Accounting Cycle

Accounting cycle is a step-by-step process of recording, classification and summarization of economic

transactions of a business. It generates useful financial information in the form of financial
statements including income statement, balance sheet, cash flow statement and statement of changes
in equity.
The time period principle requires that a business should prepare its financial statements on periodic
basis. Therefore accounting cycle is followed once during each accounting period. Accounting Cycle
starts from the recording of individual transactions and ends on the preparation of financial
statements and closing entries.

Major Steps in Accounting Cycle

Following are the major steps involved in the accounting cycle. We will use a simple example problem
to explain each step.

1. Analyzing and recording transactions via journal entries

2. Posting journal entries to ledger accounts
3. Preparing unadjusted trial balance
4. Preparing adjusting entries at the end of the period
5. Preparing adjusted trial balance
6. Preparing financial statements
7. Closing temporary accounts via closing entries
8. Preparing post-closing trial balance

Flow Chart
 Debit Credit Rules

In financial accounting debit and credit are simply the left and right side of a T-Account respectively.
They are used to indicate the increase or decrease in certain accounts. When there is a change in an
account, that change is indicated by either debiting or crediting that account according to following
rules:

 Assets and Expenses 

An increase is recorded as debit (left side) 
A decrease is recorded as credit (right side) 
 Liabilities, Equities and Revenues 
A decrease is recorded as debit (left side) 
An increase is recorded as credit (right side) 
 Contra-accounts 
Contra-accounts behave exactly in opposite way to the respective normal accounts.

Examples

1. The owner brings cash from his personal account into the business 
Analysis: 
Cash (an asset) is increased thus debit Cash 
Owner capital (an equity) is increased thus credit Owners' Capital
2. Office supplies are purchased on account 
Analysis: 
Office Supplies (an asset) is increased thus debit Office Supplies 
Accounts Payable (a liability) is increased thus credit Accounts Payable
3. Wages payable are paid 
Analysis: 
Wages Payable (a liability) is decreased thus debit Wages Payable 
Cash (an asset) is decreased thus credit Cash
4. Revenue is earned but not yet received 
Analysis: 
Accounts Receivable (an asset) is increased thus debit Accounts Receivable 
Revenue (a revenue) is increased thus credit Revenue
Journal Entries

Analyzing transactions and recording them as journal entries is the first step in the accounting cycle.
It begins at the start of an accounting period and continues during the whole period. Transaction
analysis is a process which determines whether a particular business event has an economic effect on
the assets, liabilities or equity of the business. It also involves ascertaining the magnitude of the
transaction i.e. its currency value.
After analyzing transactions, accountants classify and record the events having economic effect via
journal entries according to debit-credit rules. Frequent journal entries are usually recorded in
specialized journals, for example, sales journal and purchases journal. The rest are recorded in a
general journal.

The following example illustrates how to record journal entries:

Example

Company A was incorporated on January 1, 2010 with an initial capital of 5,000 shares of common
stock having $20 par value. During the first month of its operations, the company engaged in
following transactions:

Date Transaction
Jan 2 An amount of $36,000 was paid as advance rent for three months.
Jan 3 Paid $60,000 cash on the purchase of equipment costing $80,000. The remaining
amount was recognized as a one year note payable with interest rate of 9%.
Jan 4 Purchased office supplies costing $17,600 on account.
Jan Provided services to its customers and received $28,500 in cash.
13
Jan Paid the accounts payable on the office supplies purchased on January 4.
13
Jan Paid wages to its employees for first two weeks of January, aggregating $19,100.
14
Jan Provided $54,100 worth of services to its customers. They paid $32,900 and promised
18 to pay the remaining amount.
Jan Received $15,300 from customers for the services provided on January 18.
23
Jan Received $4,000 as an advance payment from customers.
25
Jan Purchased office supplies costing $5,200 on account.
26
Jan Paid wages to its employees for the third and fourth week of January: $19,100.
28
Jan Paid $5,000 as dividends.
31
Jan Received electricity bill of $2,470.
31
 Jan Received telephone bill of $1,494.
31
Jan Miscellaneous expenses paid during the month totaled $3,470
31

The following table shows the journal entries for the above events.

Date Account Debit Credit

Jan 1 Cash 100,000  
  Common Stock   100,000
Jan 2 Prepaid Rent 36,000  
  Cash   36,000
Jan 3 Equipment 80,000  
  Cash   60,000
  Notes Payable   20,000
Jan 4 Office Supplies 17,600  
  Accounts Payable   17,600
Jan Cash 28,500  
13
  Service Revenue   28,500
Jan Accounts Payable 17,600  
13
  Cash   17,600
Jan Wages Expense 19,100  
14
  Cash   19,100
Jan Cash 32,900  
18
  Accounts Receivable 21,200  
  Service Revenue   54,100
Jan Cash 15,300  
23
  Accounts Receivable   15,300
Jan Cash 4,000  
25
  Unearned Revenue   4,000
Jan Office Supplies 5,200  
26
  Accounts Payable   5,200
Jan Wages Expense 19,100  
28
  Cash   19,100
 Jan Dividends 5,000  
31
  Cash   5,000
Jan Electricity Expense 2,470  
31
  Utilities Payable   2,470
Jan Telephone Expense 1,494  
31
  Utilities Payable   1,494
Jan Miscellaneous Expense 3,470  
31
  Cash   3,470
At the end of the period, all the journal for the period are posted to the ledger accounts.

Posting Journal Entries to Ledger Accounts

The second step of accounting cycle is to post the journal entries to the ledger accounts.
The journal entries recorded during the first step provide information about which accounts are
to be debited and which to be credited and also the magnitude of the debit or credit (see debit-
credit-rules). The debit and credit values of journal entries are transferred to ledger accounts one
by one in such a way that debit amount of a journal entry is transferred to the debit side of the
relevant ledger account and the credit amount is transferred to the credit side of the relevant
ledger account.
After posting all the journal entries, the balance of each account is calculated. The balance of an
asset, expense, contra-liability and contra-equity account is calculated by subtracting the sum of
its credit side from the sum of its debit side. The balance of a liability, equity and contra-asset
account is calculated the opposite way i.e. by subtracting the sum of its debit side from the sum
of its credit side.

