- 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.