Accounting Relationship: Linking the Income Statement

and Balance Sheet

When communicating financial information to readers of the information,
standard formats for financial statements have been

established.

The two most widely used statements are

the Balance Sheet and Income Statement. Here we will learn how the
Income Statement and Balance Sheet relate.
THE INCOME STATEMENT AND BALANCE SHEET
Income Statement
The income statement communicates the inflows and outflows of assets,
where inflows are the revenues generated and outflows are the expenses. An
excess of inflows over outflows is called net income, and an excess of
outflows over inflows is called a net loss.
The income statement can be expressed as an equation:
Revenue Expenses = Net Income (Loss)
The income statement is a summary of the sources of revenues and
expenses that result in a profit or a loss for a specified accounting
period. Typically that period is one year but it can be a month or a quarter as
well. Income statements are always prepared for a period of time and the
term for the period ended is included in the title.

Revenue: The sources of revenue for any business depend on the type of
business being operated. A company that manufactures or resells a product
would generate sales revenue. A service company on the other hand might
generate fees revenue or service revenue.
Expense: Examples of typical expenses encountered are salaries, utilities,
rent, insurance, and office supplies. Here again, each entity will have its own
unique set of expenses depending on the type of business being operated.
Net Income (Loss): The difference between revenues and expenses is
expressed as a positive or negative depending on whether revenues were
greater or less than expenses.
If revenues for the month are $5000 and expenses are $3500, then the
entity has a net income of $1500. If the expenses were instead $5500, then
the entity would have a net loss of $500.
Balance Sheet
The balance sheet communicates what the entity owns in terms of assets,
what it owes in terms of liabilities, and the difference between those two
which represents what the owners of the company are entitled to. The
owners portion is called equity.
The balance sheet can be expressed as the fundamental accounting
equation:
Assets = Liabilities + Equity
The balance sheet shows a snapshot of an organizations assets, liabilities,
and equity at one point in time and it demonstrates the accounting
equation. Balance sheets are always prepared for a point in time and the
term as at is included in the title.

Assets: The assets of a company represent the resources owned by the

company. These assets can be in the form of cash or things that can be
converted to cash like accounts receivable and they can also be fixed assets
like cars and office equipment.
Liabilities: What a company owes to creditors is reported in the liabilities
section of the balance sheet. Creditors are banks and other lending
institutions as well as suppliers that are owed money in the form of accounts
receivable as well as money that is owed but not yet paid (accruals). A
common example of an accrued liability is yearly taxes.
Equity: The difference between what the entity owns and what it owes
represents the owners share of the company. For sole proprietorships this
equity is usually called capital and for public companies it is often referred to
as common stock or share capital. The equity in a company is the owners
claim against the assets owned.
The income statement and balance sheet of a company are linked through
the net income for a period and the subsequent increase, or decrease, in
equity that results. The income that an entity earns over a period of time is
transcribed to the equity portion of the balance sheet. The income
represents an increase in the owners claim against the assets: Income is
NOT a cash asset. It is through the income and equity accounts that the
balance sheet and income statement reflect the total financial picture of the
entity.
Statement Example:

Accounting Trial Balance Example and Financial

Statement Preparation
The last two steps in the accounting process are preparing a trial balance
and then preparing the balance sheet and income statement. This
information is provided in order to communicate the financial position of the
entity to interested parties.
TRIAL BALANCE

A trial balance is a list and total of all the debit and credit accounts for an
entity for a given period usually a month. The format of the trial balance is
a two-column schedule with all the debit balances listed in one column and
all the credit balances listed in the other. The trial balance is prepared after
all the transactions for the period have been journalized and posted to the
General Ledger.
Key to preparing a trial balance is making sure that all the account balances
are listed under the correct column. The appropriate columns are as follows:
Assets = Debit balance
Liabilities = Credit balance
Expenses = Debit Balance
Equity = Credit balance
Revenue = Credit balance
Should an account have a negative balance, it is represented as a negative
number in the appropriate column. For example, if the company is $500 into
the overdraft in the checking account the balance would be entered as -$500
or ($500) in the debit column. The $500 negative balance is NOT listed in the
credit column.

Example Trial Balance:

The trial balance ensures that the debits equal the credits. It is important to
note that just because the trial balance balances, does not mean that the
accounts are correct or that mistakes did not occur. There might have been
transactions missed or items entered in the wrong account for example
increasing the wrong asset account when a purchase is made or the wrong
expense account when a payment is made. Another potential error is that a
transaction was entered twice. Nevertheless, once the trial balance is
prepared and the debits and credits balance, the next step is to prepare the
financial statements.
Income Statement
The income statement is prepared using the revenue and expense accounts
from the trial balance. If an income statement is prepared before an entitys
year-end or before adjusting entries (discussed in future lessons) it is called
an interim income statement. The income statement needs to be prepared
before the balance sheet because the net income amount is needed in order
to fill-out the equity section of the balance sheet. The net income relates to
the increase (or in the case of a net loss, the decrease) in owners equity.

Now that the net income for the period has been calculated, the balance
sheet can be prepared using the asset and liability accounts and by including
the net income with the other equity accounts.

When preparing balance sheets there are two formats you can use. The
format above is called the Report form and the Account form lists assets on
the left side and liabilities and equity on the right side.

For a teaching lesson plan for this lesson see:

Trial Balance and Financial Statement Preparation Lesson Plan

Accrual Accounting and Adjusting Entries

Businesses go through a series of financial transactions that occur on a
continuous basis within an accounting period. This sequence of transactions
is referred to as an operating cycle and it goes like this:

1.