Example

The ledger accounts shown below are derived from the journal entries of Company A.
Asset Accounts

Cash   Accounts Receivable

$100,00 $36,000   $21,20 $15,300
0 0
28,500 60,000      
32,900 17,600      
15,300 19,100      
4,000 19,100      
  5,000      
  3,470      
$20,430     $5,900  
 Office Supplies   Prepaid Rent

$17,600     $36,00  
0
5,200        
$22,800     $36,00  
0
Equipment
$80,000  
$80,000  
Liability Accounts

Accounts Payable   Notes Payable

$17,60 $17,600     $20,000
0
  5,200      
  $5,200     $20,000
Utilities Payable   Unearned Revenue

  $2,470     $4,000
  1,494      
  $3,964     $4,000

Equity Accounts

Common Stock
  $100,000
  $100,000
Revenue, Dividend and Expense Accounts

Service Revenue   Dividend

  $28,50   $5,000  
0
  54,100      
  $82,60   $5,000  
0
Wages Expense   Miscellaneous Expense
$19,10     $3,470  
0
19,100        
$38,20     $3,470  
0
Electricity Expense   Telephone Expense
 $2,470     $1,494  
$2,470     $1,494

Home > Financial Accounting > Accounting Cycle > Unadjusted Trial Balance

Unadjusted Trial Balance

A trial balance is a list of the balances of ledger accounts of a business at a specific point of time
usually at the end of a period such as month, quarter or year.

An unadjusted trial balance is the one which is created before any adjustments are made in the ledger
accounts.

The preparation of a trial balance is very simple. All we have to do is to list the balances of the ledger
accounts of a business.

Example

Following is the unadjusted trial balance prepared from the ledger accounts of Company A.
Company A
Unadjusted Trial Balance
January 31, 2010
 
  Debit Credit
Cash $20,430  
Accounts Receivable 5,900  
Office Supplies 22,800  
Prepaid Rent 36,000  
Equipment 80,000  
Accounts Payable   $5,200
Notes Payable   20,000
Utilities Payable   3,964
Unearned Revenue   4,000
Common Stock   100,000
Service Revenue   82,600
Wages Expense 38,200  
Miscellaneous Expense 3,470  
Electricity Expense 2,470  
Telephone Expense 1,494  
Dividend 5,000  
Total $215,764 $215,764
 Since, in double entry accounting we record each transaction with two aspects, therefore the total of
debit and credit balances of the trial balance are always equal. Any difference shall indicate some
mistake in the recording process or in the calculations. Although each unbalanced trial balance
indicates mistake, but this does not mean that all errors cause the trial balance to unbalance. There
are few types of mistakes which will not unbalance the trial balance and they may escape un-noticed if
we do not review our work carefully. For example, to omit an entry, to record a transaction twice, etc.

Adjusting Entries

Adjusting entries are journal entries recorded at the end of an accounting period to adjust income and
expense accounts so that they comply with theaccrual concept of accounting. Their main purpose is to
match incomes and expenses to appropriate accounting periods.
The transactions which are recorded using adjusting entries are not spontaneous but are spread over
a period of time. Not all journal entries recorded at the end of an accounting period are adjusting
entries. For example, an entry to record a purchase on the last day of a period is not an adjusting
entry. An adjusting entry always involves either income or expense account.

Types

There are following types of adjusting entries:

 Accruals:
These include revenues not yet received nor recorded and expenses not yet paid nor recorded. For
example, interest expense on loan accrued in the current period but not yet paid.
 Prepayments:
These are revenues received in advance and recorded as liabilities, to be recorded as revenue and
expenses paid in advance and recorded as assets, to be recorded as expense. For example,
adjustments to unearned revenue, prepaid insurance, office supplies, prepaid rent, etc.
 Non-cash:
These adjusting entries record non-cash items such as depreciation expense, allowance for doubtful
debts etc.

Example

This example is a continuation of the accounting cycle problem we have been working on. In the
previous step we prepared an unadjusted trial balance. Here we will pass adjusting entries.
Relevant information for the preparation of adjusting entries of Company A
Office supplies having original cost $4,320 were unused till the end of the period. Office
supplies having original cost of $22,800 are shown on unadjusted trial balance.
Prepaid rent of $36,000 was paid for the months January, February and March.
The equipment costing $80,000 has useful life of 5 years and its estimated salvage value is
$14,000. Depreciation is provided using the straight line depreciation method.
 Relevant information for the preparation of adjusting entries of Company A
The interest rate on $20,000 note payable is 9%. Accrue the interest for one month.
$3,000 worth of service has been provided to the customer who paid advance amount of $4,000.

The adjusting entries of Company A are:

Date Account Debit Credit

Jan Supplies Expense 18,480
31
Office Supplies 18,480
Supplies Expense = $22,800 − $4,320 = $18,480
Jan Rent Expense 12,000
31
Prepaid Rent 12,000
Rent Expense = $36,000 ÷ 3 = $12,000
Jan Depreciation Expense 1,100
31
Accumulated 1,100
Depreciation
Depreciation Expense = ($80,000 − $14,000) ÷ (5 × 12) = $1,100
Jan Interest Expense 150
31
Interest Payable 150
Interest Expense = $20,000 × (9% ÷ 12) = $150
Jan Unearned Revenue 3,000
31
Service Revenue 3,000

Adjusted Trial Balance

An Adjusted Trial Balance is a list of the balances of ledger accounts which is created after the
preparation of adjusting entries. Adjusted trial balance contains balances of revenues and expenses
along with those of assets, liabilities and equities. Adjusted trial balance can be used directly in the
preparation of the statement of changes in stockholders' equity, income statement and the balance
sheet. However it does not provide enough information for the preparation of the statement of cash
flows.
The format of an adjusted trial balance is same as that of unadjusted trial balance.

