1. The Accounting Cycle Reporting Financial Results
Chapter 5
The Accounting Cycle Reporting Financial Results
Chapter 5: The Accounting Cycle—Reporting Financial Results

2. Learning Objective
To prepare an income statement, a statement of retained earnings, and a balance sheet.
Learning objective number 1 is to prepare an income statement, a statement of retained earnings, and a balance sheet.
LO1

3. This is the Adjusted Trial Balance for JJ’s.
Now, let’s prepare the financial statements for JJ’s Lawn Care Service for May.
Recall the Adjusted Trial Balance of JJ’s Lawn Care at May 31, 2007, that was completed at the end of Chapter Four. We will use that adjusted trial balance to begin preparing JJ’s financial statements. The first financial statement to prepare is the income statement.

4. Net income also appears on the Statement of Retained Earnings.
Here is JJ’s Income Statement for the month ended May 31, JJ’s has produced net income of four hundred dollars. Revenues total seven hundred fifty dollars. Expenses include gasoline expense and depreciation on the company’s equipment and truck. Once the income statement is completed, the statement of retained earnings can be prepared. Net income is an integral part of the statement of retained earnings.
Net income also appears on the Statement of Retained Earnings.

5. Statement of Retained Earnings
This statement summarizes the increases and decreases in Retained Earnings during the period.
Business Earnings
Dividends
Business Losses
Remember that net income increases retained earnings. Dividends and net losses decrease retained earnings for the period.

6. Now, let’s prepare the Balance Sheet.
JJ’s Lawn Care was started in May, so the beginning balance in retained earnings was zero. We add net income of four hundred dollars to the beginning balance of zero and subtract the dividends paid of two hundred dollars to arrive at the ending retained earnings balance of two hundred dollars. Retained earnings at May 31st will appear on the balance sheet of JJ’s Lawn Care.
Now, let’s prepare the Balance Sheet.

7. Note the two hundred dollar balance in Retained Earnings toward the bottom of the balance sheet. The contra accounts, Accumulated Depreciation dash Tools and Equipment and Accumulated Depreciation dash Truck, reduce the balance in the related asset accounts.

8. Learning Objective
To explain how the income statement and the statement of retained earnings relate to the balance sheet.
Learning objective number 2 is to explain how the income statement and the statement of retained earnings relate to the balance sheet.
LO2

9. Preparing Financial Statements
Part I
This is the income statement for JJ’s Lawn Care at the end of May.
Part II Net income impacts the retained earnings of the company. Part III
The ending balance of retained earnings appears on the balance sheet. It’s clear to see how all the financial statements articulate with each other.

10. To explain the concept of adequate disclosure.
Learning Objective
To explain the concept of adequate disclosure.
Learning objective number 3 is to explain the concept of adequate disclosure.
LO3

11. Drafting Notes to the Financial Statements
Examples of Items Disclosed
Lawsuits pending
Scheduled plant closings
Governmental investigations
Significant events occurring
after the balance sheet date
Specific customers that
account for a large portion of
revenue
Unusual transactions and
related party transactions
Notes to the
Financial Statements
In addition to the basic financial statements, accountants must prepare notes to the financial statements. The purpose of the notes is to explain certain items or transactions to the reader. The first note is usually a summary of significant accounting policies. For example, JJ’s Lawn Care would probably disclose that straight-line depreciation was used to determine depreciation expense. The notes also explain any unusual or infrequent items that may be of interest to the reader. Almost all major corporations have a note disclosure about pending litigation.

