3.5 Preparing Financial Statements and Closing Entries

Understanding the Flow of Financial Information

Why is the income statement (IS) prepared first and the balance sheet (BS) last?

  • The income statement is prepared first because it reports net income or net loss (revenues minus expenses), which is needed to prepare the statement of retained earnings.
  • The balance sheet is prepared last because it needs the ending balance from the statement of retained earnings to complete the shareholders’ equity section of the statement.

Note that the statement of cash flow is not prepared from the adjusted trial balance. We will cover this later in the course.

© Course Author(s) and University of Waterloo

Preparing the Income Statement

An income statement can be prepared in two ways:

Single-Step
  • All revenues grouped together under the heading revenues, or revenues and gains.
  • All expenses grouped together under the heading expenses or expenses and losses.
  • One step:
    • Net Income (Net Loss) =
      Revenues – Expenses
Multi-Step
  • Shows subtotals to emphasize relationships between revenues and expenses:
    • Gross profit
    • Income from operations
    • Income before taxes
    • Net income
MOST COMMONLY USED

Single-Step Income Statement

© Course Author(s) and University of Waterloo

Multi-Step Income Statement

© Course Author(s) and University of Waterloo

Balance Sheet

On the balance sheet, assets and liabilities are classified as current or long-term to indicate their relative liquidity — how quickly an item can be converted to cash. Assets and liabilities are listed in the order of relative liquidity in their respective sections.

A classified balance sheet separates current assets from long-term assets and current liabilities from long-term liabilities.

  • Current assets: converted to cash, sold, or consumed within the next year or the operating cycle, whichever is longer.
  • Long-term assets: held for longer than one year or the operating cycle, whichever is longer.
  • Current liabilities: must be paid within one year or the operating cycle, whichever is longer.
  • Long-term liabilities: due date longer than one year or the operating cycle, whichever is longer.

There are two formats to present a balance sheet:

Report Format
  • Assets listed at the top.
  • Liabilities and shareholders’ equity below.
MOST COMMONLY USED
Account Format
  • Assets on the left.
  • Liabilities and shareholders’ equity on the right in the same way that a T-account appears – with assets (debit accounts) on the left and liabilities and shareholders’ equity (credit accounts) on the right.

Closing the Books!

Closing the books means to prepare the accounts for the next period’s transactions. The closing entries set the revenue, expense, and dividend balances back to zero at the end of the period. 

The idea is the same as setting the scoreboard back to zero after a game.

Temporary Accounts

The following accounts are “temporary accounts” that are closed off to zero at the end of the reporting period:

  • Expenses and revenues reported on the income statement
  • Dividend account which records dividends declared and issued in the year

Note: Temporary accounts such as expenses, revenues, and dividends show up on financial statements that show amounts FOR a period of time (income statement, statement of retained earnings).

Permanent Accounts

Assets, liabilities, and equity accounts that are reported on the balance sheet are never closed. Their balances carry forward from one reporting period to another. Their balances at the end of one period become the beginning balances of the next period. 

Note: these accounts show up on the balance sheet which shows the balances AT a point in time.

The Role of Closing Entries

Closing entries transfer the revenue, expense, and dividends balances to retained earnings. To record and post the closing journal entries at the end of each period:

  1. Debit each revenue account for the amount of its credit balance. Credit retained earnings for the sum of the revenues. Now the sum of the revenues is added to retained earnings and the revenue accounts have a zero balance.
  2. Credit each expense account for the amount of its debit balance. Debit retained earnings for the sum of the expenses. Now the sum of the expenses is deducted from retained earnings and the expense accounts have a zero balance.
  3. Credit the dividends account for the amount of its debit balance. Debit retained earnings for the amount of dividends. Now the dividends are deducted from retained earnings and dividends has a zero balance. (Remember that dividends are not expenses. Dividends never affect net income.)
  4. Post all of the journal entries to the ledger to close the accounts for the period.