Example

The following adjusted trial balance was prepared after posting the adjusting entries of Company A to
its general ledger and calculating new account balances:
 Company A
Adjusted Trial Balance
January 31, 2010

Debit Credit
Cash $20,430 −
Accounts Receivable 5,900 −
Office Supplies 4,320 −
Prepaid Rent 24,000 −
Equipment 80,000 −
Accumulated − $1,100
Depreciation
Accounts Payable − 5,200
Utilities Payable − 3,964
Unearned Revenue − 1,000
Interest Payable − 150
Notes Payable − 20,000
Common Stock − 100,000
Service Revenue − 85,600
Wages Expense 38,200 −
Supplies Expense 18,480 −
Rent Expense 12,000 −
Miscellaneous Expense 3,470 −
Electricity Expense 2,470 −
Telephone Expense 1,494 −
Depreciation Expense 1,100 −
Interest Expense 150 −
Dividend 5,000 −
Total $217,014 $217,014

The totals of an adjusted trial balance must be equal. Any difference indicates that there is some error
in the journal entries or in the ledger or in the calculations.
 Adjusting Entries

Adjusting entries are journal entries recorded at the end of an accounting period to adjust income and
expense accounts so that they comply with theaccrual concept of accounting. Their main purpose is to
match incomes and expenses to appropriate accounting periods.
The transactions which are recorded using adjusting entries are not spontaneous but are spread over
a period of time. Not all journal entries recorded at the end of an accounting period are adjusting
entries. For example, an entry to record a purchase on the last day of a period is not an adjusting
entry. An adjusting entry always involves either income or expense account.

Types

There are following types of adjusting entries:

 Accruals:
These include revenues not yet received nor recorded and expenses not yet paid nor recorded. For
example, interest expense on loan accrued in the current period but not yet paid.
 Prepayments:
These are revenues received in advance and recorded as liabilities, to be recorded as revenue and
expenses paid in advance and recorded as assets, to be recorded as expense. For example,
adjustments to unearned revenue, prepaid insurance, office supplies, prepaid rent, etc.
 Non-cash:
These adjusting entries record non-cash items such as depreciation expense, allowance for doubtful
debts etc.

Example

This example is a continuation of the accounting cycle problem we have been working on. In the
previous step we prepared an unadjusted trial balance. Here we will pass adjusting entries.

Relevant information for the preparation of adjusting entries of Company A

Office supplies having original cost $4,320 were unused till the end of the period. Office
supplies having original cost of $22,800 are shown on unadjusted trial balance.
Prepaid rent of $36,000 was paid for the months January, February and March.
The equipment costing $80,000 has useful life of 5 years and its estimated salvage value is
$14,000. Depreciation is provided using the straight line depreciation method.
The interest rate on $20,000 note payable is 9%. Accrue the interest for one month.
$3,000 worth of service has been provided to the customer who paid advance amount of $4,000.
The adjusting entries of Company A are:

Date Account Debit Credit

Jan Supplies Expense 18,480
 Date Account Debit Credit
31
Office Supplies 18,480
Supplies Expense = $22,800 − $4,320 = $18,480
Jan Rent Expense 12,000
31
Prepaid Rent 12,000
Rent Expense = $36,000 ÷ 3 = $12,000
Jan Depreciation Expense 1,100
31
Accumulated 1,100
Depreciation
Depreciation Expense = ($80,000 − $14,000) ÷ (5 × 12) = $1,100
Jan Interest Expense 150
31
Interest Payable 150
Interest Expense = $20,000 × (9% ÷ 12) = $150
Jan Unearned Revenue 3,000
31
Service Revenue 3,000

Adjusted Trial Balance

An Adjusted Trial Balance is a list of the balances of ledger accounts which is created after the
preparation of adjusting entries. Adjusted trial balance contains balances of revenues and expenses
along with those of assets, liabilities and equities. Adjusted trial balance can be used directly in the
preparation of the statement of changes in stockholders' equity, income statement and the balance
sheet. However it does not provide enough information for the preparation of the statement of cash
flows.
The format of an adjusted trial balance is same as that of unadjusted trial balance.
Example

The following adjusted trial balance was prepared after posting the adjusting entries of Company A to
its general ledger and calculating new account balances:
Company A
Adjusted Trial Balance
January 31, 2010

Debit Credit
Cash $20,430 −
Accounts Receivable 5,900 −
Office Supplies 4,320 −
Prepaid Rent 24,000 −
Equipment 80,000 −
Accumulated − $1,100
Depreciation
Accounts Payable − 5,200
Utilities Payable − 3,964
Unearned Revenue − 1,000
Interest Payable − 150
Notes Payable − 20,000
Common Stock − 100,000
Service Revenue − 85,600
Wages Expense 38,200 −
Supplies Expense 18,480 −
Rent Expense 12,000 −
Miscellaneous Expense 3,470 −
Electricity Expense 2,470 −
Telephone Expense 1,494 −
Depreciation Expense 1,100 −
Interest Expense 150 −
Dividend 5,000 −
Total $217,014 $217,014

The totals of an adjusted trial balance must be equal. Any difference indicates that there is some error
in the journal entries or in the ledger or in the calculations.

Post-Closing Trial Balance

A post-closing trial balance is a list of balances of ledger accounts prepared after closing entries have
been passed and posted to the ledger accounts. Since the closing entries transfer the balances of
temporary accounts (i.e. expense, revenue, gain, dividend and withdrawal accounts) to the retained
earnings account, the new balances of temporary accounts are zero and therefore they are not listed
on a post-closing trial balance. However, all the other accounts having non-negative balances are
listed including the retained earnings account.

The preparation of post-closing trial balance is the last step of the accounting cycle and its purpose is
to be sure that sum of debits equal the sum of credits before the start of new accounting period. It
provides the openings balances for the ledger accounts of the new accounting period.

Example

The following post-closing trial balance was prepared after posting the closing entries of Company A to
its general ledger and calculating new account balances:
Company A
Adjusted Trial Balance
January 31, 2010
 
  Debit Credit
Cash $20,430 −
Accounts Receivable 5,900 −
Office Supplies 4,320 −
Prepaid Rent 24,000 −
Equipment 80,000 −
Accumulated − $1,100
Depreciation
Accounts Payable − 5,200
Utilities Payable − 3,964
Unearned Revenue − 1,000
Interest Payable − 150
Notes Payable − 20,000
Common Stock − 100,000
Retained Earnings − 3,236
Total $134,650 $134,650
Financial Statements

A set of financial statements is a structured representation of the financial performance and financial
position of a business and how its financial position changed over time. It is the ultimate output of an
accounting information system and has following six components:

1. Income Statement
2. Balance Sheet
3. Statement of Cash Flows
4. Statement of Changes in Equity
5. Notes and Other Disclosures

Financial statements are better understood in context of all other components of the financial
statements. For example a balance sheet will communicate more information if we have the related
income statement and the statement of cash flows too.

Following the time-period principle, financial statements are prepared after a specified period; say a
quarter, year, etc.

