P5: Financial Statements from Adjusted TB

🎯 Learning Objectives

Understand the purpose and structure of the adjusted trial balance
Identify which accounts appear on which financial statement
Explain the sequential preparation order of financial statements
Calculate net income from the income statement
Prepare the statement of retained earnings from net income data
Construct a complete balance sheet from adjusted trial balance data

📚 Background & Principles

The adjusted trial balance is the final stop before preparing financial statements. It contains all accounts with their updated balances after all adjusting entries have been recorded. From this trial balance, accountants systematically extract and organize data to create the three main financial statements.

Core Principle: Financial statements must be prepared in a specific order because they are interconnected. The income statement feeds into the statement of retained earnings, which in turn affects the balance sheet. This is called statement linkage.

💡 Key Insight: Think of the adjusted trial balance as the "official final scoreboard" before printing the team's season report. All the numbers are finalized and verified, ready to be presented in the proper format.

🔑 Key Concepts

Adjusted Trial Balance

A listing of all account balances after adjusting entries have been posted. Serves as the source for financial statement preparation.

Income Statement

Reports revenues and expenses for a period. Result is net income (or loss) which flows to retained earnings.

Statement of Retained Earnings

Shows changes in equity from net income and dividends. Beginning balance + Net Income - Dividends = Ending balance.

Balance Sheet

Reports assets, liabilities, and equity at a point in time. Must balance: Assets = Liabilities + Equity.

Statement Linkage

The flow of information from one statement to another. Net income flows from income statement to retained earnings.

Account Classification

Categorizing accounts as revenues, expenses, assets, liabilities, or equity determines which statement they appear on.

🔍 Deep Dive

Explore financial statement preparation at different levels of depth:

🟢 Foundational Level

Understanding the basic flow from trial balance to financial statements.

The Scoreboard Analogy

Analogy: The Final Score

Think of preparing financial statements like compiling a sports team's season report.

Unadjusted Trial Balance:

The raw game scores during the season—before any corrections or adjustments.

Adjusting Entries:

The referees reviewing plays and making corrections—adding penalty points or bonus scores.

Adjusted Trial Balance:

The Official Final Score. This is what we use to write the season report.

Which Statement? Basic Classification

Learn where each account type belongs:

Income Statement Accounts:

Revenues (Service Revenue, Sales) and Expenses (Salaries, Rent, Utilities)

Balance Sheet Accounts:

Assets (Cash, Accounts Receivable, Equipment), Liabilities (Accounts Payable, Loans), Equity (Common Stock, Retained Earnings)

🟡 Standard Level

Understanding statement linkage and proper preparation order.

The Preparation Order

Why Order Matters: Financial statements are interconnected. You must prepare them in sequence.

Step 1: Income Statement

List all revenues and expenses. Calculate: Net Income = Total Revenues - Total Expenses

Step 2: Statement of Retained Earnings

Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

Step 3: Balance Sheet

Assets = Liabilities + (Common Stock + Ending Retained Earnings)

Sample Data from Adjusted Trial Balance

Given adjusted trial balance excerpts:

Account	Debit	Credit
Service Revenue		$50,000
Salaries Expense	$20,000
Rent Expense	$5,000
Utilities Expense	$3,000
Retained Earnings (beg)		$10,000
Dividends	$4,000

Step 1 - Income Statement:

Revenues: $50,000 | Expenses: $28,000 | Net Income: $22,000

Step 2 - Retained Earnings:

$10,000 + $22,000 - $4,000 = $28,000 ending balance

🔴 Advanced Level

Complex statement linkages and verification techniques.

The Accounting Equation Check

Verifying Balance Sheet Accuracy: After preparing the balance sheet, always verify the accounting equation.

Total Assets:

Sum of all asset balances from adjusted trial balance (Cash + AR + Equipment + etc.)

Total Liabilities + Equity:

Sum of all liability balances + (Common Stock + Ending Retained Earnings)

The Check:

If Assets ≠ (Liabilities + Equity), there's an error in classification or calculation.

Handling Contra Accounts

Important: Contra accounts reduce their parent account:

Accumulated Depreciation:

Appears as a contra-asset (credit balance). Always subtracted from related asset on balance sheet.

Allowance for Doubtful Accounts:

Contra-asset reducing Accounts Receivable. Shows expected uncollectible amounts.

Sales Returns and Allowances:

Contra-revenue (debit). Subtracted from gross sales to get net sales.

🎨 Interactive: Statement Linkage Simulator

See how numbers flow from one statement to another:

Service Revenue ($)

Salaries Expense ($)

Rent Expense ($)

Utilities Expense ($)

Beginning Retained Earnings ($)

Dividends ($)

Net Income

$33,000

Ending Retained Earnings

$43,000

Total Expenses

$42,000

🚫 Common Misconceptions & Professional Tips

❌ Misconception 1: "You can prepare any financial statement in any order."

✅ Reality: Statements must be prepared in order: Income Statement → Statement of Retained Earnings → Balance Sheet. Skipping steps or changing order will result in incorrect figures because statements are interconnected.

❌ Misconception 2: "Net income is reported directly on the balance sheet."

✅ Reality: Net income does NOT appear directly on the balance sheet. It first goes to retained earnings (via the statement of retained earnings), which then appears on the balance sheet as part of equity.

❌ Misconception 3: "All debit balances go on the income statement."

✅ Reality: Not all debits are expenses! Asset accounts (Cash, Accounts Receivable, Equipment) have debit balances but appear on the balance sheet, not the income statement.

💡 Professional Tip #1: Always cross-check your work. After preparing the balance sheet, verify that Assets = Liabilities + Equity. If they don't balance, review your classifications and calculations.

💡 Professional Tip #2: Use the adjusted trial balance as a checklist. Ensure every account is properly classified before transferring numbers to financial statements.

💡 Professional Tip #3: Watch for contra accounts (Accumulated Depreciation, Allowance for Doubtful Accounts). They have opposite normal balances and must be classified correctly.

🧠 Memory Aids & Quick Reference

⚡ Quick Recall: Statement Preparation Order

Income → Retained Earnings → Balance Sheet

Revenue − Expense = Net Income → Add to Beginning RE − Dividends = Ending RE → Flow to Balance Sheet

📊 Income Statement

Revenues (credits) − Expenses (debits) = Net Income. Use only temporary accounts.

📋 Retained Earnings

Beginning + Net Income − Dividends = Ending. Bridge between income statement and balance sheet.

📈 Balance Sheet

Assets (debits) = Liabilities (credits) + Equity (credits). Permanent accounts only.

🔗 Statement Linkage

Net Income flows to RE, RE flows to Balance Sheet. Never skip the chain!

📖 Glossary

Adjusted Trial Balance

A list of all account balances after adjusting entries have been posted, used to prepare financial statements.

Income Statement

Financial statement showing revenues and expenses for a period, resulting in net income or loss.

Statement of Retained Earnings

Financial statement showing changes in retained earnings from net income and dividends over a period.

Balance Sheet

Financial statement showing assets, liabilities, and equity at a specific point in time.

Net Income

Revenue minus expenses. If positive, increases retained earnings; if negative, decreases retained earnings.

Contra Account

An account with a balance opposite to its related account. Examples: Accumulated Depreciation, Sales Returns.

Temporary Accounts

Revenue and expense accounts that are closed at period-end. Appear only on income statement.

Permanent Accounts

Asset, liability, and equity accounts that are NOT closed at period-end. Appear on balance sheet.

Financial Statements from Adjusted Trial Balance