12. To explain the purposes of closing entries; prepare these entries.
Learning Objective
To explain the purposes of closing entries; prepare these entries.
Learning objective number 4 is to explain the purposes of closing entries; prepare these entries.
LO4

13. Closing the Temporary Accounts
The closing process gets the temporary accounts ready for the next accounting period.
Close Revenue accounts to Income Summary.
Close Expense accounts to Income Summary.
Close Income Summary account to Retained Earnings.
Close Dividends to Retained Earnings.
Once the financial statements have been prepared, the books are closed and it’s time to get ready for the next accounting period. Net income is earned over a period of time. At the start of a new period we want all revenue and expense accounts to have a zero balance so we can start recording income in this period. The closing of a company’s books is a four step process. Step one is to close all revenue accounts to a temporary account called Income Summary. Step two is to close all expense accounts to the Income Summary account. At this point, net income is isolated in the Income Summary. Step three is to then close Income Summary to Retained Earnings. Net income transfers from Income Summary to Retained Earnings and zeros out Income Summary. The Income Summary account never appears in the financial statements. The forth and final step is to close Dividends to Retained earnings. Net income is added to Retained Earnings and Dividends is subtracted from Retained Earnings. This updates Retained Earnings. Let’s prepare the closing entries for JJ’s Lawn Care.

14. Closing the Temporary Accounts
Let’s prepare the closing entries for JJ’s Lawn Care Service.
All of the accounts that must be closed are highlighted on the adjusted trial balance shown here—dividends, sales revenue, and the three expense accounts. When the closing process is complete, the Retained Earnings account will have the proper balance. Notice that there is no Retained Earnings account because the company was started in May. Let’s get started by closing Sales Revenue.

15. Closing Entries for Revenue Accounts
Since Sales Revenue has a credit balance, the closing entry requires a debit to the Sales Revenue account.
Part I Sales Revenue has a credit balance, so to close the account it must be debited for its current balance and credited to Income Summary. Part II The closing entry for revenues is to debit the revenue account, Sales Revenue, for its balance of seven hundred fifty dollars, and credit Income Summary for the same amount.
Let’s look at the ledger accounts to see what we have accomplished with this entry.

16. Closing Entries for Revenue Accounts
Notice that the balance in the Sales Revenue account is zero. We can now start accumulating revenue for the next accounting period, the month of June. Income Summary has a credit balance of seven hundred fifty dollars. The total revenues have been transferred to the credit side of Income Summary.
Now, let’s close the three expenses.

17. Closing Entries for Expense Accounts
Since expense accounts have a debit balance, the closing entry requires a credit to the expense accounts.
Part I
Expense accounts have a debit balance. The account is closed by a credit to the expense account and a debit to Income Summary. Part II A credit is made to each of the three expense accounts for their balances with a debit to Income Summary for the total of three hundred fifty dollars. Let’s look at the ledger accounts after making the second closing entry.

18. Closing Entries for Expense Accounts
Each expense account has a zero balance. We can begin to record expenses incurred during the month of June. Income Summary is debited for three hundred fifty dollars and has a credit balance of four hundred dollars. This four hundred dollars represents income for the month of May. Next, net income must be transferred from Income Summary to Retained Earnings.
Net Income

19. Closing the Income Summary Account
Since Income Summary has a $400 credit balance, the closing entry requires a debit to Income Summary.
Income Summary has a credit balance of four hundred dollars. To close this account, Income Summary must be debited for four hundred dollars and a credit must be made to Retained Earnings for that amount. Let’s look at the ledger account balances.

20. Closing the Income Summary Account
Income Summary now has a zero balance and net income appears on the credit side of Retained Earnings. Remember, credits to Retained Earnings increase the account balance. The final closing entry deals with Dividends.
The balance in Income Summary is now zero.

21. Closing the Dividends Account
Since the Dividends account has a debit balance, the closing entry requires a credit to the Dividends account.
The Dividends account has a debit balance. To close this account a credit is made to the Dividends account and debit to Retained earnings. Our final closing entry transfers the amount of dividends to the Retained Earnings account. Let’s look at the ledger account balances.

22. Closing the Dividends Account
The Dividends account has a zero balance after we make the closing entry. Retained Earnings now has a credit balance of two hundred dollars. This is the amount that appears on the balance sheet for JJ’s Lawn Care.

