Preparing Financial Statements: A Simple Worked Example
Preparing financial statements starts with an adjusted trial balance. First, use revenues and expenses to prepare the income statement. Next, carry net income into the retained earnings statement. Then carry ending retained earnings into the balance sheet. The statement of cash flows is usually prepared last, using the income statement, comparative balance sheets, and supporting transaction details. This sequence keeps the statements connected and prevents using an outdated equity balance.
This lesson follows a simple corporation through the first three reports, then shows where the statement of cash flows fits. A complete set of financial statements also includes notes, which explain the numbers in more detail.
Video: how to prepare financial statements
Prefer to watch first? In this segment (2:35 to 10:48), Professor Farhat walks through preparing financial statements in order, starting from the adjusted trial balance. Then follow Cedar Studio’s numbers below.
What is the correct order for preparing financial statements?
Financial statements are formal reports that summarize a company’s results for a period and its financial position on a specific date. The usual preparation sequence follows the connections among the reports: net income feeds into retained earnings, ending retained earnings feeds into the balance sheet, and the statement of cash flows draws on several statements and supporting records.
An adjusted trial balance is the list of ledger balances after adjusting entries have been recorded and posted. Adjustments put items such as used supplies, earned revenue, and accrued wages into the appropriate period. Start with those updated balances, not the unadjusted list. If you want to see how the original transactions reached the ledger, start with accounting transaction analysis.
| Report | Information used | Result passed forward |
|---|---|---|
| Income statement | Revenue and expense balances | Net income or net loss |
| Retained earnings statement | Beginning retained earnings, net income or loss, dividends | Ending retained earnings |
| Balance sheet | Assets, liabilities, common stock, ending retained earnings | Assets = liabilities + equity |
The income statement and retained earnings statement cover a period. The balance sheet describes a particular date. The U.S. Securities and Exchange Commission’s guide to financial statements explains this distinction and the relationship among the reports. Knowing the sequence matters because one incorrect amount can affect several statements.
Each statement also needs a three-line heading: the company name, the statement name, and the date or period it covers. For example, Cedar’s income statement reads “For the Year Ended December 31, 20X7,” while its balance sheet reads “December 31, 20X7.”
Preparing Financial Statements: Put the Steps in Order
Practice the sequence used in this introductory lesson: start with adjusted balances, calculate net income, update retained earnings, and prepare the balance sheet. This exercise focuses on these three connected statements; it does not cover the complete financial reporting package.
What is the correct sequence for preparing these three financial statements? Choose an action for each step, using each action once. Then select Check answers.
Review the explanation
Preparing financial statements begins with an adjusted trial balance. Use revenues and expenses to prepare the income statement, carry net income into the retained earnings statement, and carry ending retained earnings into the balance sheet. This sequence keeps the statements connected and prevents using an outdated equity balance.
Original example: Cedar Studio’s adjusted trial balance
Hypothetical example. Cedar Studio Inc. provides design services. Its adjusted trial balance on December 31, 20X7 appears below. Assume this is a simplified teaching case with no income taxes or other transactions. The $8,000 retained earnings balance is the beginning balance because the current year has not yet been closed.
| Account | Debit | Credit |
|---|---|---|
| Cash | $24,000 | — |
| Accounts receivable | 12,000 | — |
| Supplies | 1,000 | — |
| Prepaid insurance | 3,000 | — |
| Equipment | 30,000 | — |
| Accumulated depreciation—equipment | — | $6,000 |
| Accounts payable | — | 7,000 |
| Salaries payable | — | 2,000 |
| Unearned service revenue | — | 5,000 |
| Common stock | — | 30,000 |
| Retained earnings, before closing | — | 8,000 |
| Dividends | 2,000 | — |
| Service revenue | — | 40,000 |
| Salaries expense | 16,000 | — |
| Rent expense | 6,000 | — |
| Insurance expense | 1,000 | — |
| Supplies expense | 2,000 | — |
| Depreciation expense | 1,000 | — |
| Total | $98,000 | $98,000 |
Equal debit and credit totals are a useful arithmetic check, but they do not establish that every account is correct. For example, an omitted adjustment can leave the totals equal. See the comparison of adjusted and post-closing trial balances for a fuller explanation.
Prepare the three connected statements
1. Income statement: calculate net income
Cedar Studio Inc.’s income statement is headed “For the Year Ended December 31, 20X7.” List service revenue and the five expense accounts. Supplies and equipment themselves are assets, so do not deduct their full balances as expenses.
| Income statement item | Amount |
|---|---|
| Service revenue | $40,000 |
| Salaries expense | (16,000) |
| Rent expense | (6,000) |
| Insurance expense | (1,000) |
| Supplies expense | (2,000) |
| Depreciation expense | (1,000) |
| Total expenses | (26,000) |
| Net income | $14,000 |
Dividends do not reduce net income. They distribute earnings to shareholders; they are not a cost of earning service revenue. For additional presentation background, use the income statement guide.
2. Retained earnings statement: update accumulated earnings
Use the same period heading. In this simplified case, ending retained earnings equals beginning retained earnings plus net income minus dividends.
| Retained earnings item | Amount |
|---|---|
| Beginning retained earnings | $8,000 |
| Add: net income | 14,000 |
| Less: dividends | (2,000) |
| Ending retained earnings | $20,000 |
The $20,000 is an equity balance, not the cash available for dividends. Cedar’s cash is $24,000. Also, preparing this statement does not itself post the closing entries to the ledger.
