From adjusted trial balance to financial statements¶
The adjusted trial balance you just built is a list of correct numbers sitting in no particular order. A bank reviewing a loan application does not want that list. It wants an income statement, a statement of stockholders' equity, and a balance sheet, each answering a different question. The good news is that every number on those three statements is already sitting in your adjusted trial balance. The only work left is sorting it into the right report, in the right order.
Why the order is income statement, then equity, then balance sheet¶
Chapter 1 introduced four statements and showed how they hand numbers to each other. That hand-off is not optional, and it forces a build order. The income statement's net income is one of the inputs the statement of stockholders' equity needs to roll Retained Earnings forward. That statement's ending Retained Earnings is one of the numbers the balance sheet needs for its equity section. Build them out of order and you are plugging in a number you have not calculated yet.
Statements are prepared in this order: income statement, then statement of stockholders' equity, then balance sheet.
The income statement and the statement of stockholders' equity¶
Willow Creek Yoga just finished its second year in business. Its adjusted trial balance shows Service Revenue of $84,650 and four expense accounts: Salaries Expense, Advertising Expense, Depreciation Expense, and Interest Expense. Building the income statement is nothing more than listing revenue, listing every expense, and subtracting.
Willow Creek Yoga
Income Statement
For the Year Ended December 31, 20X2
| Income statement item | Amount |
|---|---|
| Service Revenue | $84,650 |
| Salaries Expense | $60,600 |
| Advertising Expense | $4,350 |
| Depreciation Expense | $700 |
| Interest Expense | $1,080 |
| Total Expenses | $66,730 |
| Net Income | $17,920 |
Net income of $17,920 now becomes the "Add: Net Income" line on the next statement. Because this is Willow Creek Yoga's second year, Retained Earnings does not start at zero. The $2,600 sitting in Retained Earnings on the adjusted trial balance is last year's ending balance. It has not been updated for this year's results yet, because that update only happens through the roll-forward you build here (closing entries, which make it official in the ledger, come next).
Common mistake: net income is not the change in cash
Net income of $17,920 does not mean Willow Creek Yoga's cash balance grew by $17,920 this year. Depreciation Expense of $700 lowered net income without using a dollar of cash. Accounts Receivable, Salaries Payable, and Deferred Revenue also let revenue and expenses land in a different period than the related cash. Net income and the change in cash almost never match exactly, and that gap is exactly what the statement of cash flows exists to explain.
Willow Creek Yoga
Statement of Stockholders' Equity
For the Year Ended December 31, 20X2
| Line | Amount |
|---|---|
| Common Stock | $10,500 |
| Retained Earnings, beginning of year | $2,600 |
| Add: Net Income | $17,920 |
| Less: Dividends | ($3,000) |
| Retained Earnings, end of year | $17,520 |
| Total Stockholders' Equity | $28,020 |
The classified balance sheet: current versus long-term¶
A classified balance sheet sorts assets into current and long-term buckets, and does the same for liabilities. Current assets are cash plus whatever the company expects to convert to cash or use up within one year. Current liabilities are debts due within one year. That one-year test, not how big a number is, decides where everything lands.
Equipment sits in the long-term asset section, listed at its full cost with Accumulated Depreciation subtracted directly below it, giving Equipment's book value.
Common mistake: Accumulated Depreciation is not a cash fund
Accumulated Depreciation is a contra asset, never a liability, and it is not money Willow Creek Yoga has set aside to buy new equipment. It simply tracks how much of Equipment's original cost has already been expensed. No cash moves when depreciation is recorded, and none is sitting anywhere labeled for a future purchase.
The same one-year test applies to liabilities, and it depends on the due date, not the size of the debt. Willow Creek Yoga's $12,000 note payable is due in 24 months, so the whole thing is long-term even though $12,000 is a large number next to a $3,000 Salaries Payable balance. A note due in three months would be current no matter how small.
Put together, Willow Creek Yoga's classified balance sheet separates current from long-term on both sides:
Willow Creek Yoga
Balance Sheet
At December 31, 20X2
| Assets | Amount |
|---|---|
| Cash | $29,590 |
| Accounts Receivable | $11,800 |
| Total Current Assets | $41,390 |
| Equipment | $5,000 |
| Less: Accumulated Depreciation | ($1,400) |
| Equipment, net | $3,600 |
| Total Assets | $44,990 |
| Liabilities and equity | Amount |
|---|---|
| Salaries Payable | $3,000 |
| Interest Payable | $270 |
| Deferred Revenue | $1,700 |
| Total Current Liabilities | $4,970 |
| Notes Payable | $12,000 |
| Total Liabilities | $16,970 |
| Common Stock | $10,500 |
| Retained Earnings, end of year | $17,520 |
| Total Stockholders' Equity | $28,020 |
| Total Liabilities and Stockholders' Equity | $44,990 |
Notice the Retained Earnings figure here, $17,520, is the exact ending balance from the statement of stockholders' equity above it, and total assets equal total liabilities plus total stockholders' equity, just as the accounting equation from Chapter 1 requires.
Pause and work¶
Try the full sequence yourself: income statement, then equity statement, then classified balance sheet, all from one adjusted trial balance.
The income statement and equity numbers are filled in for you here. Finish the classified balance sheet totals.
Now try a fresh company, with fresh numbers, start to finish.
Once a set of statements is built, the ledger accounts behind it still show revenue and expense balances piling up year after year, and the next section closes them out to get the books ready for a fresh start.