Financial statements and closing entries

Financial statement preparation starts after all period-end adjustments have been posted. The adjusted account balances provide many of the statement line items. Other facts provide beginning equity balances, owner transactions, and the cash-flow and disclosure information that does not appear in ledger totals.

Statement preparation and closing are separate stages. First, the company reports the completed period. It then closes the temporary accounts and lists the permanent balances that carry into the next period.

What a complete set of financial statements reports

For a business entity, United States generally accepted accounting principles (US GAAP) requires a complete set of financial statements to report 5 types of information. The statements can use different titles, and some information can be combined, but the complete set reports all 5 types.

Notes accompany the statements. They explain accounting policies, estimates, line items, and other information needed to understand the reported amounts. ASC 205-10-45-1A identifies the 5 types of information in a complete set. ASC 235-10-50-1 addresses significant accounting-policy disclosures.

The income statement, statement of comprehensive income, statement of changes in equity, and statement of cash flows each cover a period. The balance sheet reports balances at the end of that period. Notes can explain both period activity and amounts reported at the end of the period.

In this chapter, you will use an adjusted trial balance to prepare the income statement, statement of comprehensive income, statement of changes in equity, and balance sheet. In Chapter 10, you will prepare the statement of cash flows. Later chapters use notes when a line item needs policy, estimate, or other disclosure information.

How adjusted balances become statements

An adjusted trial balance lists the ledger balances after period-end adjustments have been posted. Statement totals such as net income and ending equity are not ledger accounts. They must be calculated from the adjusted balances and the other facts for the reporting period.

Four relationships determine the order of the statement calculations:

• Revenue and gains minus expenses and losses equals net income.
• Net income plus other comprehensive income equals comprehensive income.
• For each equity component, the beginning balance plus increases minus decreases equals the ending balance.
• Assets equal liabilities plus ending equity at the reporting date.

These relationships apply to any business entity. The sections below first explain each statement and then apply the relationship to Beacon Design.

Apply the adjusted-balance logic to Beacon

Beacon Design is a design-services corporation in its first reporting year, ending December 31, 2026. After Beacon posts the adjustments from Chapter 2, its adjusted trial balance includes accounts that did not appear in the unadjusted trial balance. These accounts include Wages Payable, Insurance Expense, and Accumulated Depreciation.

Unearned revenue is a liability for payment received before a company provides the promised goods or services. Beacon calls this liability account Unearned Service Revenue.

Beacon's Retained Earnings account has a zero balance, so that account is omitted from this trial balance. Current-year income has not yet been transferred into it. When Retained Earnings appears on an adjusted trial balance, its balance still excludes the current period's closing transfers. The equity rollforward starts with that balance and adds the current period's changes to calculate ending retained earnings.

Net income, ending retained earnings, total equity, and statement totals do not appear as accounts on the adjusted trial balance. These amounts must be calculated from the listed balances and Beacon's other year-specific facts.

The income statement

The income statement reports the revenue, gains, expenses, and losses included in net income for a stated period. Gains and losses arise from nonowner activities outside the company's main revenue-producing work, such as selling equipment.

Net income equals revenue and gains minus expenses and losses for a stated period. It excludes items reported in OCI. Beacon has no gains or losses, so its income statement uses only the year's revenue and expenses.

Parentheses identify amounts subtracted in the financial statements. Workbook formulas use minus signs for subtraction.

Subtracting $116,400 of expenses from $120,900 of revenue gives Beacon $4,500 of net income. The statement of comprehensive income begins with that amount.

The statement of comprehensive income

Some gains and losses are excluded from net income and reported in other comprehensive income (OCI). Examples include certain unrealized gains and losses on debt securities, foreign-currency translation adjustments, pension adjustments, and the effective portion of some cash-flow hedges.

Comprehensive income is net income plus OCI. A company can present both in one continuous statement or in 2 separate statements. Under the 2-statement approach, the statement of comprehensive income follows the income statement and starts with net income.

Beacon has no OCI. Its comprehensive income therefore equals its $4,500 net income. A separate statement makes that relationship visible:

ASC 220-10-45-1A and 45-1B govern this presentation. In Chapter 6, you will examine the income statement, OCI, comprehensive income, and accumulated OCI in depth.

The statement of changes in equity

The statement of changes in equity reports how each component of equity changed during a stated period. It reconciles each component from its beginning balance to its ending balance.

This reconciliation is an equity rollforward. A corporation might report common stock, additional paid-in capital, retained earnings, accumulated other comprehensive income, and treasury stock. Other entities use components that fit their ownership structure. For a corporation, the report is also called a statement of stockholders' equity.

Retained earnings is an accumulated equity balance. Its main changes are net income, which increases it, and net losses and dividends, which reduce it. Dividends are distributions to shareholders, not expenses, so they do not reduce net income.

Ending retained earnings equals beginning retained earnings plus net income, or minus a net loss, less dividends for the period. Direct adjustments to retained earnings, when applicable, also enter the rollforward. The capitalized name Retained Earnings identifies the ledger account.

Beacon's equity has only 2 components: Common Stock and Retained Earnings. It begins the year with zero retained earnings and declares no dividends. Its statement shows the $40,000 share issue separately from the $4,500 of net income:

Retained earnings ends at $4,500: the zero beginning balance plus $4,500 of net income and no dividends. The same $4,500 appears as net income on the income statement and in the statement of changes in equity.

A statement of retained earnings is a narrower statement that reconciles only Retained Earnings. The statement of changes in equity also reports changes in other equity accounts, such as Common Stock.

The balance sheet

The balance sheet reports an entity's assets, liabilities, and equity at a stated date. Beacon reports these balances as of December 31, 2026.

