The trial balance is a list of all the accounts a company uses with the balances in debit and credit columns. There are three types of trial balances: the unadjusted trial balance, the adjusted trial balance and the post- closing trial balance. All three have exactly the same format.
The unadjusted trial balance is prepared before adjusting journal entries are completed. This trial balance reflects all the activity recorded from day-to-day transactions and is used to analyze accounts when preparing adjusting entries. For example, if you know that the remaining balance in prepaid insurance should be $600, you can look at the unadjusted trial balance to see how much is currently in the account.
The post-closing trial balance shows the balances after the closing entries have been completed. This is your starting trial balance for the next year. We will discuss the post-closing trial balance in the post regarding closing entries.
Accounts in the trial balance are listed in a specific order to aid in the preparation of the financial statements. Accounts should be listed in the following order:
Assets and liabilities should be listed in order from most liquid to least liquid. Liquidity refers to how quickly an asset could be converted to cash and how quickly a liability will be paid off with cash. The most liquid asset is cash, because it has already been converted to cash (who knew?). Typically, the next most liquid asset is accounts receivable because most companies collect their receivables within 30 days.
You can also think of assets and liabilities in terms of current and long-term. A current asset is one that will most likely be used up in less than 12 months. A current liability is one that will be paid off in less than 12 months. Long-term assets and liabilities are those that will be on the trial balance for more than 12 months.
Using the Adjusted Trial Balance
Here is a sample adjusted trial balance. Notice the accounts are listed in the order described above. You might be wondering why it is such a big deal to organize the trial balance in this manner. The purpose of the trial balance is to make your life easier when preparing financial statements. Look what happens when we divide the trial balance by statement.
This is the same trial balance but I have color coded it. The orange section is for the accounts that will be used on the balance sheet, the blue is the statement of retained earnings and the green is the income statement. Because we took the time to organize the accounts, the preparation of the financial statements will be so much easier.
Creating Financial Statements
I imagine some of you are starting to wonder if there is an end to the types of journal entries in the accounting cycle! So far we have reviewed day-to-day journal entries and adjusting journal entries. Closing entries are the last step in the accounting cycle.
Closing entries serve two objectives. The first is to close all of the temporary accounts in order to start with zero balances for the next year. The second is to update the balance in Retained Earnings to agree to the Statement of Retained Earnings.
Note: Closing entries are always dated the first day of the next year. If the year end for the company is September 30, 2013, the closing entries would be dated October 1, 2013. If we closed the accounts as of September 30, we would lose the information we need to do the income statement and statement of retained earnings.
Permanent Versus Temporary Accounts
The chart of accounts can be broken down into two categories: permanent and temporary accounts. A permanent account is one where the balance carries over into the next year. A temporary account is one where the balance resets each year.
Think about some accounts that would be permanent accounts, like Cash and Notes Payable. While some businesses would be very happy if the balance in Notes Payable reset to zero each year, I am fairly certain they would not be happy if their cash disappeared. Assets, liabilities and most equity accounts are permanent accounts. The balances carry over from year-to-year.
Temporary accounts include revenue, expenses and dividends. Each of these accounts must be zeroed out so that on the first day of the year, we can start tracking these balances for the new fiscal year. Remember that the periodicity principle states that financial statements should cover a defined period of time, generally one year. If we do not close out the balances in the revenue and expense accounts, these accounts would continue to contain the revenue and expense balances from previous years and would violate the periodicity principle.
Updating the Balance in Retained Earnings
Think back to all the journal entries you’ve completed so far. Have you ever done an entry that included Retained Earnings? If you have only done journal entries and adjusting journal entries, the answer is no. Let’s look at the trial balance we used in the Creating Financial Statements post.
The balance in Retained Earnings was $8,200 before completing the Statement of Retained Earnings. According to the statement, the balance in Retained Earnings should be $13,000.
We need to complete entries to update the balance in Retained Earnings so it reflects the balance on the Statement of Retained Earnings. We know the change in the balance includes net income and dividends. Net income includes revenue and expenses. Therefore, we need to transfer the balances in revenue, expenses and dividends (the temporary accounts) into Retained Earnings to update the balance.
Using Income Summary in Closing Entries
Rather than closing the revenue and expense accounts directly to Retained Earnings and possibly missing something by accident, we use an account called Income Summary to close these accounts. Income Summary allows us to ensure that all revenue and expense accounts have been closed.
