained Earnings from previous months. Since Revenue - Expenses = Net Income, moving revenue and expense balances into Retained Earnings is the same as moving the net income.

RUNNING IN CIRCLES

A track star is practicing running a lap at a time around the track. He has a timekeeper with a stopwatch timing each lap. The timekeeper clicks “Start” and the runner takes off. He crosses the finish line in 50 seconds, the time elapsed as shown on the stopwatch when “Stop” was clicked.

The runner rests, drinks, and decides to try again to see if he can do better. The timekeeper clicks “Start” and the runner takes off, running even faster. He crosses the finish line in 95 seconds, the time elapsed as shown on thestopwatch when “Stop” was clicked.

What is wrong with this picture? Was he so much slower? He did not have a poor sprint; he had a poor timekeeper! This person did not reset the stopwatch to zero for the second run, so the 50 seconds from the first run was includedwith the 45 seconds from the second run. The runner can subtract the 50 from the 95, but who wants to do math on the track? That is what the reset button is for, and it enables the results of both runs to be easily compared.

Similarly, income statements include revenue and expense amounts for a period of time—a month or a year. After one month is reported, the ledger balances of these accounts must be reset to zero so that the next month’s income statement does not include amounts from the previous month. This is done by closing out the revenue and expense ledger balances and resetting their balances to zero.

The Retained Earnings account is not closed out; instead, revenue and expense accounts are closed out into it. The effects are that the credit balance in Retained Earnings increases each month by the month’s net income amount, and the balances of Fees Earned and all the expense accounts become zero.

Closing entries are entered in the same journal that was used for the general entries during the month. The first closing entry is journalized right after the last general entry. Closing entries must be posted to the ledgers to impact the revenue, expense, and Retained Earnings account balances.

As an example, assume that on 6/30 Fees Earned has a credit ledger balance of $2,100 and Rent Expense (the only expense account) has a debit ledger balance of $500. Net income is therefore $1,600. The closing entry process would be as follows:

Zero out the Fees Earned account (and any other revenue accounts, if there are others.)

Debit Fees Earned for its credit balance of $2,100 to close it out and bring its balance to zero.

Credit Retained Earnings for the same amount.

Date	Account	Debit	Credit
6/30	Fees Earned	2,100		▼ Fees Earned is a revenue account that is decreasing.
	Retained Earnings		2,100	▲ Retained Earnings is an equity account that is increasing.

Zero out the Rent Expense account (and any other expense accounts, if there are others.)

Credit Rent Expense for its debit balance of $500 to close it out and bring the balance to zero.

Debit Retained Earnings for the same amount.

Date	Account	Debit	Credit
6/30	Retained Earnings	500		▼ Retained Earnings is an equity account that is decreasing.
	Rent Expense		500	▼ Rent Expense is an expense account that is decreasing.

EXAMPLE

One month to the next WITHOUT closing entries on 6/30

The following journal shows five June transactions. (There would be more, but we will just use five for the example.) These are posted to the ledgers on the right. The running balance in Fees Earned as of 6/30 is a $2,100 credit. The running balances of Rent Expense and Wages Expense as of 6/30 are a $500 debit and a $300 debit, respectively. These three amounts would be reported on the income statement in arriving at a net income of $1,300 for June.

Then July begins and the journal also shows the first three July transactions. Once again Rent Expense on the first of the month is $500, the first Fees Earned transaction is $900, and Wages Expense is $300. Both amounts are posted to their respective ledgers, as is shown in the following example.

JOURNAL
Date	Account		Debit	Credit
6/1	Rent Expense	x	500
	Cash	x		500
6/5	Cash	x	600
	Fees Earned	x		600
6/8	Wages Expense	x	300
	Cash	x		300
6/20	Cash	x	700
	Fees Earned	x		700
6/29	Cash	x	800
	Fees Earned	x		800
6/29	Cash	x	800
	Fees Earned	x		800
7/1	Rent Expense	x	500
	Cash	x		500
7/2	Cash	x	900
	Fees Earned	x		900
7/7	Wages Expense	x	300
	Cash	x		300

LEDGERS (EXCEPT CASH)

Retained Earnings
Date	Item	Debit	Credit	Debit	Credit

Fees Earned
Date	Item	Debit	Credit	Debit	Credit
6/5			600		600
6/20			700		1,300
6/29			800		2,100
7/2			900		3,000

Rent Expense
Date	Item	Debit	Credit	Debit	Credit
6/1		500		500
7/1		500		1,000

Wages Expense
Date	Item	Debit	Credit	Debit	Credit
6/8		300		300
7/1		300		600

Now there is an inconsistency. When the 7/1 Rent Expense debit is posted, the running balance becomes $1,000. According to procedure, that final balance would be copied to July’s income statement. That report would indicate that it cost the company $1,000 in rent during July, which is clearly not true. It only cost $500 for rent in July. The problem is that the $500 in June became a part of the July running total.