Interim Financial Statements

Quarterly and semiannual financial statements are called interim financial statements and are
normally prepared in a condensed form. It means that the disclosures required in them are far less
than those required in annual financial statements. Quarterly financial statements are normally
unaudited but semiannual reports need to be at least reviewed by an auditor who is a qualified
professional accountant authorized to attest the authenticity of financial statements.

Annual Financial Statements

Financial statements prepared for a period of one year are called annual financial statements and are
required to be audited by an auditor (a chartered accountant or a certified public accountant). Annual
financial statements are normally published in an annual report which also includes a directors' report
(also called management discussion and analysis) and an overview of the company, its operations and
past performance.

Income statement communicates the company's financial performance over the period while a balance
sheet communicates the company's financial position at a point of time. The statement of cash flows
and the statement of changes in equity tells us about how the financial position changed over the
period. Disclosure notes to financial statements cover such material information which is not
appropriate to be communicated on the face of the main financial statements.
Single-Step Income Statement

Single-step income statement is one of the two most commonly used income statement formats, the
other being the multi-step income statement. A single step income statement uses just one
subtraction. This is done by subtotaling all the revenues and gains together at the top of income
statement and subtotaling all the expenses and losses together below revenues. The sum of expenses
and losses is then subtracted from the sum of revenues and gains to arrive at net income. Thus:
(Revenues + Gains) − (Expenses + Losses)
= Net Income

The net income calculated using the single-step income statement is equal to that calculated using a
multi-step income statement.

Example and Format

The following example shows the format of a single-step income statement.

Company A
Income Statement
For the month ended December 31, 2010
 
Revenues:  
Sales Revenues $64,510  
Interest Revenues 1,650  
Gain on Sale of 5,000  
Investments
Total Revenues $71,160
Expenses:  
Cost of Goods Sold $31,400  
Depreciation Expense 7,980  
Rent Expense 8,000  
Advertising Expense 1,000  
Salaries Expense 13,500  
Utilities Expense 1,360  
Loss due to Theft 300  
Total Expenses −63,540
Net Income $7,620
The major drawback of single-step income statement is that it does not calculate the gross profit of
the business. To calculate gross profit, revenues and expenses must be classified. This is why most
businesses use the other format of income statement called multi-step income statement.
Multi-Step Income Statement

Multi-step income statement is one of the two most commonly used income statement formats, the
other being the single-step income statement. Multi-step income statement involves more than one
subtraction to arrive at net income and it provides more information than a single-step income
statement. The most important of which are the gross profit and the operating profit figures.

Multi-step income statement is divided into two main sections: the operating section and the non-
operating sections.

The operating section contains information aboutrevenues and expenses of the principle business

activities. The gross profit and the operating profit figures are calculated in the operating section of a
multi-step income statement. All operating revenues are grouped at the top of the income statement.
The operating expenses are sub-classified into cost of goods sold, selling expenses and administrative
expenses.

Selling expenses are those which are incurred directly on making sales. Examples are: sales
commissions, sales salaries, advertising expense, delivery expense and depreciation expense of sales
equipment. The administrative expenses are those relating to general administrative activities.
Examples are: depreciation expense on office building, office salaries, office supplies expense and
office utilities expense.

The non-operating section of a multi-step income statement, usually labeled as 'other incomes and

expenses' contains those revenues and expenses which are not earned directly through principle
business activities but are incidental to them. For example gains/losses on sales of investments or
fixed assets, interest revenue/expense etc. It also includes extraordinary items of revenues and
expenses which are infrequent and unusual such as loss due to natural calamity.

Format and Example

The following example illustrates the format of a typical multi-step income statement. The calculation
steps are clarified via the '+' and '−' symbols on the left of various income and expense items.

Company A
Income Statement
For the Year Ended December 31, 2010
 
Sales Revenue:  
Total Sales $137,460  
− Sales Returns −2,060  
− Sales Discounts −5,190  
Net Sales Revenue $130,210
Less: Cost of Goods Sold:  
Beginning Stock $12,300  
+ Purchases 67,310  
+ Freight-In 4,450  
 − Purchase Discounts −3,900  
− Purchase Returns −1,000  
− Ending Stock −16,170  
Cost of Goods Sold −62,990
Gross Profit $67,220
Operating Expenses  
Selling Expenses:  
Freight-Out $6,150  
Advertising Expense 5,790  
Sales Commissions 3,470  
Expense
Administrative Expenses:  
Office Salaries Expense 18,510  
Office Rent Expense 14,000  
Office Supplies Expense 5,330  
Total Operating Expenses −53,250
Operating Income $13,970
Other Incomes and Expenses:  
Gains on Sale Equipment $2,430  
− Loss on Sales of Investments −1,640  
− Interest Expense −930  
Net Other Incomes and Expenses −140
Net Income $13,830

Income Statement

Income statement (also referred to as (a) statement of income and expense or (b) statement of profit
or loss or (c) profit and loss account) is a financial statement that summaries the results of a
company’s operations for a period. It presents a picture of a company’s revenues, expenses, gains,
losses, net income and earnings per share (EPS).

Together with balance sheet, statement of cash flows and statement of changes in shareholders
equity, income statement forms a complete set of financial statements.

Format

A typical income statement is in report form. The header identifies the company, the statement and
the period to which the statement relates, the reporting currency and the level of rounding-off. The
header is followed by revenue and cost of goods sold and calculation of gross profit. Further down the
statement there is detail of operating expenses, non-operating expenses, and taxes and eventually
the statement presents net income differentiating between income earned from continuing operations
and total net income. In case of a consolidated income statement, a distribution of net income
between the equity-holders of the parent and non-controlling interest holders is also presented. The
statement normally ends with a presentation of earnings per share, both basic and diluted. Important
line items such as revenue, cost of sales, etc. are cross-referred to the relevant detailed schedules and
notes.

Types

There are two types of income statements: single-step income statement, in which there are no sub-
totals such as gross profit, operating income, earnings before taxes, etc.; and multi-step income
statement, in which similar expenses are grouped together and intermediate figures such as gross
profit, operating income, EBIT, etc. are calculated.

Another classification of income statement depends on whether the expenses are grouped by their
nature or function. Income statement by nature classifies expenses according to their nature i.e.
without allocating them to different business activities, while income statement by function classifies
expenses according to the business operations that they support. For example, income statement by
nature shows line items such as salaries, depreciation, rent, etc., while income statement by function
allocate salaries, depreciation, rent, etc. between cost of good sold, selling expense, general and
admin expenses, etc.

