As explained in Chapter 3, the income statement, statement of owner’s equity, and balance sheet can be prepared directly [rom the amounts listed in the adjusted trial balance. (For illustrative purposes, we !1<.VC made marginal notes beside the adjusted trial balance
indicating which accounts appear in which financial statements.) Overnight’s financial statements for the year ended December 31,2002, are illustrated on the following page. The income statement is prepared first because the amount of net income appears in the statement of owner’s equity. The statement of owner’s equity, in turn, determines the amount of owner’s capital appearing in the balance sheet. Note that we have not included Overnight’s statement of cash flows with the other three reports. An in-depth discussion of the statement of cash flows is presented
Note 1: Depreciation policies ..
Depreciation expense in the financial statements is computed by the straight-line method. Estinnncd useful lives are 20 years for the building and 5 years for tools and equipment,
Note 2: Maturity dates of liabilities .’
The Company’s notes payable consist of II single obligation that matures 011 February 28 of the coming year. The maturity value of this note, inctuding interest charges, will amount to $40,900.
What Types of Information Must Be Disclosed?
There is no comprehensive list of the information that should be disclosed in financial statements. The adequacy of disclosure is based on a combination of official rules, tradition. and accountants’ professional judgment. .
As a general rule. a company should disclose any facts that an intelligent person would consider necessary for the statements to be interpreted properly. In addition to accounting methods in use and the due dates of major liabilities, businesses may need to dis dose such matters as the following
• Lawsuits pending against the business
• Scheduled plant closings
• .Governmental investigations into the safety of the company’s products or the legality of its pricing policies
• Significant events occurring after the balance sheet date but before the financial statements are actually issued
• Specific customers that account for a large portion of the company’s business
• Unusual transactions or conflicts of interest between the company and its key officers
Closing the Accounts
Accountants sometimes use the phrase “closing the accounts” to describe all of the year end procedures. But technically, closing the accounts refers only to one specific step in the accounting cycle. This step consists of closing (or transferring) the balances of all . revenue, expense, and drawing accounts into the owner’s capital account. .
Closing accounts is not at all difficult-balances are simply transferred from one account to another. In a computer-based system, this is done with the touch’ of a button. Overnight, however, has .a manual accounting system. The entries to close its revenue and expense accounts, as well as the owner’s drawing account. at December 31. 2002, are illustrated below
After these entries are posted, the revenue. expense, and drawing accounts will have zero balances and will be ready for use in measuring the activities of the coming year.
As the final step in its accounting cycle, Overnight will prepare an after-closing trial balance;
In 2002, Overnight earned net income of just over $50,600. The owner of a small business often evaluates the company’s net income in light of his or her alternative financial opportunities
Notice also the $2,000 in revenue earned in December by renting storage space to Harbor Cab. There probably are few additional expenses associated with this revenue. Thus this agreement alone may increase Overnight’s net income by $20,000 or more in the coming year. In addition, if Harbor stores its cabs in Overnight’s garage, Overnight becomes the likely candidate for performing any necessary maintenance and repairs.
The operating results over the next couple of years are likely to “tell the story.” If Overnight’s profits fall-or even remain at current levels-McBryan probably will not consider the business a success. But if the business grows, it could soon provide him with an income far above what he might earn in a salaried position. This is why investors-and business owners-consider the trend in profitability more important than the results of a given year
Solvency, at least in the short term, may be independent of profitability. And in the short term, Overnight has potential cash flow problems. In the very near future, Overnight may be confronted with the need to make two major cash expenditures, Notice that the company’s insurance policy expires at the end of January. Based on last year, this could require about an $18,000 cash outlay, due around February I. Next, Overnight’s ‘$40,000 note payable comes due at the end of February. Together, these cash outlays could amount to nearly $60,OOO-an amount well in excess of the company’s liquid assets (cash and receivables).
Overnight probably can handle the cost of a new insurance policy, but not repayment , of the note. If the’ bank will not renew this loan. McBryan may be forced to close Overnight’s doors and liquidate its assets. Thus Mcbryan’s business appears to be at the mercy of the bank
McBryan probably can solve his cash flow, problem if he is able to replace the short-term notes payable, which’ frequently require,refinancing, with a long-term mortgage loan (which would lower his monthly payments by stretching out the term of the’ loan). In our opinion. this should be among his top business priorities .
Focusing Management’s Attention
One of the primary uses of accounting information is in directing management’s attention to problems and opportunities. We have mentioned the opportunity inherent in the new rental agreement with Harbor Cab. Management also should review the income statement to determine whether any expenses appear to be excessive.
Preparing Financial Statements Covering Different Periods of Time
Many businesses prepare financial statements every quarter, as well as at year-end. In addition, they may prepare financial statements covering other time periods. such as one month or the year-to-date.
