Preparing the Financial Statements
Ultimately, the journals, ledgers and adjusting entries exist purely so companies can create accurate financial statements, both to show shareholders how their investment is performing, and to allow the tax authorities to deduct the correct amount of tax. As such, once the trial balances have been balanced and any adjusting entries have been made, the next task in the accounting process is to use the information from the ledger accounts to complete the financial statements.
As the financial statements are all interlinked, and have some dependencies on the other statements, they are usually prepared in the following sequence:
- Profit and loss account / Income statement
- Statement of retained earnings / changes in equity
- Balance sheet
- Cash flow statement
The profit and loss account details all of the company’s revenues, expenses and tax costs, which are used to create an overall profit figure for the company. As such, it includes information from all revenue and expense accounts, as well as any capital gains or losses made over the accounting period and any adjusting entries
The statement of retained earnings demonstrates how much of the profits earned by the company, or losses made, have been retained in the company as shareholder’s equity. As the only way companies can increase the value of their shareholder’s equity is to make profits, the retained earnings are made up of the company’s net profits, less any earnings distributed to shareholders in the form of dividends. Therefore, to prepare the statement of retained earnings company’s simply take their previous level of retained earnings, add their net profit and subtract any dividends paid out and the value of any share repurchases.
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The balance sheet exists to provide a snapshot of the company’s assets, liabilities and shareholders’ equity, according to the accounting equation. As such, it is prepared by adding the balance of all asset accounts to create the total assets figure, adding all liability accounts to create the total liabilities figure, then adding the capital stock balance and the retained earnings balance to create the total shareholders’ equity figure. The total assets figure should be equal to the sum of the total liabilities and the total shareholders’ equity, according to the accounting equation.
The cash flow statement is somewhat unique amongst the financial statements, in that it does not actually reflect any change in the value of the company. Instead, it simply explains what changes have taken place to the company’s cash balance over the years. However, as most companies go bankrupt due to a lack of cash flow to pay expenses and debts, the cash flow statement still plays an important role in accounting.
As the cash flow statement is purely based on the cash held by the company it cannot be produced from the ledger accounts, as these will include accruals and deferrals. Therefore, it must be derived from available information in one of two ways. The company can either use its net income figure, adding or subtracting noncash items from it, or the company can simply create a cash flow statement from all its cash receipts and payments.