The same issue is true for Fees Earned. Only $900 was earned in July so far as of 7/2, but the running balance is showing $3,000. That is because the running total to date in July also includes the $2,100 that was earned in June.

The matching principle in accounting states that the revenue earned in a period must be reported in conjunction with the expenses incurred in that same period. The period we are now referring to is the month of July in this example. However, June’s revenues and expenses are still included in the balances in the ledgers. Closing entries on 6/30 here would have avoided this situation but were omitted, so the July balances erroneously contain amounts from June as well.

EXAMPLE

One month to the next WITH closing entries on 6/30

The following journal has similar transactions to the previous example PLUS it has the necessary closing entries in red for the three income statement accounts. It also shows how posting the closing entries impact the ledger account balances: revenue and expense balances are now zero on 6/30, and the Retained Earnings balance has increased from zero. Closing entries are shown in red in the following example. It is a good idea to enter the word “Closing” in the Item column in the ledgers to indicate that a closing entry has been posted.

JOURNAL
Date	Account		Debit	Credit
6/1	Rent Expense	x	500
	Cash	x		500
6/5	Cash	x	600
	Fees Earned	x		600
6/8	Wages Expense	x	300
	Cash	x		300
6/20	Cash	x	700
	Fees Earned	x		700
6/29	Cash	x	800
	Fees Earned	x		800
6/30	Fees Earned	x	2,100
	Retained Earnings	x		2,100
6/30	Retained Earnings	x	500
	Rent Expense	x		500
6/30	Retained Earnings	x	300
	Wages Expense	x		300
7/1	Rent Expense	x	500
	Cash	x		500
7/2	Cash	x	900
	Fees Earned	x		900
7/7	Wages Expense	x	300
	Cash	x		300

LEDGERS (EXCEPT CASH)

Retained Earnings
Date	Item	Debit	Credit	Debit	Credit
6/30	Closing		2,100		2,100
6/30	Closing	500			1,600
6/30	Closing	300			1,300

Fees Earned
Date	Item	Debit	Credit	Debit	Credit
6/5			600		600
6/20			700		1,300
6/29			800		2,100
6/30	Closing	Closing			0
7/2			900		900

Rent Expense
Date	Item	Debit	Credit	Debit	Credit
6/1		500		500
6/30	Closing		500	0
7/1		500		500

Wages Expense
Date	Item	Debit	Credit	Debit	Credit
6/8		300		300
6/30	Closing		300	0
7/1		300		300

Notice when the first July transactions are posted to the income statement accounts, the amounts are added to previous balances of zero. When the first July transaction is recorded in these accounts, it becomes the beginning balance for the new accounting period.

By doing this, the income statement for June reports only June transactions, and the income statement for July reports only July transactions. The income statements for the two months can then easily be compared.

The following table summarizes information about the accounts you know so far:

ACCOUNTS SUMMARY TABLE
ACCOUNT TYPE	ACCOUNTS	TO INCREASE	TO DECREASE	NORMAL BALANCE	FINANCIAL STATEMENT	CLOSE OUT?
Asset	Cash	debit	credit	debit	Balance Sheet	NO
Stockholders’ Equity	Retained Earnings	credit	debit	credit	Balance Sheet	NO
Revenue	Fees Earned	credit	debit	credit	Income Statement	YES
Expense	Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense	debit	credit	debit	Income Statement	YES

1.4.5 Revenue Transactions on Account

EXAMPLE

6/1 Provide a service to a customer for $100 and receive cash.

Date	Account	Debit	Credit
6/1	Cash	100		▲ Cash is an asset account that is increasing.
	Fees Earned		100	▲ Fees Earned is a revenue account that is increasing.

The 6/1 transaction is complete on that day. The company provided the service, and the customer paid cash in full for that service.

A second possibility involves the business sending a bill, or invoice, to the customer and typically giving the customer thirty days to pay. This is a revenue transaction on account.

The business records earnings and credits Fees Earned when it provides the service, regardless of when it receives the payment. When Fees Earned is credited because revenue is earned, there are now two possible debit accounts: Cash (paid on the spot), or Accounts Receivable (to be paid in the future).

Accounts Receivable is an asset account that keeps track of how much customers owe because a business sent invoices for goods or services to the customers rather than immediately receiving cash from them. This account is used as a substitute for a debit to Cash when a company provides services to customers and bills them on account rather than receiving cash right away.

When the customer pays the invoice and the business receives the cash payment, Cash is debited and Accounts Receivable is credited. The customer’s Accounts Receivable balance becomes zero now that they have paid in full.

The rules of debit and credit for Accounts Receivable are the same as they are for Cash since both are asset accounts.

