Chapter Summary

The financial statements are prepared directly from the adjusted trial balance. The income statement is prepared by reporting all revenue earned during the period, less all expenses incurred in generating the related revenue. The statement of retained earnings reconciles the beginning Retained Earnings account balance with its ending balance. The retained earnings statement reports any increase to Retained Earnings resulting from net income earned for the period, as well as any decreases to Retained Earnings resulting from dividends declared or a net loss incurred for the period. The balance sheet reveals the company's financial position by reporting its economic resources (assets), and the claims against those resources (liabilities and owners' equity).

An income statement shows the revenue and expenses of a business for a specified accounting period. In the statement of retained earnings, the net income figure from the income statement is added to the beginning Retained Earnings balance, while dividends declared during the period are subtracted, in arriving at the ending Retained Earnings balance. The ending Retained Earnings balance is then reported in the balance sheet as a component of owners' equity.

Adequate disclosure is a generally accepted accounting principle, meaning that financial statements should include any information that an informed user needs to interpret the statements properly. The appropriate disclosures usually are contained in several pages of notes that accompany the statements.

Closing entries serve two basic purposes. The first is to return the balances of the temporary owners' equity accounts (revenue, expenses, and dividend accounts) to zero so that these accounts may be used to measure the activities of the next reporting period. The second purpose of closing entries is to update the balance of the Retained Earnings account. Four closing entries generally are needed: (1) close the revenue accounts to the Income Summary account, (2) close the expense accounts to the Income Summary account, (3) close the balance of the Income Summary account to the Retained Earnings account, and (4) close the Dividends account to the Retained Earnings account.

After the revenue and expense accounts have been closed, it is desirable to prepare an after-closing trial balance consisting solely of balance sheet accounts. The after-closing trial balance, or post-closing trial balance, gives assurance that the accounts of the general ledger are in balance and ready for recording transactions for the new accounting period.

Profitability is an increase in stockholders' equity resulting from revenue exceeding expenses, whereas solvency refers to a company's ability to meet its cash obligations as they come due. Solvency, at least in the short term, may be independent of profitability. Financial statements are useful tools for evaluating both profitability and solvency. Used separately, or in combination, the income statement and balance sheet help interested parties to measure a company's current financial performance, and to forecast its profit and cash flow potential. On page 000, we illustrated several measures of profitability and solvency computed using financial statement information. Throughout the remainder of this text we introduce and discuss many additional measures.

When a business closes its accounts only at year-end, the revenue, expense, and owner's drawing accounts have balances representing the activities of the year to date. To prepare an income statement for any period shorter than the year-to-date, we subtract from the current balance in the revenue or expense account the balance in the account as of the beginning of the desired period. This process of subtracting prior balances from the current balance is repeated for each revenue and expense account and for the owner's drawing account. No computations of this type are required for the balance sheet accounts, as a balance sheet is based on the account balances at the balance sheet date.

A worksheet is a "testing ground" on which the ledger accounts are adjusted, balanced, and arranged in the format of financial statements. A worksheet consists of a trial balance, the end-of-period adjusting entries, an adjusted trial balance, and columns showing the ledger accounts arranged as an income statement and as a balance sheet. The completed worksheet is used as the basis for preparing financial statements and for recording adjusting and closing entries in the formal accounting records.

In Chapter 5 we have completed our study of the accounting cycle for a service-type business. We have also completed our continued illustrated example of Overnight Auto Service. In Chapter 6 we will extend these concepts by focusing on some additional steps needed to account for inventories of goods sold by wholesale or retail merchandising businesses.