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Financial Statements and the Accounting Cycle
Business Essentials · Chapter 20: Accounting FundamentalsSection 20.5 · lesson 90 of 10512 min · free with a free account
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In this lesson
From a single transaction to 4 finished statements.
- Describe the accounting cycle, step by step
- Apply debits and credits in double-entry bookkeeping
- Explain what each of the 4 statements shows
- Read a set of statements, and see what they don't say
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Everything said in the video, section by section (1,673 words). Read along, or search it.
Accounting Fundamentals
Financial Statements and the Accounting Cycle
A design studio's profit rises every quarter. Its cash balance falls every quarter. Both numbers are accurate. This section shows how they fit together. It's educational content, and not accounting, tax, investment, or legal advice. Reading a real business's statements for a decision calls for professional guidance. We'll walk the accounting cycle, from one transaction to finished statements. We'll learn how debits and credits keep the books balanced. Then we'll take the four statements one at a time, and see how they connect. And we'll read a full set, including what it can't tell you.
The Accounting Cycle
8 Steps, Every Reporting Period
The accounting cycle is the sequence a business follows each period to turn transactions into statements. First, identify and analyze transactions. Which events have a financial effect worth recording, and what is it? Second, record each one in the journal, in order. That's the initial chronological record. Third, post each journal entry to the ledger, into the specific accounts it affects, like cash or revenue. Now each account's running balance can be seen. Fourth, prepare a trial balance, confirming total debits equal total credits before going further. Fifth, make adjusting entries, to meet accrual accounting's requirements. Sixth, an adjusted trial balance confirms the accounts still balance. Seventh, prepare the statements from those adjusted balances. And eighth, close the temporary accounts. Revenue and expense accounts track one period, so they reset to zero. Assets and liabilities carry forward.
Double-Entry Bookkeeping
Every Transaction Touches 2 Accounts
Double-entry bookkeeping means every transaction affects at least two accounts. That's what keeps the accounting equation in balance at all times. Each account has two sides. The debit is the left side, and the credit is the right. Don't think of them as plus and minus. Think about their effect on each type of account. For assets and expenses, a debit increases the balance, and a credit decreases it. For liabilities, equity, and revenue, it's the reverse. A credit increases, and a debit decreases. Here are four illustrative transactions. A customer pays five thousand dollars for services already provided. Debit cash, credit service revenue. Monthly rent of twelve hundred dollars is paid in cash. Debit rent expense, credit cash. Equipment worth eight thousand dollars is bought on credit. Debit equipment, credit accounts payable. The owner withdraws two thousand dollars for personal use. Debit owner's withdrawals, credit cash. In every case the two sides are equal, so the equation stays balanced.
Adjusting Entries
Events No Ordinary Transaction Captured
Adjusting entries exist because of accrual accounting. They record events that have happened, but that no ordinary cash transaction has captured yet. There are two kinds. Accruals record revenue earned, or expenses incurred, that aren't yet recorded. Think of interest earned on a deposit but not yet paid out. Or wages employees earned in the final days of a period, that won't be paid until the next one. Deferrals are the reverse. Cash has moved in advance. A customer pays ahead for a service not yet delivered. That's recorded first as a liability, and becomes revenue only as the service is performed. Depreciation is the adjustment people find least intuitive. It's the systematic allocation of a long-term asset's cost over its useful life. It's not an estimate of the asset's market value. And no cash leaves the business in that period. The cash went out, or was borrowed, when the asset was bought. Depreciation spreads that cost across the periods the asset helps earn revenue. That's the matching principle at work.
The Income Statement
Revenue to Net Income, Over a Period
The income statement reports revenues and expenses over a period, arriving at profit or loss. Revenue is what the business earns from its ordinary activities. Subtract cost of goods sold, the direct cost of producing or acquiring what was sold. That leaves gross profit. Subtract operating expenses, like rent, salaries, and marketing, and you reach operating income. That's the profit from core operations, before interest and taxes. Net income is the final profit, after every revenue and every expense. Two margins answer two different questions. Gross margin shows how efficiently the business produces or buys what it sells, relative to its prices. Operating margin shows how efficiently the whole core business runs, including all its operating costs. A business can have a strong gross margin and a weak operating margin, if its broader costs are high. So each margin points you toward a different part of the business to examine.
The Balance Sheet
A Snapshot at One Instant
The balance sheet reports what a business owns, owes, and is worth to its owners, at a single instant. It's the accounting equation, laid out directly. Current assets are expected to become cash, or be used, within about a year. Cash, amounts customers owe, and inventory are examples. Non-current assets, like equipment and buildings, provide value over a longer period. Liabilities split the same way. Current means due within about a year, and non-current means due later. Equity is the owners' residual claim. Now the single most important structural point. A balance sheet is a snapshot at an instant. It isn't a record of activity over a period, the way the income statement is. A balance sheet dated the last day of a quarter says nothing directly about what happened during it. It only tells you where things stood at the end.
