5 Financial Statements and the Closing Process

From adjusted balances to statements

Financial statements are prepared from the adjusted trial balance at the end of an accounting period. Prepare them in sequence: the income statement determines net income or loss; that result helps determine ending equity; and ending equity appears on the balance sheet. Record closing entries only after the statements have been prepared.

Income statement

The income statement reports revenues and expenses over a period of time. Use the adjusted balances of revenue and expense accounts. Do not include assets, liabilities, owner contributions, or dividends as revenues or expenses.

Calculate the period’s result as:

If expenses exceed revenues, the result is a net loss.

For the year ended December 31, the example has service revenue of $\$120{,}000$, salaries expense of $\$60{,}000$, rent expense of $\$18{,}000$, supplies expense of $\$4{,}000$, and depreciation expense of $\$6{,}000$. Total expenses are $\$88{,}000$, resulting in net income of $\$32{,}000$.

Changes in equity

The statement of changes in equity explains how owners’ equity changed during the period. For a corporation, it may show changes in common stock and retained earnings. Owner contributions increase contributed capital, not revenue. The statement of retained earnings is a focused presentation of the retained-earnings portion of the broader statement of changes in equity.

The retained-earnings calculation is:

A net loss reduces retained earnings instead of increasing it. In the example for the year ended December 31, beginning common stock is $\$50{,}000$ and beginning retained earnings are $\$20{,}000$, for beginning total equity of $\$70{,}000$. Shares issued add $\$10{,}000$ to common stock and total equity. Net income adds $\$32{,}000$ to retained earnings, while dividends reduce it by $\$7{,}000$. Ending common stock is $\$60{,}000$, ending retained earnings are $\$45{,}000$, and ending total equity is $\$105{,}000$.

Balance sheet

The balance sheet reports assets, liabilities, and equity at a specific date. Its fundamental relationship is:

Use the ending equity balances from the statement of changes in equity. The balance sheet is a snapshot as of its stated date, not a summary of activity over the whole period.

At December 31, the example lists cash of $\$40{,}000$, accounts receivable of $\$20{,}000$, supplies of $\$3{,}000$, and equipment, net, of $\$70{,}000$, for total assets of $\$133{,}000$. Accounts payable are $\$28{,}000$, common stock is $\$60{,}000$, and retained earnings are $\$45{,}000$. Total liabilities and equity are also $\$133{,}000$, since $\$28{,}000 + \$105{,}000 = \$133{,}000$.

If the totals do not agree, investigate the account balances and statement calculations. A balanced equation alone does not guarantee that every account is classified or recorded correctly.

Closing entries and the next period

Closing entries reset temporary accounts for the next period and transfer the period’s net result and distributions to equity. Revenue, expense, and dividends accounts are temporary; asset, liability, and equity accounts are permanent and carry forward. A common method uses Income Summary as a temporary clearing account.

Using the example, record the closing entries in this order:

1. Close revenue accounts: Debit each revenue account for its balance and credit Income Summary for total revenues of $\$120{,}000$.

2. Close expense accounts: Debit Income Summary for total expenses of $\$88{,}000$ and credit each expense account for its balance.

3. Close net income: Debit Income Summary for $\$32{,}000$ and credit Retained Earnings for $\$32{,}000$. For a net loss, reverse the debit and credit.

4. Close dividends: Debit Retained Earnings and credit Dividends for $\$7{,}000$.

After posting, revenue, expense, Income Summary, and dividends accounts have zero balances. Permanent accounts remain open. The post-closing trial balance therefore contains permanent accounts, ready for the next accounting period. Closing entries follow statement preparation so the statements include the period’s revenues, expenses, and dividends before those temporary balances are reset.