Preparation of financial statements

Once the adjusting entries have been made or entered into a worksheet, the financial statements can be prepared using information from the ledger accounts. Because some of the financial statements use data from the other statements, the following is a logical order for their preparation:

  • Income statement
  • Statement of retained earnings
  • Balance sheet
  • Cash flow statement

Income Statement

The income statement reports revenues, expenses, and the resulting net income. It is prepared by transferring the following ledger account balances, taking into account any adjusting entries that have been or will be made:

  • Revenue
  • Expenses
  • Capital gains or losses

Statement of Retained Earnings

The retained earnings statement shows the retained earnings at the beginning and end of the accounting period. It is prepared using the following information:

  • Beginning retained earnings, obtained from the previous statement of retained earnings.
  • Net income, obtained from the income statement
  • Dividends paid during the accounting period

Balance Sheet

The balance sheet reports the assets, liabilities, and shareholder equity of the company. It is constructed using the following information:

  • Balances of all asset accounts such cash, accounts receivable, etc.
  • Balances of all liability accounts such as accounts payable, notes, etc.
  • Capital stock balance
  • Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement

The cash flow statement explains the reasons for changes in the cash balance, showing sources and uses of cash in the operating, financing, and investing activities of the firm. Because the cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account balances of an accrual accounting system. Rather, it is derived by converting the accrual information to a cash-basis using one of the following two methods:

  • Direct method: cash flow information is derived by directly subtracting cash disbursements from cash receipts.

  • Indirect method: cash flow information is derived by adding or subtracting non-cash items from net income.