4.5 Prepare Financial Statements Using the Adjusted Trial Balance

Financial Statements

Construction of financial statements

The adjusted trial balance is your starting point for building financial statements. It contains the final account balances after all adjusting entries have been posted, so every number you need is already there.

Three financial statements come directly from the adjusted trial balance:

• Income statement reports revenues, expenses, and the resulting net income or net loss over a specific period (a month, quarter, or year)
• Statement of retained earnings shows how retained earnings changed during that same period
• Balance sheet presents assets, liabilities, and equity at a specific point in time

To construct them, follow these steps:

1. Pull each account balance from the adjusted trial balance.
2. Classify every account as a revenue, expense, asset, liability, or equity account.
3. Place each balance into the correct statement using the formats below.

The order matters. You prepare the income statement first because you need net income for the statement of retained earnings. You prepare the statement of retained earnings second because you need the ending retained earnings figure for the balance sheet.

All three statements rely on accrual basis accounting, which recognizes revenues when earned and expenses when incurred, regardless of when cash actually changes hands.

Comparison of financial statement types

The income statement focuses on performance over a period. It answers the question: Did the company make a profit? Revenues earned minus expenses incurred gives you net income or net loss. For example, if a company earned $\$50{,}000$ in service revenue and incurred $\$35{,}000$ in expenses during January, its net income for the month is $\$15{,}000$.

The statement of retained earnings bridges the income statement and the balance sheet. It starts with the beginning retained earnings balance, adds net income (or subtracts a net loss), and subtracts any dividends declared. The result is the ending retained earnings balance that flows onto the balance sheet.

The balance sheet captures financial position at a single moment in time. It lists assets (cash, accounts receivable, equipment), liabilities (accounts payable, unearned revenue, notes payable), and equity (common stock, retained earnings). The totals must satisfy the accounting equation: Assets = Liabilities + Equity.

A key distinction to remember: the income statement and statement of retained earnings cover a period of time, while the balance sheet reports a point in time.

Use of 10-column worksheets

A 10-column worksheet is an optional tool that organizes all the data you need in one place before you draft formal financial statements. Its ten columns are arranged as five pairs of debit/credit columns:

1. Unadjusted trial balance
2. Adjustments
3. Adjusted trial balance
4. Income statement
5. Balance sheet

Here's how to complete it:

1. Enter unadjusted balances. Copy each account's debit or credit balance from the unadjusted trial balance into the first pair of columns.
2. Record adjustments. Enter each adjusting entry in the adjustments columns. Label them (a), (b), (c), etc., so you can trace each one.
3. Compute adjusted balances. Combine the unadjusted balance with the adjustment for each account and place the result in the adjusted trial balance columns. Verify that total debits equal total credits.
4. Extend to financial statement columns. Move each adjusted balance to the correct column pair: revenue and expense accounts go to the income statement columns; assets, liabilities, and equity accounts go to the balance sheet columns.
5. Balance the columns. Total the income statement columns. The difference between total credits (revenues) and total debits (expenses) is net income or net loss. Carry that figure to the balance sheet columns so both pairs balance.

The worksheet doesn't replace the formal statements, but it makes errors much easier to spot before you finalize anything.

Accounting Principles and Practices

Double-entry bookkeeping requires every transaction to affect at least two accounts, with total debits always equaling total credits. This is what keeps the accounting equation in balance throughout the entire cycle.

The materiality principle helps accountants decide what information is significant enough to include in financial statements. If omitting or misstating an item could influence a user's decision, it's material and must be reported. Minor amounts that wouldn't affect anyone's judgment can be handled in a simpler way (for instance, expensing a $\$5$ stapler rather than depreciating it as an asset).