Income statement presents the results related to revenue and expense transactions for the current period. This is the 4th and major step in the accounting cycle. This step is also called the completing step of the accounting cycle. We will use a proprietorship business called Jackson’s Retail to illustrate the procedure of completing the accounting cycle.
The Accounting Cycle Process
Assume that the company had two transactions for December 2010.
Dec. 1: Collected and deposited $10,000 from cash sales
Dec. 2: Paid $5,000 for staff salaries
Step 1: Journals
Enter the transactions into the general journal. The first transaction can be recorded by debiting cash and crediting sales. The second transaction can be recorded by debiting salaries expense and crediting cash.
Step 2: General Ledger
Now transfer (post) the amounts to the general ledger from the general journal.
Step 3: Trial Balance
A trial balance is prepared to ensure that the total value of the debits equals the total value of the credits. (The ledgers have been repeated to make it easier to illustrate the cross-reference.)
The total value of the debits should equal the total value of the credits.
Continuing with our example for January, we will follow the sequence to complete a set of financial statements.
1. Complete the general journal
2. Post to the general ledger
3. Create a trial balance
Step 1: The Completed General Journal
Step 2: The Completed General Ledger
Step 3: Transfer of Totals from the General Ledger
The totals from the general ledger are transferred to the trial balance. Th e worksheet reflected in figure below facilitates the preparation of financial statements. The worksheet is essentially a trial balance with various columns: two for the original entries (unadjusted trial balance), four for adjustments and the adjusted trial balance, two for the income statement and two for the balance sheet.
Each of the above amounts has been transferred from the totals of the general ledger accounts to the trial balance. This process ensures that the total value of the debits equals the total value of the credits. Notice the sequence in which the accounts are listed.
Balance sheets categories:
Income statement categories:
Step 4: Adjustments
Most businesses must make some adjustments at the end of the accounting period – for example,
• depreciating assets
• recognizing prepaid expenses as an expense for the period
• adding bank charges that were not previously known
The additional journal entries need to be completed and then posted to the general ledger. The new totals are then transferred to the worksheet to ensure that the value of the debits equals the value of the credits.
Figure below reflects these examples:
1. The month’s bank statement indicates that the bank deducted bank charges amounting to $30 from the bank account. This fact was not previously known and had therefore not been recorded.
2. Prepaid insurance of $100 needs to be recorded as an expense for the current month.
Journalize the two adjusting entries as follows:
Step 5: General Ledger Postings
Step 6: Adjusted Trial Balance
Adjustment number 1 in figure below refers to the bank charges; number 2 refers to the prepaid expenses recognized as an expense and number 3 ensures that for each debit entry adjustment there is an equal credit entry. The adjustments are added to the original entry in a new column called the adjusted trial balance, which provides the new totals of all accounts. Once again, it is important to ensure that they all balance. Bear in mind that it is a difficult task to go back and find errors. Constant checking is necessary to ensure that all accounts remain in balance.
Th is trial balance does not yet indicate whether the business is operating with a profit or a loss. One further step is required to complete this process.
Step 7: Separation of Income Statement Items and Balance Sheet Items
In figure below, the income statement and balance sheet accounts are separated. Number 4, 5, 6, 7 and 10 refer to the balance sheet accounts. Number 8 and 9 refer to the income statement accounts. The difference between the revenue column (CR) and the expense column (DR) represents the net income or net loss. In this case, total revenue exceeds total expenses therefore Jackson’s Retail has made a net income. Th is net income is allocated to the owner’s equity (i.e. credit into the capital account). Number 11 shows that the balance sheet is in balance again after the allocation is made.
Step 8: Data Displayed in an Easy-to-Read Format
The trial balance is not laid out in a useful manner for the reader. It is therefore important to create a readable document in the form of an income statement, balance sheet and statement of owner’s equity. So far you have learned how to post the transactions from the general journal to the general ledger and to ensure that the total value of the debits equals the total value of the credits. All balance sheet totals are transferred to the balance sheet column and all income statement balances are transferred to the income statement column. Once they are separated, they will be out of balance (unless there is no profi t or loss). If revenue (credits) exceeds expenses (debits), a profi t will be entered and this will balance the worksheet. Similarly, if expenses exceed revenue, a loss will be entered, thereby
balancing the worksheet.
The reference numbers in figure below will explain how the account totals are presented.
Number 12 shows that the ending balance of the capital account equals the value of owner’s equity in a proprietorship business.
After reading this article you will be able to:
- Understand the use of debits and credits
- Record transactions in the general journal
- Post journal entries to the general ledger
- Prepare a trial balance
- Record adjustments at the end of an accounting period
- Prepare an adjusted trial balance
- Prepare financial statements using an adjusted trial balance
- Post Closing Trial Balance