THE WORK SHEET
A worksheet illustrates. in one place the relationships between the unadjusted trial balance. proposed. adjusting entries. and the financial statements. A worksheet is prepared at the end of.the period. but before the adjusting entries are formally recorded in the accounting records. IUs not a formal step in the accounting cycle. Rather. it is the “scratch’ pad” on which accountants work out the details of the proposed end-of-period adjustments.
It also provides them with a preview of how the financial statements will look. A worksheet for Overnight Auto Service at December 31. 2002. is illustrated on the .following page
Isn’t This Really a “Spreadsheet”?
Yes: The term “worksheet” is a holdover from the days when these schedules were prepared manually on large sheets of columnar paper. Today. most worksheets arc prepared on a computer using spreadsheet software. such as Lotus 1-2-3T’!.f or, Exc~/TM.,or with general ledger software such as Peachtree or Dac-Easy+
What’s It Used For?
A worksheet serves several purposes. It allows accountants to see the effects or adjusting entries without actually entering these adjustments in the accounting records. This makes it relatively easy for them to correct errors or make changes in estimated amounts . It also enables accountants and management to preview the financial statements before the final drafts are developed. Once the worksheet is complete. it serves as the source for recording adjusting and closing entries in the accounting records and for preparing financial statements.
Another important use of the worksheet is in the preparation or interimfinancial statements. Interim statements arc financial statements developed at various points the fiscal year. Most companies close their accounts only once each year, Yet they often need to develop quarterly or monthly financial statements. Through the use of a worksheet. they can develop these interim statements without having to formally adjust and close their accounts:
to add a few more accounts duririg the adjusting process: Additional income statement accounts can be added on the lines below the trial balance totals.)
2. Enter the adjustments in the Adjustments columns. The next step is the most important: Enter the appropriate end-of-period adjustments in the Adjustments columns. In our illustration, these adjustments appear in red. Notice that each adjustment includes both debit and credit entries, whichare linked together by the small key letters appearing to the left of the dollar amount. Thus, ad’: justing entry’ a consists of a $600 debit to Insurance Expense and, a $600 credit to Unexpired Insurance. Because the individual adju~ting entries include equal debit and credit amounts, the totals of the debit and credit Adjustment columns should be equal. Sometimes the adjustments require adding accounts to the original trial balance. (The three ledger account titles printed in red were added during the adjusting process.)
3. Prepare em adjusted trial balance. Next, an adjusted trial balance is prepared. The balances in the original trial balance (blue) are,adjusted for the deblt.or credit amounts in the Adjustments columns (red). This process of horizontal addition or subtraction is called cross-footing. The adjusted trial balance is totaled to determine that the accounts remain in balance. At this point, the worksheet is almost complete. We have emphasized that financial statements are prepared directly from the adjus’~d -‘1’./al balance. Thus we have only to arrange these accounts into the format of financial statement . For this rea- . son, we show the ‘adjusted trial balance amounufn blue-both in the Adjusted Trial Balance columns and when these amounts are exiended (carried forward) into the financial statement columns.
4, Extend the adjusted ‘trial balance amounts lnta the appropriate flnanclal statement columns. The balance sheet accounts-assets, liabilities, and owner’s equity-‘::nre extended into the Balance Sheet columns; income statement amounts, .into the Income Statement columns. (The “Balance Sheet” and “Income Statement” captions in the original trial balance should simplify this procedure. Notice ‘each amount is extended to only one column. Also, the account ‘retains the same debit or credit balance as shown in the adjusted trial balance.)
5. Total the financial statement columns,’ determine and record net income or net loss. The final step in preparing the worksheet consists of totaling the income Statement and Balance Sheet columns and then bringing each set of columns into balance. These rasks are performed on the bottom three lines of the worksheet. In our illustration, the a-mounts involved in this final step are shown in black.
computers Do the “Pencll Pushing”
When a worksheet is prepared by computer, accountants perform only one of the steps listed above-entering the adjustments. The computer automatically lists the ledger accounts in the form of a trial balance. After the a.ccountant has entered the adjustments, it automatically computes the. adJllsted account balances and completes the worksheet. (Once the adjusted balances are determined, completing the worksheet involves nothing more than putting these amounts In the appropriate column and determining the column totals.)
A Special Application of Worksheet Software
We have discussed a relatively simple application of the worksheet concept-illustrating the effects of proposed adjusting entries on account balances. But the same concept can be applied to propose dfitture transactions. The effects of the proposeft transactions simply are entered in the “Adjustments” columns. Thus, without-disrupting the accounting records, accountants can prepare schedules showing how the company’s financial statements might be affected by such events as a merger with another company, a 15% in- . crea e in sales volume, or the closure of a plant.
There is a tendency to view worksheets as mechanical and old fashlone~. This ‘Is not Ilt all the case. Today, the mechanical aspects are handled entirely by computer ..The real purpose of a worksheet is to show quickly and efficiently how specific events or transactions. will affect the financial statements. This Isn’t bookkeeping-it’s planning