Example: Template

Below is a sample income statement. The first five lines make the header followed by a multi-step
overview of expenses. All amounts other than EPS are in million USD.

IS Global, Inc.
(Consolidated) Statement of Income and Expense
for the year ended 31 December
 
Notes 2013 2012
Revenue 14 201.9 182.1
Cost of sales 15 (158.4) (151.6)
Gross profit 43.5 30.5
 
Selling and distribution expenses 16 (9.8) (8.9)
General and administrative expenses 17 (14.0) (11.0)
Other operating income and gains 18 1.8 2.6
Other operating expenses and losses 19 (3.4) (1.3)
Operating profit/earnings before interest and taxes 18.1 11.9
(EBIT)
 
Interest income 20 1.3 0.6
 IS Global, Inc.
(Consolidated) Statement of Income and Expense
for the year ended 31 December
 
Notes 2013 2012
Interest expense 20 (3.6) (2.8)
Net interest expense 20 (4.9) (3.4)
Profit from investments under equity method 22 6.9 5.5
Earnings before taxes 20.1 14.0
 
Income taxes 23 (6.0) (4.2)
Income from continuing operations 14.1 9.8
 
Income from discontinued operations 24 2.1 3.1
Net income 17 16.2 12.9
 
Distribution of net income:
Equity-holders of parents 14.6 11.6
Non-controlling interest-holders 1.6 1.3
 
Earnings per share: 19
Basic, attributable parent 0.15 0.12
Diluted, attributable to parent 0.15 0.11
Basic, from continued operations, attributable to parent 0.14 0.10
Diluted, from continued operations, attributable to parent 0.14 0.09

Components

Following are key line items that appear on a typical income statement:

 Revenue: represents the amount earned by the company in exchange of goods it supplied

and services it provided. When there are few sources of revenue, a breakup may appear on the face of
the income statement; otherwise, a separate note provides a complete picture.
 Cost of sales: represents the cost of goods sold and services provided. It includes all such
costs that can be traced or assigned to goods sold or services provided. Examples include raw
materials, salaries of factory or service shop employees, manufacturing facility rent, depreciation of
manufacturing equipment, lease rentals on equipment used in manufacturing or service delivery,
indirect materials needed for production, etc. Typically, a separate note provides a complete break-up
of cost of sales.
 Gross profit = revenue – cost of sales; it represents the profit earned on the goods and
services of the company before any selling, general and administrative expenses and finance costs are
accounted for.
 Operating expenses: mainly include selling and distribution expenses and general and
administrative expenses. Examples include salary of the CEO, marketing expenses, office rent, salaries
of administrative staff, fuel for delivery vehicles, etc.
 Operating profit: (equivalent to earnings before interest and taxes (EBIT)) = gross profit –
operating expenses; as the name suggests, it is the profit after cost of sales and all operating
expenses have been charged to revenue. It is before any adjustment for interest or investment
income and interest expense and taxes.
 Income from continuing operations = EBIT – taxes; it represents the net income (i.e.
after-tax income) earned from business components that the company intends to own in the future. It
excludes any income earned during the year from business components that are treated as
discontinued operations. Income from continuing operations provides a picture of the company’s
continuing earning capacity.
 Income from discontinued operations: is the after-tax income of business components
which the company has disposed-off during the year or has classified as held-for-sale at the year-end.
 Net income = income from continued operations + after-tax income from discontinued
operations; a company’s total net income includes income from both continued operations and
discontinued operations. It represents the income earned during the year after accounting for all
expenses. It is carried to statement of changes in shareholders’ equity where it is added to opening
balance of the retained earnings component of equity.
 Distribution of income: a consolidated income statement provides a statement of how the
income is distributed between parent and minority shareholders.
 Earnings per share (EPS): is a critical part of income statement for companies that are
required to calculate and present their EPS (mainly companies listed on a stock exchange). Both basic
EPS and diluted EPS are reported, where basic EPS = (net income – preferred dividends)/weighted-
average number of common shares.

Balance Sheet

A balance sheet also known as the statement of financial position tells about the assets, liabilities and
equity of a business at a specific point of time. It is a snapshot of a business.
A balance sheet is an extended form of the accounting equation. An accounting equation is:
Assets = Liabilities + Equity

Assets are the resources controlled by a business, equity is the obligation of the company to its
owners and liabilities are the obligations of parties other than owners.

A balance sheet is named so because it lists all resources owned by the company and shows that it is
equal to the sum of all liabilities and the equity balance.

A balance sheet has two formats: account form and report form.

An account form balance sheet is just like a T-account listing assets on the debit side and equity and
liabilities on the right hand side. A report form balance sheet lists assets followed by liabilities and
equity in vertical format.

The following example shows a simple balance sheet based on the post-closing trial balance of
Company A.
Company A
Balance Sheet
As on December January 31, 2011
 
ASSETS LIABILITIES AND EQUITY
Current Assets: Liabilities:
Cash $20,430 Accounts Payable $5,200
Accounts Receivable 5,900 Utilities Payable 3,964
Office Supplies 4,320 Unearned Revenue 1,000
Prepaid Rent 24,000 Interest Payable 150
Total Current Assets $54,650 Notes Payable 20,000
Non-Current Assets: Total Liabilities $30,314
Equipment $80,000 Common Stock 100,000
Accumulated Depreciation −1,100 Retained Earnings 3,236
Net Non-Current Assets $78,900    
Total Assets $133,550 Total Liabilities and Equity $133,550

Home > Financial Accounting > Financial Statements > Statement of Cash Flows

Statement of Cash Flows

A statement of cash flows is a financial statement which summarizes cash transactions of a business
during a given accounting period and classifies them under three heads, namely, cash flows from
operating, investing and financing activities. It shows how cash moved during the period by indicating
whether a particular line item is a cash in-flow or a cash out-flow. The term cash as used in the
statement of cash flows refers to both cash and cash equivalents. Cash flow statement provides
relevant information in assessing a company's liquidity, quality of earnings and solvency.

