Making the financial statements

Once all journal entries are made and organized, a year-end balance for each account can be computed. This information is summarized in a trial balance, which is a listing of all the accounts and their balances. Hannah's end-of-year trial balance looks like this. Now, note that the total of the debit balance is $5.3 million, which is equal to the total of the credit balances. When manual accounting systems were predominant, the equality of the debits and credits in the trial balance was used to indicate whether the accounting process had been completed correctly. From a trial balance, we can easily prepare a balance sheet and an income statement. Each account, with its associated balance, is merely copied to the appropriate place in the appropriate financial statement. The trial balance contains every account in the books of a company. For large companies, a paper copy of the trial balance can involve thousands of pages. These thousands of pages are then summarized into a one-page balance sheet and a one-page income statement. Now, in constructing the financial statements, it works better if we start with the income statement. We do this by selecting all of the revenue and expense accounts. In identifying which items go in the income statement and which items go in the balance sheet, a useful tip to remember is that nothing appears in both the income statement and the balance sheet. Let's take cash as an example. Here's the rationale that some people sometimes use incorrectly. Cash is good, revenues are good, therefore cash should appear in the income statement as a revenue. No. Cash is an asset. Assets go in the balance sheet, and nothing appears in both the balance sheet and the income statement. Now, why is this true? Well, that's a discussion that is deep and interesting and not relevant for our discussion here. We are just trying to assemble the data. So just trust me, and remember, nothing appears in both the income statement and the balance sheet. Now, before we get excited about the balance sheet, we need to compute the ending retained earnings balance. The trial balance reports the beginning-of-the-year balance, which is zero because this is a first-year company. Also in this example, Hannah is not paying any dividends in this first year of business, so all the net income is being retained in the business. The retained earnings calculation is as follows, beginning retained earnings, plus net income, minus dividends, equals ending retained earnings. Now we are ready to identify the assets, liabilities, and equities that make up the balance sheet. Well, what about the statement of cash flows? Easy. We won't show it here, but we could just go back to the detailed journal entries, identify the items involving cash, and then sort those cash flows into operating, investing, and financing activities. Transaction analysis leads to a journal entry with which we record a company's business events chronologically as they occur. These data in the journal entries are then organized to update the balances in each of the individual accounts yielding the trial balance. And finally, the culmination of the accounting process is the production of the financial statements. And next, well, next is the best part. The analysis of those financial statements, but that is another story.