RULES OF DEBIT AND CREDIT

Debit ACCOUNTS RECEIVABLE when you invoice a customer	Accounts Receivable increases
Credit FEES EARNED when you provide a service to a customer	Fees Earned increases
Debit CASH when the customer pays the invoice	Cash increases
Credit ACCOUNTS RECEIVABLE when the customer pays	Accounts Receivable decreases

The journal and the Accounts Receivable ledger below illustrate a revenue transaction on account for a business.

EXAMPLE

6/1 Provide a service to a customer for $200 on account and send the customer an invoice.

6/30 Receive payment on account from the customer for the service provided on 6/1.

JOURNAL
Date	Account		Debit	Credit
6/1	Accounts Receivable	x	200		▲ Accounts Receivable is an asset account that is increasing.
	Fees Earned	x		200	▲ Fees Earned is a revenue account that is increasing.
6/30	Cash	x	200		▲ Cash is an asset account that is increasing.
	Accounts Receivable	x		200	▼ Accounts Receivable is an asset account that is decreasing.

LEDGER
Accounts Receivable
Date	Item	Debit	Credit	Debit	Credit
6/1			200		200
6/30		200			0

In the 6/1 transaction, the company has received the product or service but has not paid for it yet. When the company does pay on 6/30, both parties in the 6/1 transaction have now received what they are due.

Stated another way, the company credited Accounts Payable when it received the product or service and later debited it when it paid the cash to the vendor. By 6/30, the two Accounts Payable entries negate one another (one credit and one debit to the same account for the same amount), resulting in a zero balance in that account on 6/30. If the Accounts Payable lines are crossed out in the journal since they wash out to zero, notice you are ultimately left with a debit to Supplies Expense and a credit to Cash. Both parties have received what they are due from the transaction by 6/30. The company received product or service and the vendor received cash.

The following table summarizes information about the accounts you know so far:

ACCOUNTS SUMMARY TABLE
ACCOUNT TYPE	ACCOUNTS	TO INCREASE	TO DECREASE	NORMAL BALANCE	FINANCIAL STATEMENT	CLOSE OUT?
Asset	Cash Accounts Receivable	debit	credit	debit	Balance Sheet	NO
Liability	Accounts Payable	credit	debit	credit	Balance Sheet	NO
Stockholders’ Equity	Retained Earnings	credit	debit	credit	Balance Sheet	NO
Revenue	Fees Earned	credit	debit	credit	Income Statement	YES
Expense	Wages Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Advertising Expense Maintenance Expense Miscellaneous Expense	debit	credit	debit	Income Statement	YES

All accounts are reported on one of three financial statements. The balances of two of the five types of accounts—revenue and expenses—are reported on the income statement at the end of each accounting period. The summary number on the income statement is net income, which is revenue minus expenses.

FAQs

What is financial statement 1? ›

Financial statements are a set of documents that show your company's financial status at a specific point in time. They include key data on what your company owns and owes and how much money it has made and spent.

Learn More ›

What are all 4 financial statements? ›

The 4 types of financial statements

Balance sheets.
Income statements.
Cash flow statements.
Statements of shareholders' equity.

Nov 1, 2023

What is a strong financial statement? ›

Strong balance sheets will possess most of the following attributes: intelligent working capital, positive cash flow, a balanced capital structure, and income generating assets.

Find Out More ›

What are the most common errors in accounting? ›

What are the most common types of accounting errors & how do they occur?

Data entry errors. ...
Error of omission. ...
Error of commission. ...
Error of transposition. ...
Compensating error. ...
Error of duplication. ...
Error of principle. ...
Error of entry reversal.

More items...

Sep 3, 2020

Know More ›

What does a current ratio of 1.2 mean? ›

A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.

What is the common size statement of P&L? ›

Common Size Income Statement

The income statement (also referred to as the profit and loss (P&L) statement) provides an overview of flows of sales, expenses, and net income during the reporting period. The income statement equation is sales minus expenses and adjustments equals net income.

Learn More ›

How to interpret a common size balance sheet? ›

Common size balance sheet refers to percentage analysis of balance sheet items based on the common figure as each item is presented as the percentage which is easy to compare, like each asset is shown as a percentage of total assets and each liability is shown as a percentage of total liabilities and stakeholder equity ...

Discover More Details ›

What is the statement of financial position 1? ›

The statement of financial position

A statement of financial position is a financial statement that summarises a company's assets (what it owns), liabilities (what it owes), and equity (assets less liabilities) on a particular date – usually at the end of a financial month or financial year.

Get More Info Here ›

What is financial accounting 1? ›

Financial accounting is the process of recording, summarizing, and reporting a company's business transactions through financial statements. These statements are: (1) the income statement, (2) the balance sheet, (3) the cash flow statement, and (4) the statement of retained earnings.

Show Me More ›

What does 1 the term financial statement cover? ›

Financial statement covers trading, profit and loss account and balance sheet of the organisation.

What is the first financial statement? ›

Income statement: This is the first financial statement prepared. The income statement is prepared to look at a company's revenues and expenses over a certain period, such as a month, a quarter, or a year.

Explore More ›