The Statement Of Cash Flows
Actual Cash, In and Out
The statement of cash flows reports the actual movement of cash, in and out, over a period. It has three categories. Operating activities cover cash generated or used by the business's core operations. Investing activities cover cash spent on, or received from selling, long-term assets. Financing activities cover cash raised from, or repaid to, lenders and owners. That includes borrowing, repaying debt, and an owner's contributions or withdrawals. The statement typically begins by reconciling net income to operating cash flow. That reconciliation explains something that surprises many owners. A profitable business can run out of cash. Net income can be positive while operating cash is small, or even negative. That happens when receivables grow faster than payables, or when cash gets tied up in inventory.
Table 20.5.1
From Net Income to Operating Cash Flow
Here's a reconciliation for a described business, using illustrative figures. Net income is fifty-two thousand dollars. That's the accrual-based starting point. Add back eighteen thousand of depreciation. It was subtracted as an expense, but no cash left this period. Subtract fourteen thousand for the rise in what customers owe. That revenue was earned, but not collected. Add nine thousand for the rise in what's owed to suppliers. Those expenses haven't been paid out yet. Subtract six thousand for the rise in inventory. Cash was spent, but inventory isn't an expense. Add twelve thousand for accrued wages. They were expensed as earned, but not yet paid. The result is seventy-one thousand dollars of cash from operating activities. The source calls this the single most important idea in the chapter. Reported profit and operating cash flow will very rarely be the same number. And the gap between them is entirely explained by timing differences like these.
Equity And Notes
The Statement of Owners' Equity, and the Notes
The statement of owners' equity explains how equity changed over the period. It starts with the beginning balance, and adds the period's net income. Then it subtracts any withdrawals or distributions paid to owners. The result is the ending balance, which then appears on the balance sheet. So it links the income statement's bottom line to the balance sheet's equity figure. Then there are the notes, required under the full disclosure principle. They frequently matter more than the numbers themselves. The notes disclose the methods used, such as which inventory costing method was applied. They give the detail behind summarized lines, and contingencies, like pending legal matters. Read only the numbered statements, and you've read the headlines and skipped the story.
Figure 20.5.1
How the 4 Statements Connect
The four statements aren't independent documents. They connect in specific, traceable ways. Here they are for one described business, with illustrative figures. Net income of fifty-two thousand dollars flows from the income statement into the statement of owners' equity. Equity there grows from one hundred eighty thousand to two hundred twelve thousand dollars. That ending equity is the figure that appears on the balance sheet. And the statement of cash flows explains the change in the balance sheet's own cash balance. Operating activities alone brought in seventy-one thousand dollars. Knowing these links lets you answer questions no single statement can. Why did equity grow by less than net income? The withdrawal line in the equity statement answers that directly.
Reading The Statements
What They Reveal, and What They Don't
So what does this set of statements tell us? Three things, and there are two it doesn't. First, the business was profitable, with net income of fifty-two thousand dollars. Second, operating cash flow, at seventy-one thousand, exceeded net income. That suggests it collected from customers, and managed payables, in a way that supported cash generation. Third, equity grew from one hundred eighty thousand to two hundred twelve thousand, net of withdrawals. Now the limits. The statements don't show whether this profit is typical, or an unusual year. A single period says nothing about trend without comparison to other periods. And they don't show whether fifty-two thousand is strong or weak for a business of this size and industry. That takes comparative and ratio analysis, which the next chapter takes up.
Case Vignette
Growing Profit, Shrinking Cash
Camille owns a graphic design studio that's grown fast, adding several large corporate clients. Her income statement shows revenue and net income rising every quarter. By every measure on that one statement, the business looks like a clear success. Yet her cash balance keeps falling, and she can't see why. The statement of cash flows explains it. Her new corporate clients pay on much longer terms than her smaller clients did. So the amounts customers owe her have grown sharply. That cash is earned and counted, but not collected. Meanwhile she pays her subcontracted designers promptly, to keep them working for her. So her own payables haven't grown to offset the receivables. She may have little power to demand faster payment from clients much larger than her studio. Her conclusion is that she's more profitable than before, and also under real cash pressure. Those aren't contradictory facts. They're exactly the pattern the reconciliation explains. How to manage that gap, including financing and working capital, comes in the next chapter.
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Business Essentials (Business 100) is a self-paced online course of 105 video lessons in 24 chapters, from the business environment, economics and global markets to ownership, management, leadership, operations, people, marketing, accounting, finance and banking. It carries a NCCRS credit recommendation for 3 semester credits.
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