Sections

As stated above, a statement of cash flows comprises of three sections:

1. Cash Flows from Operating Activities

This section includes cash flows from the principal revenue generation activities such as sale and
purchase of goods and services. Cash flows from operating activities can be computed using two
methods. One is theDirect Method and the other Indirect Method.
2. Cash Flows from Investing Activities
Cash flows from investing activities are cash in-flows and out-flows related to activities that are
intended to generate income and cash flows in future. This includes cash in-flows and out-flows
from sale and purchase oflong-term assets.
3. Cash Flows from Financing Activities
Cash flows from financing activities are the cash flows related to transactions with stockholders
and creditors such as issuance of share capital, purchase of treasury stock, dividend payments etc.

Format and Example

Following is a cash flow statement prepared using indirect method:

Company A, Inc.
Cash Flow Statement
For the Year Ended Dec 31, 2010
 
Cash Flows from Operating Activities:
Operating Income (EBIT) $489,000
Depreciation Expense 112,400
Loss on Sale of Equipment 7,300
Gain on Sale of Land −51,000
Increase in Accounts Receivable −84,664
Decrease in Prepaid Expenses 8,000
Decrease in Accounts Payable −97,370
Decrease in Accrued Expenses −113,86
0
Net Cash Flow from Operating $269,806
Activities
 
Cash Flows from Investing Activities:
Sale of Equipment $89,000
 Sale of Land 247,000
Purchase of Equipment −100,00
0
Net Cash Flow from Investing Activities 136,000
 
Cash Flows from Financing Activities:
Payment of Dividends −
$90,000
Payment of Bond Payable −200,00
0
Net Cash Flow from Financing −290,000
Activities
Net Change in Cash $115,806
Beginning Cash Balance 319,730
Ending Cash Balance $435,536
 Statement of Changes in Shareholders Equity

A statement of changes in shareholders equity is a financial statement that presents a summary of the
changes in shareholders’ equity accounts over the reporting period. It reconciles the opening balances
of equity accounts with their closing balances.

There are two types of changes in shareholders’ equity: (a) changes that originate from transactions
with shareholders such as issue of new shares, payment of dividends, etc. and (b) changes that result
from changes in total comprehensive income, such as net income for the period, revaluation of fixed
assets, changes in fair value of available for sale investments, etc.

Components

Typically, a statement of shareholders equity summaries changes in the following equity components:

 Common stock, which represents the legal capital of the company and it equals the product of
shares issued and the stated value of each share.
 Additional paid-up capital (also called share premium), which is the excess of paid-up capital
over the legal capital. Additional paid-up capital = (issue price – stated price) * total number of shares
issued.
 Treasury stock, which represents the value of shares repurchased by the company. It is a
contra-account to the paid-up capital.
 Capital reserve(s).
 Retained earnings: accumulated earnings since the start of the company net of dividends paid
or any restatement adjustments.
 Gains and losses on cash flow hedge: unrealized portion of change in fair value.
 Gains and losses on available for sale securities: i.e. the unrealized portion of change in fair
value.
 Revaluation surplus: represents the effect of revaluation of fixed assets.

Following are the most common changes in shareholders’ equity:

 Issue of new share capital: it increases the common stock and additional paid-up capital
component.
 Net income (loss) for the period: it increases (decreases) retained earnings.
 Payment of cash dividends: it decreases retained earnings.
 Purchase of treasury stock: it increases treasury stock component and eventually decreases
total net shareholders equity.
 Sale of treasury stock: it decreases treasury stock component and affects retained earnings
and additional paid-up capital and ultimately increases total shareholders equity.
 Issue of bonus shares: affects common stock, additional paid-up capital and retained earnings.
 Revaluation of fixed assets: increases revaluation surplus.
 Reversal of revaluation of fixed assets: may decrease revaluation surplus.
 Effect of foreign-exchange translation: increase/decrease in foreign-exchange reserve.
 Effect of changes in value of available-for-sale securities: increase/decrease in available-for-
sale securities reserve.
 Restatement of financial statements, for e.g. due to change in accounting principle: changes in
retained earnings.

Format: Example

Alumina, Inc. is a company engaged in extraction of Aluminum. The company’s CFO has asked you to
prepare a statement of changes in equity for the company for the year ended 30 June 2014.

Following information is available:

 The composition of the company’s shareholders equity as at 1 July 2013 was as follows:
USD in million
Common stock, 20 M authorized shares, 5 M issued and 50
outstanding
Additional paid-in capital 120
Capital reserves 30
Retained earnings 90
Revaluation surplus 15
305
 On 30 August 2014, the company declared and issued 10% bonus shares. Price per share at
the date was $40.
 On 1 September 2014, the company issued 1 million new shares for total consideration of $45
million. The stated price of a common share is $10.

Profit for the financial yearStatement of Changes in Shareholders Equity

A statement of changes in shareholders equity is a financial statement that presents a summary of the
changes in shareholders’ equity accounts over the reporting period. It reconciles the opening balances
of equity accounts with their closing balances.

There are two types of changes in shareholders’ equity: (a) changes that originate from transactions
with shareholders such as issue of new shares, payment of dividends, etc. and (b) changes that result
from changes in total comprehensive income, such as net income for the period, revaluation of fixed
assets, changes in fair value of available for sale investments, etc.

Components

Typically, a statement of shareholders equity summaries changes in the following equity components:

 Common stock, which represents the legal capital of the company and it equals the product of
shares issued and the stated value of each share.
 Additional paid-up capital (also called share premium), which is the excess of paid-up capital
over the legal capital. Additional paid-up capital = (issue price – stated price) * total number of shares
issued.
 Treasury stock, which represents the value of shares repurchased by the company. It is a
contra-account to the paid-up capital.
 Capital reserve(s).
 Retained earnings: accumulated earnings since the start of the company net of dividends paid
or any restatement adjustments.
 Gains and losses on cash flow hedge: unrealized portion of change in fair value.
 Gains and losses on available for sale securities: i.e. the unrealized portion of change in fair
value.
 Revaluation surplus: represents the effect of revaluation of fixed assets.

Following are the most common changes in shareholders’ equity:

 Issue of new share capital: it increases the common stock and additional paid-up capital
component.
 Net income (loss) for the period: it increases (decreases) retained earnings.
 Payment of cash dividends: it decreases retained earnings.
 Purchase of treasury stock: it increases treasury stock component and eventually decreases
total net shareholders equity.
 Sale of treasury stock: it decreases treasury stock component and affects retained earnings
and additional paid-up capital and ultimately increases total shareholders equity.
 Issue of bonus shares: affects common stock, additional paid-up capital and retained earnings.
 Revaluation of fixed assets: increases revaluation surplus.
 Reversal of revaluation of fixed assets: may decrease revaluation surplus.
 Effect of foreign-exchange translation: increase/decrease in foreign-exchange reserve.
 Effect of changes in value of available-for-sale securities: increase/decrease in available-for-
sale securities reserve.
 Restatement of financial statements, for e.g. due to change in accounting principle: changes in
retained earnings.

