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Resources - Applied Finance / Chapter 8

Preparing financial statements

Preparing financial statements

Overview

In the previous chapters, we learned about trial balance, its uses, its preparation, and the process of passing adjusting entries to get adjusted trial balances. In this chapter, we will learn how the major accounting statements are prepared from the adjusted trial balances.

Scope:

  • Preparing Income Statement
  • Preparing Retained Earnings Statement
  • Preparing the Balance Sheet
ABC Co Pvt. Ltd.
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March 31, 2022

Adjusted Trial Balance
...DebitCredit
Cash 30,000 ...
Accounts Receivables 10,000 ...
Inventory 5,000 ...
Prepaid Expenses 5,000 ...
Gross Assets 15,000 ...
Accumulated Depreciation ... 5,000
Accounts Payable ... 8,000
Expenses Payable ... 4,000
Salary Payable ... 10,000
Common Stock ... 34,000
Retained Earnings ... 0
Dividends 1,000 ...
Sales ... 25,000
Salary Expense 10,000 ...
Depreciation Expense 5,000 ...
... 86,000 86,000

Preparing the income statement

All the revenue/income & expense account balances from the adjusted trial balance are used to prepare the income statement and get the net profit/loss. The income & expense accounts in the adjusted trial balance are highlighted below and have been used to prepare a simplified income statement below.

ABC Co Pvt. Ltd.
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March 31, 2022

Adjusted Trial Balance
...DebitCredit
Cash 30,000 ...
Accounts Receivables 10,000 ...
Inventory 5,000 ...
Prepaid Expenses 5,000 ...
Gross Assets 15,000 ...
Accumulated Depreciation ... 5,000
Accounts Payable ... 8,000
Expenses Payable ... 4,000
Salary Payable ... 10,000
Common Stock ... 34,000
Retained Earnings ... 0
Dividends 1,000 ...
Sales ... 25,000
Salary Expense 10,000 ...
Depreciation Expense 5,000 ...
... 86,000 86,000
ABC Co Pvt. Ltd.
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For the Quarter ending March 31,2022

Income Statement
Revenues......
Sales Revenue ... 25,000
Expenses ... ...
Salary Expense 10,000 ...
Depreciation Expense 5,000 ...
Other Expense 5,000 ...
Total Expense ... 20,000
Net Income ... 5,000

Preparing the Retained Earnings Statement

Next, we need to account for the profit made in the current year. Since the company is considered a separate entity from the owners, any profits made by the company appears on the liability side of the balance sheet statement.

A retained earnings statement is prepared to update the retained earnings account before transferring the updated balance of the same to the balance sheet. The current period profit is added to the previous retained earnings account balance and any payouts (made to the shareholder such as dividend payments) are subtracted to obtain the updated retained earnings balances.

ABC Co. Pvt. Ltd.'s retained earnings statement has been prepared below. Note that the Net profit comes from the income statement & dividends, and starting retained earnings from the adjusted trial balance.

ABC Co Pvt. Ltd.
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For the Quarter ending March 31,2022

Retained Earnings Statement
Retained Earnings as on January 31, 20220
Add: Net profit for the period 5,000
Less: Dividends 1,000
Retained Earnings as on March 31, 2022 4,000

Preparing the Balance Sheet

Next, we use the asset accounts, the liability accounts and the stockholder’s equity accounts to prepare the balance sheet. Understanding which accounts come under the income statement and which ones under the balance sheets can be confusing. Our following 2 chapters will introduce the major accounts and provide more clarity. Meanwhile, the asset & liability accounts in the original adjusted trial balance have been highlighted below.

ABC Co Pvt. Ltd.
Icon

March 31, 2022

Adjusted Trial Balance
...DebitCredit
Cash 30,000 ...
Accounts Receivables 10,000 ...
Inventory 5,000 ...
Prepaid Expenses 5,000 ...
Gross Assets 15,000 ...
Accumulated Depreciation ... 5,000
Accounts Payable ... 8,000
Expenses Payable ... 4,000
Salary Payable ... 10,000
Common Stock ... 34,000
Retained Earnings ... 0
Dividends 1,000 ...
Sales ... 25,000
Salary Expense 10,000 ...
Depreciation Expense 5,000 ...
... 86,000 86,000
ABC Co Pvt. Ltd.
Icon

As on March 31,2022

Balance Sheet
Assets ... ...
Cash... 30,000
Accounts Receivables... 10,000
Inventory... 5,000
Prepaid Expenses... 5,000
Gross Assets 15,000 ...
Less: Accumulated Depreciation5,000 ...
Net Assets ... 10,000
Total Assets ... 60,000
Liabilities and Sharehilder's Equity ... ...
Liabilities ... ...
Accounts Payable ... 8,000
Expenses Payable... 4,000
Salary Payable ... 10,000
Total Liabilities ... ...
Shareholder's Equity ... ...
Common Stock ... 34,000
Total Shareholder's Equity 5,000 38,000
Total Liabilities and Shareholder's Equity ... 60,000

Note that the updated retained earnings from the retained earnings statement has been used to prepare the balance sheet. Also, note that the balance sheet obeys the accounting relationship: Assets = Liabilities + Shareholder’s Equity.

Closing summary

To sum up, all the revenue/income & expense account balances from the adjusted trial balance are used to prepare the income statement. To account for the profit made in the current year, a retained earnings statement is prepared before transferring the updated balance of the retained earnings account to the balance sheet. Lastly, the asset accounts, the liability accounts & the stockholder’s equity accounts are used to prepare the balance sheet. In our subsequent chapters, we’ll talk about which accounts are covered under the income statement and wich under the balance sheet.