3. Balance sheet: use ending retained earnings
Head the balance sheet “December 31, 20X7.” Accumulated depreciation is a contra asset, meaning an account that reduces a related asset. It lowers equipment’s carrying amount, which is cost minus accumulated depreciation ($30,000 − $6,000 = $24,000 for Cedar). It is neither a liability nor an additional current-year expense.
| Balance sheet item | Amount |
|---|---|
| Assets | |
| Cash | $24,000 |
| Accounts receivable | 12,000 |
| Supplies | 1,000 |
| Prepaid insurance | 3,000 |
| Equipment, $30,000 less $6,000 accumulated depreciation | 24,000 |
| Total assets | $64,000 |
| Liabilities | |
| Accounts payable | $7,000 |
| Salaries payable | 2,000 |
| Unearned service revenue | 5,000 |
| Total liabilities | $14,000 |
| Stockholders’ equity | |
| Common stock | $30,000 |
| Retained earnings | 20,000 |
| Total stockholders’ equity | $50,000 |
| Total liabilities and stockholders’ equity | $64,000 |
The check is $64,000 = $14,000 + $50,000. Unearned service revenue remains a liability until the service is performed. To study current and noncurrent presentation separately, read classified financial statements. For a line-by-line guide to reading a balance sheet, see balance sheet explained.
Where does the statement of cash flows fit?
The statement of cash flows is usually prepared last. It explains why cash changed during the period by sorting cash receipts and payments into three groups: operating, investing, and financing activities.
The income statement and comparative balance sheets are starting points. Supporting transaction details are also needed to distinguish cash receipts and payments from noncash changes and identify investing and financing transactions. Cedar Studio’s example provides only one balance sheet date and does not include the supporting cash-flow data, so we stop at the three connected statements here. When you are ready for the fourth statement, read the statement of cash flows guide, which walks through the three sections with an example.
Common mistakes when preparing financial statements
Using $8,000 on the balance sheet. That is the pre-closing retained earnings balance. The statement needs the calculated ending balance of $20,000.
Subtracting dividends twice. Dividends reduce retained earnings once. Do not also deduct them in calculating net income.
Mixing expense and asset accounts. Insurance expense is $1,000; prepaid insurance is $3,000. Depreciation expense is $1,000; accumulated depreciation is $6,000. The expense is this year’s cost on the income statement. Prepaid insurance is coverage not yet used, and accumulated depreciation is all depreciation recorded on the equipment so far. Both belong on the balance sheet.
Closing too early. Prepare and retain the financial statements from the adjusted balances. Then record the closing entries that reset temporary accounts. Temporary accounts are revenues, expenses, and dividends, which start each new year at zero.
Three practice questions with explained answers
1. What is Cedar’s net income?
Answer: $14,000. Service revenue of $40,000 less total expenses of $26,000 gives the year’s profit. The $2,000 dividend does not enter this calculation.
2. Suppose beginning retained earnings is $9,000, net loss is $3,000, and dividends are $1,000. What is ending retained earnings?
Answer: $5,000. A loss reduces retained earnings: $9,000 − $3,000 − $1,000 = $5,000.
3. Which Cedar balances belong in the asset section: supplies, supplies expense, or accumulated depreciation?
Answer: Supplies is an asset. Accumulated depreciation is shown as a deduction from equipment. Supplies expense belongs on the income statement.
Key takeaways
- Start from the adjusted trial balance, never the unadjusted one.
- Income statement first: revenues minus expenses gives net income ($14,000 for Cedar).
- Retained earnings statement second: beginning balance plus net income minus dividends ($8,000 + $14,000 − $2,000 = $20,000).
- Balance sheet third: use ending retained earnings, then check that assets equal liabilities plus equity ($64,000 = $14,000 + $50,000).
- Dividends reduce retained earnings, not net income.
- Prepare the statements before you record closing entries.
Frequently asked questions
Can an income statement be prepared from the post-closing trial balance?
Not from that list alone. Revenue and expense accounts have already been reset to zero. Use the adjusted trial balance or the retained pre-closing records.
Why does net income appear in more than one place?
It is calculated on the income statement and then carried into the retained earnings reconciliation. That transfer connects the statements; it does not record revenue a second time.
Is a retained earnings statement the same as a statement of stockholders’ equity?
No. The retained earnings statement explains one equity component. A statement of stockholders’ equity also explains changes in other components, such as common stock.
What are the four financial statements, in order?
Most accounting courses prepare them in this order: income statement, retained earnings statement (or the broader statement of stockholders’ equity), balance sheet, and statement of cash flows. Net income flows into retained earnings, and ending retained earnings flows into the balance sheet. The statement of cash flows draws on the income statement, comparative balance sheets, and supporting transaction details. Notes to the financial statements accompany the full set.
What happens after the financial statements are prepared?
You record closing entries, which move revenue, expense, and dividend balances into retained earnings and reset those accounts to zero. Then you prepare a post-closing trial balance to confirm that only permanent accounts (assets, liabilities, and equity) still have balances.
What changes for a sole proprietorship?
A sole proprietorship has no retained earnings or common stock. Instead, it prepares a statement of owner’s equity: beginning capital, plus owner investments, plus net income, minus owner withdrawals, equals ending capital. Ending capital then goes on the balance sheet.
About the author
Mansour Farhat, CPA, CIA, DBA, teaches the accounting and CPA exam courses at Farhat Lectures and explains topics like this one on the Farhat Lectures YouTube channel. Read more about Professor Farhat.
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