This unclassified balance sheet groups assets, liabilities, and equity without separating current and noncurrent items. In Chapter 9, you will classify those items as current or noncurrent. Equipment's carrying amount is its reported amount after accumulated depreciation is deducted from cost.

Both sides total $77,500. The balance sheet reports Beacon's $4,500 ending Retained Earnings balance. That amount equals the zero beginning balance plus $4,500 of current-year net income and no current-year dividends. In later years, beginning retained earnings will already contain the accumulated effects of prior-period income, losses, and dividends. Current-period revenue and expense accounts do not appear as separate balance-sheet lines.

The statement of cash flows

The statement of cash flows shows how the total of cash, cash equivalents, restricted cash, and restricted cash equivalents changed during a period. It reconciles the beginning total to the ending total through operating, investing, and financing cash flows.

An adjusted trial balance gives ending account balances, but a cash-flow statement must explain the changes between beginning and ending balances. Comparative balance sheets and transaction details provide those changes.

In Chapter 10, you will prepare the complete statement, including the direct and indirect operating sections, noncash transactions, and the reconciliation of beginning cash to ending cash. ASC 230 contains the governing requirements. ASC 230-10-45-4 addresses the total that includes restricted cash and restricted cash equivalents.

The notes to the financial statements

The notes to the financial statements are an integral part of the statements. They explain significant accounting policies, estimates, commitments, uncertainties, and details that cannot fit on the statement faces. For example, a note may disaggregate a line item, explain how an amount was measured, or describe a material event that is not recognized in statement totals.

The disclosures required for a company depend on its transactions, policies, estimates, and governing guidance. In Chapter 5, you will locate amounts in the statements, notes, and accounting-policy footnotes of an actual filing. Later chapters return to the relevant notes for each statement line item.

How the statements connect

Financial statement articulation means that amounts reported in one statement connect to related amounts in the others. Net income enters comprehensive income. Comprehensive income enters the equity rollforward, and ending equity appears on the balance sheet. The statement of cash flows reconciles its ending cash total to the cash reported on the balance sheet.

The 5 statements form 2 connected paths. The performance path carries net income through comprehensive income and the equity rollforward to the balance sheet. The cash path connects ending cash on the statement of cash flows to cash on the balance sheet.

An omitted adjustment can affect several statements at once. The table shows the effect of omitting Beacon's $2,700 wage accrual. The difference column subtracts the correct amount from the amount reported after the omission. Parentheses indicate a negative difference.

Closing the temporary accounts

Revenue, gain, expense, loss, and dividend accounts measure activity for one period. Gain and loss accounts here contain amounts included in net income. Together, these accounts are temporary accounts and must begin the next period at zero. Permanent accounts hold balances for continuing assets, liabilities, and equity. Their ending balances carry forward because the resources, obligations, and owners' claims that exist on December 31 still exist on January 1.

A closing entry brings a temporary account to zero and transfers its effect to a permanent equity account. Retained Earnings is permanent even though closing changes its balance. Closing records the transfer after the statements have been prepared; it does not create the income or distributions already reported.

Beacon uses direct closing, which transfers each temporary-account balance directly to Retained Earnings.

First, close Service Revenue directly to Retained Earnings. Service Revenue has a $120,900 credit balance, so the closing entry debits it for $120,900. The credit to Retained Earnings transfers the revenue's effect on equity:

Second, close the expenses. Each expense has a debit balance, so each receives a credit equal to that balance. The $116,400 debit to Retained Earnings transfers the expenses' combined effect on equity:

Service Revenue returns to zero, while Retained Earnings receives the difference between revenue and expenses. The T-accounts show both closing entries and the resulting balances:

After the revenue and expense entries, closing has increased Beacon's retained earnings by its $4,500 net income. Beacon's ending retained earnings happens to equal net income because this is its first year, beginning retained earnings is zero, and it declared no dividends. In a later year, ending retained earnings will also include the beginning balance and any dividends or direct adjustments.

If a company has a Dividends balance, a separate entry credits Dividends and debits Retained Earnings. For example, a $3,000 debit balance in Dividends closes with this entry:

Closing transfers temporary-account balances into the permanent equity account; it does not change the income or equity already reported.

The post-closing trial balance

A post-closing trial balance lists the permanent ledger balances after the closing entries have been posted. It establishes the balances that carry into the next accounting period. Accountants also use it to confirm that temporary accounts have been closed and that the ledger remains in balance.

The selected accounts below show that closing leaves permanent asset and liability balances in place, brings temporary revenue and expense balances to zero, and transfers their net effect to Retained Earnings.

Every account left is permanent. The $80,500 debit and credit column totals are not balance-sheet totals. The trial balance lists Equipment at its $18,000 cost and Accumulated Depreciation as a separate $3,000 credit. The balance sheet nets those amounts to report a $15,000 carrying amount within its $77,500 of total assets.

Closing preserves the accounting history

A zero ending balance can look as if closing deleted the period's activity. Closing instead adds dated entries to the journal and ledger. Beacon can still trace the completed year's revenue and expenses even though those accounts begin the next period at zero. The post-closing trial balance lists the balances carried forward, not the full transaction history.

From adjusted balances to the next period

Financial statement preparation converts adjusted account balances and other facts into reports about performance, equity, financial position, and cash flows. Derived amounts connect those reports: net income enters comprehensive income, comprehensive income changes equity, and ending equity appears on the balance sheet.

Closing comes after the statements. Revenue, gain, expense, loss, and dividend accounts return to zero. Permanent asset, liability, and equity balances carry forward on the post-closing trial balance and become the next period's opening ledger balances.

The end-of-chapter practice that follows asks you to apply the statement and closing sequence to a company other than Beacon.