23. To prepare an after-closing trial balance.
Learning Objective
To prepare an after-closing trial balance.
Learning objective number 5 is to prepare an after-closing trial balance.
LO5

24. After all closing entries are made, JJ’s After-Closing Trial Balance looks like this.
After preparing all the closing entries, an after-closing trial balance is drafted.
The after-closing trial balance shows we have no revenues, expenses, or dividends. The proper balance of Retained Earnings appears on the after-closing trial balance. If there are any revenues, expenses, or dividends on the after-closing trial balance, an error has been made and the closing entries must be reviewed.

25. Learning Objective
To use financial statement information to evaluate profitability and liquidity.
Learning objective number 6 is to use financial statement information to evaluate profitability and liquidity.
LO6

26. Evaluating the Business
Did the business earn a profit or loss in the current period?
What is the business’s future potential for a profit?
Evaluating Profitability
Does the business have assets available to pay debts as they become due?
Evaluating Liquidity
Measures of profitability help users of financial information assess current profitability of a company and future potential for increased profits. Measures of liquidity help users assess the ability of the company to pay its debts when they fall due.

27. Evaluating the Business
Evaluating Profitability
Evaluating Liquidity
Net Income Percentage
Net Income Total Revenue =
Return on Equity
Net Income Avg. Stockholders’ Equity
Two common measures of profitability include the company’s net income percent, and its return on equity. When a ratio is calculated that has an income measure in the numerator and balance sheet measures in the denominator, an average must be used for the denominator. For the return on equity, add together the beginning balance in stockholders’ equity and the ending balance, then divide by two. Almost all companies calculate working capital and current ratio. Working capital is current assets less current liabilities. The current ratio is current assets divided by current liabilities.
Current Ratio
Current Assets Current Liabilities =
Working Capital
Current Assets – Current Liabilities

28. Learning Objective
To explain how interim financial statements are prepared in a business that closes its accounts only at year-end.
Learning objective number 7 is to explain how interim financial statements are prepared in a business that closes its accounts only at year-end.
LO7

29. Preparing Financial Statements Covering Different Periods of Time
Many companies prepare financial statements at various points throughout the year.
Annually
Quarterly
Interim Financial Statements
Monthly
Almost all companies prepare annual and interim financial statements. An annual financial statement covers one year of operations. The year does not have to be a calendar year. Interim financial statements are usually prepared monthly and quarterly. Most large corporations publish quarterly reports for their shareholders.
Jan. 1
Dec. 31

30. Ethics, Fraud, and Corporate Governance
A company should disclose any facts that an intelligent person would consider necessary for the statements to be interpreted properly.
Public companies are required to file annual reports with the Securities and Exchange Commission (SEC). The SEC requires that companies include a section labeled “Management Discussion and Analysis” (MD&A) because the financial statements and related notes may be inadequate for assessing the quantity and sustainability of a company’s earnings.
A company should disclose any facts that an intelligent person would consider necessary for the statements to be interpreted properly.
Public companies are required to file annual reports with the Securities and Exchange Commission (SEC). The SEC requires that companies include a section labeled “Management Discussion and Analysis” (MD&A) because the financial statements and related notes may be inadequate for assessing the quantity and sustainability of a company’s earnings.

31. To prepare a worksheet and explain its uses.
Learning Objective
To prepare a worksheet and explain its uses.
Learning objective number 8 is to prepare a worksheet and explain its uses.
LO8

32. The Worksheet
A worksheet illustrates in one place the relationships among the unadjusted trial balance, proposed adjusting entries, and financial statements. A worksheet is prepared at the end of the period, but before the adjusting entries are formally recorded in the accounting records.
On this slide we illustrated an abbreviated version of a worksheet. The dotted lines indicate that some accounts are not listed for illustrative purposes. To complete a worksheet follow these 5 steps.
Enter the ledger account balances ion the Trial Balance columns.
Enter the adjustments in the Adjustments columns.
Prepare an adjusted trial balance.
Extend the adjusted trial balance amounts into the appropriate financial statement columns.
Total the financial statement columns and determine and record net income or net loss.

33. End of Chapter 5
End of chapter 5.