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Sometimes the basic financial statements will have slightly different names, such as the Statement of Income instead of the Income Statement or the Statement of Changes in Owners Equity instead of the Statement of Retained Earnings. Accountants have flexibility when it comes to account titles and statement names; the important thing is that anyone can recognize what the account or statement is. The names and titles used in this book are both typical and descriptive.
The Income Statement lists the companys revenues and expenses and gives the difference between them. This difference is called net income. For the most part, revenues arise from selling goods or services. Expenses are the costs involved in operating the business.
Some examples of accounts that are classified as revenues and expenses are:
Sales Cost of goods sold
Interest income Salary expense
This is a very short list of the accounts that may be found on the Income Statement. Salary expense is also known as Wage expense or Payroll expense. The names are synonymous and are used interchangeably. It is also common not to use the full title Rent expense, but to call it simply Rent. This is done for most items where there is not a revenue and an expense with similar names. For instance, in the list given here, we cannot call Interest income simply Interest, since if we did, we would not be able to distinguish between the income and expense accounts. We have to use the full name Interest income in order not to confuse this account with Interest expense. When an account comes in two flavors (income and expense), we cannot shorten its name.
The Income Statement is concerned with how much
money the company brought in and how much it spent in order to bring that money in. The Income Statement covers a period of time. This period may be a month, a quarter, six months, a year, or any other period of time that the company feels is appropriate. Many companies prepare their financial statements on a monthly, quarterly, and annual basis. A proper heading for the Income Statement will have three lines: the name of the company, the name of the statement, and the period of time the statement covers. An example is:
Jeffry Haber Company Income Statement For the Year Ended December 31, 2002
If the statement is for the quarter ended December 31, 2002, there are two acceptable ways to state the period of time:
For the Quarter Ended December 31, 2002
For the Three Months Ended December 31, 2002
The revenues are listed in one section and the expenses in another. The order of the accounts within each section is usually determined by the size of the account balances, with the largest balances listed first. Each section is then totaled.
Financial statements have some weird rules. For one thing, it is typical to capitalize only the first letter of each account name (for example, Interest income). There are also some other peculiarities related to the appearance of the financial statements. The first number in each section gets a dollar sign ($), as does the last number in each section. The last number before a subtotal is underlined, and the final total is double-underlined. Each number in a section is indented after the
subheading. Figure 2-1 is an example of a typical Income Statement.
Even though such rules seem silly, and for the most part are not very important as long as it is obvious to the reader how to interpret the information, they do serve a purpose. The double underline tells the reader what the final total of the statement is. The single underline alerts the reader that a subtotal is coming on the next line. Indenting is an efficient way of depicting a grouping of like items.
Statement of Retained Earnings
The Statement of Retained Earnings takes the beginning balance of Retained earnings (which is the same as the ending
balance from the previous period), then adds net income and subtracts dividends paid to stockholders to arrive at the ending balance of Retained earnings. Dividends are distributions of money to shareholders. The Statement ofRetained Earnings is for a period oftime, and the period should be the same as that of the Income Statement. A dollar sign ($) is used for the first and last numbers, and the last number is double-underlined. Some people like to use a subtotal after net income, but this is not required.
A sample Statement of Retained Earnings is given in Figure
Note that the net income amount is the same as the net income shown on the Income Statement. The financial statements are related to one another, and at times, a figure from one statement is carried over to another statement.
The Balance Sheet lists the assets, liabilities, and equity accounts of the company. The Balance Sheet is prepared as on a particular day, and the accounts reflect the balances that existed at the close of business on that day. The Balance Sheet is
Jeffry Haber Company Statement of Retained Earnings For the Year Ended December 31, 2002
Beginning balance, January 1, 2002 $100,000
Add: Net income 85,500
Less: Dividends 35,500
Ending balance, December 31, 2002 $150,000
prepared on the last day that the Income Statement covers, so if the Income Statement is for the period ending December 31, 2002, the Balance Sheet would be as on December 31, 2002. You can state the date in a variety of formats. All of the following are acceptable:
As on December 31, 2002
December 31, 2002
On December 31, 2002
The following are typical accounts that are classified as assets, liabilities, and equity accounts. (These accounts are defined later on in the book. There is no reason why you need to know the definitions at this point, but if you are curious, you can turn to the glossary.)
Assets Liabilities Equity
Cash Accounts payable Common stock Accounts receivable Salaries payable Paid-in capital
Prepaid expenses Taxes payable Retained earnings
Inventory Unearned revenue
Land Notes payable
Building Bonds payable
Equipment Mortgage payable Vehicles
A good general rule of thumb is that any account that has the word receivable in its title will be an asset, and any account that has the word payable in its title will be a liability. Any account that has the word expense in its title is likely to be classified as an expense on the Income Statement, except for
the account Prepaid expenses, which is an asset. Any account with the word income or revenue in its title is classified as revenue on the Income Statement, except for the account Unearned revenue, which is a liability.
A sample Balance Sheet is shown in Figure 2-3.
On the Balance Sheet, the largest numbers in each section are not necessarily listed first. On the asset side of the Balance Sheet, the accounts are listed in order of their liquidity. Liquidity means nearness to cash. Cash is listed first, since cash is already cash. Each current asset is then listed in the order in which it is expected to become cash. Accounts receivable
comes second, since this company believes that its accounts receivable will be collected prior to the other assets being turned into cash.
On the liability side, the accounts are listed in the order in which they are expected to be satisfied (a fancy way of saying paid). The order of the equity accounts is defined by custom and tradition.
There is a special type of Balance Sheet called a classified Balance Sheet. In a classified Balance Sheet, the assets are separated into current and noncurrent (or long-term; the names noncurrent and long-term are synonymous in accounting) assets, and the liabilities are similarly classified as current and noncurrent. Included in the current section of the assets are those assets that are expected to be turned into cash or used up within the next year. Assets that are not expected to be turned into cash or used up within the next year are classified as noncurrent. Current liabilities are those liabilities that are expected to be paid during the next year. Noncurrent liabilities are those liabilities that are expected to be paid sometime after next year.
We have talked about three of the statements (the Income Statement, the Statement of Retained Earnings, and the Balance Sheet). Which statement do you prepare first? This is strictly a matter of preference; however, as a general rule, it makes the most sense to prepare the Income Statement first, then the Statement ofRetained Earnings, and then the Balance Sheet. (The Statement of Cash Flows will be dealt with in a later chapter and is not discussed here.)
Why does that order make sense? To complete the Balance Sheet, the ending amount of Retained earnings is needed. This number comes from the Statement of Retained Earnings, so it makes sense to prepare the Statement of Retained Earnings
prior to preparing the Balance Sheet. In order to complete the Statement of Retained Earnings, the amount of net income is required, and this comes from the Income Statement. Therefore, it makes sense to prepare the Income Statement prior to preparing the Statement of Retained Earnings.
Income Statement Net Income -
Statement of Retained Earnings Ending Balance of Retained Earnings
Thus, while the statements may be prepared in any order, if you prepare them in a different sequence, you will not be able to finish the statement you are working on without stopping and going to work on another statement. Eventually they will all be completed, but it will involve some jumping around.
This chapter covered the end result of financial accounting, the preparation of financial statements. Now we jump back to the beginning of the accounting process and look at how the information gets recorded in order to be available to be put on the financial statements.
The Accounting Process
We started with the end product of the accounting process, the financial statements. The steps involved in getting to the financial statements are:
These steps include some words we havent used before. They will be explained later in the chapter.
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