The first accounts to close are the revenue accounts. The trial balance above only has one revenue account, Landscaping Revenue. If the account has a $90,000 credit balance and we wanted to bring the balance to zero, what do we need to do to that account? In order to cancel out the credit balance, we would need to debit the account. Sometimes it helps to visualize this with a T-account.
Debiting the account will get the desired result:
The other account in the entry will be Income Summary.
Now that the revenue account is closed, next we close the expense accounts. You must close each account; you cannot just do an entry to “expenses”. You can, however, close all the expense accounts in one entry. If the balances in the expense accounts are debits, how do you bring the balances to zero? Credit them! We will also close these accounts to Income Summary. The debit to income summary should agree to total expenses on the Income Statement.
Here is the journal entry to close the expense accounts:
After these two entries, the revenue and expense accounts have zero balances. Let’s look at the T-account for Income Summary.
Notice the balance in Income Summary matches the net income calculated on the Income Statement. We know that all revenue and expense accounts have been closed. If we had not used the Income Summary account, we would not have this figure to check, ensuring that we are on the right path.
The next step is to close Income Summary. This account is a temporary equity account that does not appear on the trial balance or any of the financial statements. It is a helper account, aiding us in the closing process. To close Income Summary, we will debit the account. What is our credit in the entry? What did we do with net income when preparing the financial statements? We added it to Retained Earnings on the Statement of Retained Earnings. To add something to Retained Earnings, which is an equity account with a normal credit balance, we would credit the account.
What else went into the calculation of Retained Earnings? If you said Distributions, you are correct. We now close the Distributions account to Retained Earnings. Distributions has a debit balance so we credit the account to close it. Our debit, reducing the balance in the account, is Retained Earnings.
Our T-account for Retained Earnings now has the desired balance.
The trial balance, after the closing entries are completed, is now ready for the new year to begin. We call this trial balance the post-closing trial balance.
The balance in Retained Earnings agrees to the Statement of Retained Earnings and all of the temporary accounts have zero balances. Little Landscaping, LLC is now ready to start the new year.
When doing closing entries, try to remember why you are doing them and connect them to the financial statements. To update the balance in Retained Earnings, we must transfer net income and dividends/distributions to the account. Net income is simply revenue and expenses. By closing revenue, expense and dividend/distribution accounts, we get the desired balance in Retained Earnings.
The four basic financial statements are the income statement, the statement of retained earnings, the balance sheet and the statement of cash flows. Due to the complexity of the statement of cash flows, you can find information on that statement in a separate post. Our purpose here is to get a basic feel for what goes on each of the statements and the purpose of each statement.
The first thing you should do when starting any statement is the heading. The heading tells the reader what he or she is looking at. The heading for all statements is as follows:
Name of the Statement
The date can be a bit tricky but we will discuss that in the context of each of the statements.
You must prepare the financial statements in a particular order:
- Income Statement
- Statement of Retained Earnings
- Balance Sheet
- Cash Flow
The reason for this is because you will need information from the previous statement to complete the next one. You will see the flow of information as we complete an example. It is important to note that you will only use each number from the trial balance one time. Once a number has been used, it will not be used again. Notice that I did not write once you use an account, you will not use it again. There is one account that will be used on two different statements. Can you guess which one?
The Income Statement
From the name, you should be able to tell that the statement has something to do with income. Income makes me think of revenue, but when working with businesses, most of us think of income in terms of profit. Revenue is nice but at the end of the day, those of us who are small business owners don’t get to take home our revenue because we have to pay expenses. Another name for the income statement is the profit and loss statement. The basic format for the income statement is revenue – expenses = net income.
The income statement is like a movie that tells us everything that happened in the business for the year. It includes all revenue generated and all expenses incurred. We can tell if the business borrowed money at any point in the year by looking for interest expense. We can tell if the company owns or rents the space it occupies by looking for rent expense. Does the company have employees? Look for wage expense. The income statement covers the entire period, whether that is a month, a quarter or a year. Therefore, when completing the income statement, the date in the heading should be For the (month/quarter/year) ended (date). For financial statements generated for a year long period of time that ends on December 31, 2013, the date on the income statement would read For the year ended December 31, 2013.
