340aclass6
September 10, 2002
For next time:
reading: Chapter 4
assignment: E4-4,15
Today:
Preparing financial statements and closing entries
(The income tax adjusting entry can be found in the Class 5 notes)
Step 7: Prepare the income statement and retained earnings statement
This is pretty easy once you have the adjusted trial balance completed. You just have to organize the accounts according to type (temporary vs. permanent)
First: Prepare the income statement - we will talk about the particular format in more detail in Chapter 4, but basically
(a)Revenue (temporary accounts with a credit balance) listed first and subtotalled
(b)Expense (temporary accounts with a debit balance) listed and subtotalled
(e)Net income (a) - (b)
Prepare income statement for in-class illustration.
Second: Prepare the retained earnings statement - we will talk about this statement in more detail in Chapter 4 also, but basically this is a listing of the activity in the retained earnings account (uses the adjusted trial balance and the income statement)
(a)Beginning of year retained earnings ( from adjusted trial balance)
(b)+(-) net income (loss) (from income statement, bottom line)
(c)- dividends (from adjusted trial balance)
(d)End of year retained earnings (this will go to the balance sheet)
Now we are almost ready to prepare the balance sheet - we will use a post-closing trial balance as the basis for the balance sheet. We only want permanent accounts to be listed on the post-closing trial balance so the next step is necessary to get rid of all of the temporary account balances.
Step 8: Journalize and post closing entries
These are the easiest journal entries you will ever have to do. There are 4 entries to do. They are the same 4 entries every time you close and they are the same 4 entries for just about every company that you will ever see.
Closing Entry #1:
This entry is used to zero out the revenue accounts. We look on the adjusted trial balance and find the revenue accounts. They should all have a credit balance. What would it take to make each account balance = 0? It would take a debit of the same amount, so our entry #1 is a list of debits for each revenue account for the entire balance amount. (Paris Bike revenue)
Sales Revenue2000
Interest Revenue 777
Rent Revenue 50
Income Summary2827
To close revenue accounts to Income Summary.
The Income Summary account is used only in this closing process. During the year it should NEVER have a balance.
Closing Entry #2:
Now we do the same thing with our Expenses. What would it take to make each expense account balance = 0? It would take a credit of the same amount, so our entry #2 is a list of credits for each expense account for the entire balance amount. (Paris Bike expenses). Again, we use the Income Summary to balance the journal entry.
Income Summary2668
Cost of goods sold1000
Rent expense 500
Interest expense1000
Depreciation expense 100
Income tax expense 68
To close expenses to income summary
Closing Entry #3:
Next, we get rid of the income summary account balance (post a t-account for the Income Summary account) - where have we seen the Income Summary account balance before? NET INCOME (this should ALWAYS be the case). What does it take to make the Income Summary account balance = 0?
That depends - if we had a good year, net income should be positive (revenues>expenses) and income summary should have a credit balance. In this case we would need a debit for the entire amount in our entry #3. If we had a bad year, the income summary would have a debit balance (because expenses>revenues) and would need a credit in this entry. (Paris Bike example)
Income Summary159
Retained earnings159
To close income summary to retained earnings. Remember that retained earnings is a permanent account that accumulates our earnings (net of money we have given back to the owners) from the very beginning of our business.
Closing Entry #4:
Finally, we have one more temporary account that is open -- dividends. The last closing entry closes dividends to retained earnings.
Retained EarningsXXX
DividendsXXX
To close dividends to retained earnings.
Step 9: Prepare the post-closing trial balance and the balance sheet.
This is just what's left after all of the temporary accounts have been wiped out. It better just be balance sheet accounts! Complete the Paris Bike Worksheet.
The balance sheet is taken right from the last column of this worksheet.
A=L+OE
(a) Assets listed on the left hand side, total is double underlined
(b)Liabilities listed on the right hand side first and subtotaled
(c) Equity accounts listed on the right hand side under the liabilities. The total of the liabilities and the equity accounts is double underlined. Does the left hand side = the right hand side?
Some other issues:
Reversing entries: Some companies use these to simply reverse the deferral and accrual type adjusting entries at the beginning of the next reporting period. Remember these entries were necessary only because of the difference in cash vs. accrual reporting. Not all companies do this - I won't test on them beyond your knowing that they are used to reverse deferral and accrual type adjusting entries.
Footnotes and MD&A (Management Discussion and Analysis) - we will talk about these very important parts of the financial statements throughout the course.
Control accounts, subsidiary ledgers, and special journals (Appendix 3B)
>This is pretty common sense - how would you manage the general journal if you were in charge of accounting for Famous Barr? Would you use one general journal for all of the daily transactions at every store? This would be asking for disaster!
It would be much easier to have a general journal for each store and then within each store, it would probably be easiest to keep track of the SALES to customers separate from PURCHASES of inventory and to keep CASH RECEIPTS separate from CASH PAYMENTS. This is similar to you keeping different notebooks for each of your classes.
Typically the company keeps a separate journal for each of the busiest types of accounts and then at the end of each day or at the end of each week or at the end of each month, there is one summary entry made to the general journal. All of the detail is kept in the separate journal.
Homework problem P3-4 gives you examples of working with t-accounts. It is an excellent problem to use to see how well you understand this material. You will see this type of problem again!
>in class example using accounts payable and inventory. Assume beginning A/P is $100,000 credit balance. Assume ending A/P balance is $140,000. If inventory purchases totalling $60,000 were all on credit, how much were total payments on A/P during the period?
Intro to chapter 4
What is the income statement?
- Profitability report, Earnings report, Net Income , Summary of Operations, Performance report, CHANGE in OWNERS' EQUITY
- used by whom? Investors, analysts, lenders to evaluate the probability for future income and cash flows
NOTE: one stream of accounting research deals with trying to explain the connection between a firm's earnings and its stock price (the market value of each share of stock). If earnings captured all of the economic changes, then we would expect to see stock prices move exactly in proportion to the reported earnings of a company. Is this what happens?
examples: coca cola, aol, twa, land's end (my great pictures that we didn't get to see)
>sometimes it happens and sometimes not
- Does the income statement reflect all of the company's economic changes? (what about things that happen that don't get reflected in the accounting records? hiring a new CEO, announcing a breakthrough in technology, developing a new market, good press, bad press reports, new competition)
> these things all impact the probability for future cash flows but usually do not get reflected in the income statement because there is not an associated accounting transaction. The income statement only reflects the ACCOUNTING INCOME for the period, that is, the difference between RECOGNIZED revenues and expenses.
> When are revenues recognized? This will be the whole point of chapter 7 but for now -- revenues are recognized when the earnings process is complete, an exchange of goods or services has occurred, and the collection of cash is reasonably assured .
>When are expenses recognized? The MATCHING principle answers this question - expenses should be matched against the revenues that they help generate
Recently, companies have gone to a lot of effort to report "more useful" information to investors. Companies might report:
"EBITDA" results which stands for "Earnings before interest expense, taxes expense, depreciation expense and amortization expense" or
"Pro-forma" results which follow the company's own definition of earnings.
It is easy to argue that the "more useful" information that companies report is not the most conservative information. For instance, by definition EBITDA will always be greater than GAAP net income, so the EBITDA bottom line always looks rosier than GAAP.
Next time we will talk about income statement formats - you will be looking up some earnings "press release" information.