Format: Example

Alumina, Inc. is a company engaged in extraction of Aluminum. The company’s CFO has asked you to
prepare a statement of changes in equity for the company for the year ended 30 June 2014.

Following information is available:

 The composition of the company’s shareholders equity as at 1 July 2013 was as follows:
USD in million
Common stock, 20 M authorized shares, 5 M issued and 50
outstanding
Additional paid-in capital 120
Capital reserves 30
Retained earnings 90
 Revaluation surplus 15
305
 On 30 August 2014, the company declared and issued 10% bonus shares. Price per share at
the date was $40.
 On 1 September 2014, the company issued 1 million new shares for total consideration of $45
million. The stated price of a common share is $10.
 Profit for the financial year ended 30 June 2014 amounted to $50 million and the company
paid dividends totaling $16 million.
 The company is required under law to set a side 10% of net income for the period and credit it
to capital reserve.
 500,000 shares were bought back on 30 December 2014 at $40 per share.
 The company reversed upward revaluation of an asset by $5 million. The revaluation surplus
already includes $7 million of such initial upward revaluation.
Solution

Statement of shareholders equity is normally prepared in vertical format, i.e. the equity components
appear as column headings and changes during the year appear as row headings.

Following is the statement of shareholders equity for Alumina, Inc. for financial year ended 30 June
2014. Each change is explained in the notes below:

Alumina, Inc.
Statement of Shareholders Equity
for the year ended 30 June 2014
Additional
Common Capital Treasury Retained Revaluation
paid-in Total
Note stock reserve stock earnings surplus
capital
USD in million
Balance as at 50 120 30 - 90 15 305
1-Jul-13
Issue of bonus A 5 15 - - (20) - -
shares
Issue of new B 10 35 - - - - 45
shares
Net income C - - - - 50 - 50
Transfer to D - - 5 - (5) - -
capital reserve
Dividends E - - - - (16) - -16
Share F - - - (2) - - (2)
buyback
Reversal of G - - - - - (5) (5)
revaluation
Balance as at 65 170 35 (2) 99 10 377
30-Jun-14
Notes:

A. Issue of bonus share results in increase in the common stock and additional paid-in capital
and decrease the retained earnings. Following journal entry is behind this adjustment:
Retained earnings (5,000,000 × 0.1 $20 million
× $40)
Common stock (5,000,000 × 0.1 × $5 million
$10)
Additional paid-in capital $15
(20 - 5) millio
n
B. When new shares are issued, credit to common stock equals the product of number of shares
issued and the stated price of the share. The excess of cash received over the credit to common
stock account goes to additional paid-in capital. Following is the relevant journal entry:
Cash (1,000,000 × $45) $45 million
Common stock (1,000,000 × $10) $10 million
Additional paid-in capital $35
(45 - 10) millio
n
C. Net income increases retained earnings.
D. Since 10% of profit of the year is transferred to the capital reserve according to the relevant
laws, following journal entry is behind the adjustment:
Retained earnings ($50 × 0.1) $5
million
Capital reserve $5
millio
n
E. Cash dividends decrease the retained earnings.
F. Shares repurchased are accounted for by debiting the treasury stock account, which is a
contra-account to the shareholders’ equity. Following is the journal entry behind the adjustment:
Treasury stock (500,000 × 40) $2
million
Cash $2
millio
n
G. This adjustment is only required under IFRS. If a fixed asset is revalued upwards, it increased
the asset book value and also increases revaluation surplus, which is a shareholders’ equity
component. When the same asset is subsequently revalued down, the downward revaluation is
written off to the extent of any upward revaluation originally credit to revaluation surplus in
relation to that asset. In this particular case, the asset was revaluated up in earlier year such that
a credit of $7 million was made to revaluation surplus. Now, a downgrade revaluation by $5 million
can be written off completely against revaluation surplus and hence this decrease in revaluation
surplus.
 ended 30 June 2014 amounted to $50 million and the company paid dividends totaling $16
million.
 The company is required under law to set a side 10% of net income for the period and credit it
to capital reserve.
 500,000 shares were bought back on 30 December 2014 at $40 per share.
 The company reversed upward revaluation of an asset by $5 million. The revaluation surplus
already includes $7 million of such initial upward revaluation.
Solution

Statement of shareholders equity is normally prepared in vertical format, i.e. the equity components
appear as column headings and changes during the year appear as row headings.

Following is the statement of shareholders equity for Alumina, Inc. for financial year ended 30 June
2014. Each change is explained in the notes below:

Alumina, Inc.
Statement of Shareholders Equity
for the year ended 30 June 2014
Additional
Common Capital Treasury Retained Revaluation
paid-in Total
Note stock reserve stock earnings surplus
capital
USD in million
Balance as at 50 120 30 - 90 15 305
1-Jul-13
Issue of bonus A 5 15 - - (20) - -
shares
Issue of new B 10 35 - - - - 45
shares
Net income C - - - - 50 - 50
Transfer to D - - 5 - (5) - -
capital reserve
Dividends E - - - - (16) - -16
Share F - - - (2) - - (2)
buyback
Reversal of G - - - - - (5) (5)
revaluation
Balance as at 65 170 35 (2) 99 10 377
30-Jun-14
Notes:

A. Issue of bonus share results in increase in the common stock and additional paid-in capital
and decrease the retained earnings. Following journal entry is behind this adjustment:
Retained earnings (5,000,000 × 0.1 $20 million
× $40)
 Common stock (5,000,000 × 0.1 × $5 million
$10)
Additional paid-in capital $15
(20 - 5) millio
n
B. When new shares are issued, credit to common stock equals the product of number of shares
issued and the stated price of the share. The excess of cash received over the credit to common
stock account goes to additional paid-in capital. Following is the relevant journal entry:
Cash (1,000,000 × $45) $45 million
Common stock (1,000,000 × $10) $10 million
Additional paid-in capital $35
(45 - 10) millio
n
C. Net income increases retained earnings.
D. Since 10% of profit of the year is transferred to the capital reserve according to the relevant
laws, following journal entry is behind the adjustment:
Retained earnings ($50 × 0.1) $5
million
Capital reserve $5
millio
n
E. Cash dividends decrease the retained earnings.
F. Shares repurchased are accounted for by debiting the treasury stock account, which is a
contra-account to the shareholders’ equity. Following is the journal entry behind the adjustment:
Treasury stock (500,000 × 40) $2
million
Cash $2
millio
n
G. This adjustment is only required under IFRS. If a fixed asset is revalued upwards, it increased
the asset book value and also increases revaluation surplus, which is a shareholders’ equity
component. When the same asset is subsequently revalued down, the downward revaluation is
written off to the extent of any upward revaluation originally credit to revaluation surplus in
relation to that asset. In this particular case, the asset was revaluated up in earlier year such that
a credit of $7 million was made to revaluation surplus. Now, a downgrade revaluation by $5 million
can be written off completely against revaluation surplus and hence this decrease in revaluation
surplus.
 Journalizing Closing Entries for a Merchandising
Enterprise
At this point in the accounting cycle, we have prepared the financial statements.  Now
we do the last part, the closing entries.  The videos in the adjusting entry section gave
you a preview into this process but we will discuss it in more detail.

Accounting Cycle  

1.  Analyze Transactions 5.  Prepare Adjusting Journal Entries 9.  Prepare Closing Entries

2.  Prepare Journal Entries 6.  Post Adjusting Journal Entries 10.  Post Closing Entries

3.  Post journal Entries 7.  Prepare Adjusted Trial Balance 11. Prepare Post-Closing Trial Balance

4.  Prepare Unadjusted Trial Balance 8.  Prepare Financial Statements

The closing entries will be a review as the process for closing does not change for a
merchandising company.  Do you remember why we do closing entries?  They are the
journal entry version of the statement of retained earnings to ensure the balance we
report on the statement of retained earnings and the balance sheet matches the ending
balance of retained earnings in our general ledger.  Closing entries also set the
balances of all temporary accounts (revenues, expenses, dividends) to zero for the next
period.

If the process is the same, why do we need to review it?  We have many new accounts
learned for a merchandiser and we want to see how they fit into the closing process. 
The new accounts remaining for a merchandiser after adjusting entries are:

Account Account Type

Sales Revenue

Sales Discount*

Sales Returns and Allowances*

Cost of Goods Sold

Delivery Expense

Revenue accounts typically have normal credit balances (credit to increase, debit to
decrease) but Sales Discounts and Sales Returns and Allowances are contra-accounts
because they are revenue accounts but have normal debit balances (debit to increase,
credit to decrease).  Expenses have normal debit balances.

The four basic steps in the closing process are modified slightly:

 Closing the revenue accounts with credit balances—transferring the credit

balances in the revenue accounts to a clearing account called Income Summary.
 Closing the expense accounts and contra-revenue accounts—transferring
the debit balances in the expense accounts and contra-revenue accounts to a
clearing account called Income Summary.
 Closing the Income Summary account—transferring the balance of the
Income Summary account to the Retained Earnings account (this should always
equal net income or loss from the income statement).
 Closing the Dividends account—transferring the debit balance of the
Dividends account to the Retained Earnings account.

 To illustrate, let’s look at the adjusted trial balance from Hanlon from the previous
section:

Adjusted Trial Balance Debit

Retained Earnings 25,000

Dividends* 8,000

Sales Revenue

Sales discounts* 2,000

Sales returns and allowances* 1,000

Interest revenue

Cost of goods sold 159,000

Commissions expense 10,000

Advertising expense 7,000

Sales Salaries expense 20,000

Rent expense – sales 12,000

 Rent expense – office 12,000

Office Salaries expense 40,000

Utilities expense 5,000

Interest expense 50

*Contra-accounts

We will prepare the closing entries for Hanlon.  Remember to close means to make the
balance zero.  To do this, we will do the opposite of the balance in the adjusted trial
balance in a journal entry and use Income Summary to balance the entry.

1.  Close the revenue accounts with credit balances.  We have 2 revenue accounts
with a credit balance, Sales Revenue (or Sales) and Interest Revenue.

Account Debit

Sales Revenue 275,000

Interest Revenue 150

  Income Summary

To close revenue accounts with credit balances.

2.  Close contra-revenue accounts and expense accounts with debit balances. 
We will close sales discounts, sales returns and allowances, cost of goods sold, and all
other operating and nonoperating expenses.

Account   Debit

Income Summary   268,050

  Sales Discounts

  Sales Returns and Allowances

  Cost of Goods Sold

  Commissions Expense

  Advertising Expense
   Sales Salaries Expense

  Rent Expense – Sales

  Rent Expense – Office

  Office Salaries Expense

  Utilities Expense

  Interest Expense

To close contra-revenue and expense accounts.   

3.  Close income summary into retained earnings.  We will take the difference
between income summary in step 1 $275,150 and subtract the income summary
balance in step 2 $268,050 to get the adjustment amount of $7,100.  This should
always match net income calculated on the income statement.

Account   Debit 

Income Summary (275,150 – 268,050) 7,100

    Retained Earnings

To close net income into retained earnings.   

4.  Close the debit balance of dividends into retained earnings.  Remember,
dividends are earnings of the company given back to the owner and will reduce retained
earnings.  Retained earnings is an equity account and is decreased with a debit. 
Dividends is a contra-account because it is an equity account but has a normal debit
balance.  Do not use the retained earnings balance in this entry!

Account Debit

Retained Earnings 8,000

    Dividends

To close dividends into retained earnings.  

To check our work, the Statement of Retained Earnings would look like this:
 Hanlon Food Store 

Statement of Retained Earnings 

For Year Ended December 31 

Retained Earnings, January 1

Add: Net Income

Less: Dividends

Retained Earnings, December 31  

When we post the closing entries to the general ledger, the revenues, expenses and
dividends accounts are all zero.  The retained earnings ledger card would look like:

Account: Retained Earnings    Debit    Credit 

Beginning Balance

(3) Close income summary 7,100

(4) Close dividends 8,000

The final step in the merchandising accounting cycle would be to prepare a post-closing
trial balance.  The post closing trial balance will contain assets, liabilities, common stock
and the new ending balance calculated for retained earnings.