Where do we get the information for the income statement? From the trial balance! I like to think of the trial balance was the primer for financial statement preparation. Here is the trial balance used in the post discussing them.
The trial balance is organized to help us prepare the financial statements. Notice that revenue and expenses are listed together to make preparation of the income statement fairly easy.
Notice in our statement, we listed revenue on top. If there were multiple revenue accounts, we would list them all and then get total revenue like we did for expenses. We then used our formula, revenue – expenses = net income to complete the statement.
Remember that this is a basic income statements. There are more complicated formats for the income statement but this is the basis for all income statements.
The Statement of Retained Earnings
The statement of retained earnings helps us update the balance in the retained earnings account. You will note that we have not completed a single journal entry to Retained Earnings through this process. We will use retained earnings in entries when we discuss closing entries. Because we have not entered any entries into the Retained Earnings accounts, the current balance in the account is last year’s balance. It has not yet been updated to reflect the change for this year. The statement of retained earnings is the first step in updating that balance.
Retained earnings is the amount of earnings that the company has kept (retained) over the years that the company has been in business. Each year the company generates earnings, also called net income. Some of these earnings may be paid out to the owners in the form of dividends or distributions. The difference between net income and distributions to owners is the amount that is added to the previous retained earnings balance. Therefore, the format for the statement of retained earnings is:
Beginning Balance, Retained Earnings (from the adjusted trial balance)
Plus: Net Income
Less: Dividends or Distributions
Equals: Ending Balance, Retained Earnings
Net income is taken from the income statement and dividends or distributions are taken from the trial balance.
Notice on our trial balance, the items we need are highlighted in blue. We look to the income statement which tells us our net income is $29,800. We have everything we need to complete the statement.
Note: For the date on the statement of retained earnings, we use “For the year ended December 31, 2013” because the income statement is involved in the statement. The statement of retained earnings covers all the changes to retained earnings over the course of the year, just like the income statement.
The Balance Sheet
If you look at the trial balance, you will notice that the only accounts we haven’t used are assets, liabilities and equity. Hopefully, this makes you think of the accounting equation, which states that Assets = Liabilities + Equity. We know that this equation always has to balance. The balance sheet is essentially the representation of the accounting equation. We are showing on a statement that assets do indeed equal liabilities and equity.
Unlike the income statement and statement of retained earnings, which tells us the story of the year, the balance sheet is a snapshot of the balances on the last day of the year. It is like a photograph rather than a movie. The balance sheet does not show us all the fluctuations in the balances throughout the year. It does not even show us the high and low balances for the year. It literally only shows us the balance on the last day. Therefore, when writing the date for the heading, we only put the last day. For the example we have been using, we would write “December 31, 2013”. That is all. No “For the year ended” here because it is not for the entire year, it is just for December 31.
At the beginning of the post, I stated that each statement would require something from the previous statement. What do we need from the statement of retained earnings? What type of account is retained earnings? It’s an equity account, which means that it needs to go on the balance sheet. I asked in the first section if you could guess which account is used on multiple statements. The answer is Retained Earnings, which appears on the statement of retained earnings and the balance sheet. Do not take the Retained Earnings balance from the trial balance. Use the ending balance from the statement of retained earnings.
Here is our basic balance sheet:
Notice that the equation does balance. The amount in Retained Earnings is the amount from the statement of retained earnings and not the trial balance. This is a basic, non-classified balance sheet. There are some balance sheets that show current and long-term assets, current and long-term liabilities and a separate equity section. More complex forms of the statements will be discussed in future posts.
Note: If your balance sheet does not balance, here are a few things to check:
- Did you only use revenue and expenses on your income statement? Remember that you can draw a line above your first income account and everything below that line should go on the income statement. Only the items below the line should go on the income statement.
- Did you subtract Dividends/Distributions on the statement of retained earnings?
- Did you use the ending Retained Earnings balance on your balance sheet?
A few other quick tips to keep in mind when preparing your statements.
- Prepaid Expenses are an asset, not an expense. It goes on the balance sheet!
- Accumulated Depreciation is a contra asset, not a liability. Subtract it from assets!
- Unearned Revenue is a liability, not revenue. It goes on the balance sheet!
Use your trial balance as a guide. Know where to separate the accounts and you will be much less likely to make a mistake.