At the beginning of the period, the entity has a certain

amount of cash

2. This cash is used to purchase supplies and pay for expenses

3. Revenue is earned that either results in a cash transaction or an account
receivable
4. Finally, cash is collected on accounts receivable

Revenue Recognition and the Matching Principle

Due to the continuous nature of these events, figuring out the exact balance
in any account affected by the operating cycle for a specific period is
challenging. It would be nice if all the accounts receivable generated in a
month were also collected within that month, but that is not realistic. Neither
is buying just enough supplies to generate revenue for a specific month. This
is the basis of accrual accounting not every transaction can be completely
accounted for within the period the transaction occurs.

There will always be some overlap in the accounts related to the operating
cycle. These overlaps occur in two main categories of transactions:
1.

Recording revenue: transactions involving revenue generation and

identifying at what point the revenue is earned

2.

Recording expenses: transactions involving payments and expenses

incurred to generate those revenues.

The GAAP principles that explain why these types of transactions are not
straightforward nor are they easily accounted for include the Revenue
Recognition principle and the Matching principle
Recording Revenue
Revenue recognition establishes the point at which revenue is actually
earned it is not necessarily earned when cash changes hands. GAAP says
that revenue is earned when the service is completed or the goods are sold.
In practice, this means that revenue is recognized when an invoice has been
sent. The accounting issue that arises from this convenience is how to record
revenue when an advance payment or deposit is received.
In this situation, the money is received but the revenue has not been
earned. If the service is expected to be complete by the end of the
accounting period then the receipt is recorded as revenue.
Example:
On July 1, Pauls Computing receives a $250 advance payment for a network
installation project expected to be complete by the end of the month.
Journal Entry:
DR Cash

$250

CR Revenue

$250

In the case where money is received for services that are NOT expected to
be complete before the end of the accounting period, the receipt is recorded
as a liability. The liability account involved is titled Unearned Revenue.
Example:
On July 1, Pauls Computing enters into a 6-month network service contract
totaling $2400 and receives an $800 advance payment.
Journal Entry:
DR Cash $800
CR Unearned Revenue $800
Recording Cost Outlays and Expenses
When a company purchases something (on account or with cash), that item
can be recorded as either an Asset or an Expense. Some of these are
obvious: the purchase of a truck is an Asset and the payment of the utility
bill is an expense, however, others are a mixture of the two. Consider the
purchase of office supplies. They can be considered an asset or an expense.
The asset portion is the amount of supplies left after the accounting period
and the expense portion is the amount used up during the accounting period.
Items like insurance, rent or taxes are considered assets because they are
pre-paid and thus their usefulness has not been used up yet. The rule is as
follows:

If the cost is used to purchase something that will help to produce revenue in
future accounting periods it is an Asset.

If the cost is used to purchase something that will be used up in the current
accounting period it is an Expense.

Example:
On February 1, Phils Photography purchases a one-year insurance policy for
$1200.

That purchase would be considered an Asset purchase. The insurance policy

will be used up over the course of the year but at the time of purchase, that
$1200 represents an asset of the company.
Journal Entry:
DR Prepaid-Insurance

$1200

CR Cash $1200
Accrual Accounting and Matching
Accrual accounting matches revenues with expenses for a particular period
and this is the basis of the matching principle. Accrual accounting demands
that expenses be matched with the revenue that was generated from those
expenses. The expenses for a period, therefore, must include the portion of
assets that was used up during the period. This matching is done so that the
net income reported is as accurate as possible. With accrual accounting
there are two different categories of expenses:
1.

Cost of goods (services provided or items sold) that are directly aligned

to the revenue of the period i.e. the cost of repair supplies for a repair
service business.
2.

The cost of assets partially consumed during the period i.e. the amount

of the supply inventory used in one month.

Adjusting Entries
To make sure that the expenses of an accounting period are matched with
the revenues, entries are made at the end of an accounting period to
adjust the account balances accordingly. There are two types of adjusting
entries:
1.

The amount of an asset that is used up during the accounting period is

transferred to a corresponding expense account.

2.

The amount of a liability that has been earned during the accounting

period is transferred to the corresponding revenue account.

The accounts that are affected by adjusting entries are called mixed
accounts. That means that these accounts have both a balance sheet portion
and an income statement portion. To report net income accurately, the
income statement portion must be removed by an adjusting entry.
Example: Transfer an Asset to an Expense
Previously we learned that on February 1 Phils Photography purchased a
one-year insurance policy for $1200. The journal entry on Feb. 1 was:
DR Prepaid-Insurance

$1200

CR Cash $1200
At the end of February, one months insurance has been used. The monthly
portion of insurance is $100, therefore $100 must be removed from the asset
account Pre-paid Insurance and transferred to the expense account
Insurance Expense. This adjusting entry will match the expenses incurred in
February with the revenues received in February.
Adjusting entry:
DR Insurance Expense

$100

CR Pre-Paid Insurance

$100

To record insurance expense for February.

The balance in the Pre-paid Insurance account is now $1100 and each month
another $100 will be removed until it is time to purchase next years policy.
Example: Transfer a Liability to a Revenue

When on July 1 Pauls Computing entered into a 6-month network service

contract for $2400 and received an $800 advance payment the following
journal entry was made:
DR Cash $800
CR Unearned Revenue $800
At the end of July 1 month of revenue from that contract was earned. Each
month Pauls Computing earns $400 from the contract, therefore $400 must
be removed from the liability account of Unearned Revenue and transferred
to earned Revenue account.
Adjusting entry:
DR Unearned Revenue
CR Revenue

$400

$400

The balance in the Unearned Revenue account is now $400. At the end of
August, the remaining $400 will be transferred and future payments for the
contracted service can be recorded directly into the Revenue account.
The adjusting entries require additional steps in the Accounting Process:

Analyze the account balances and prepare adjusting entries

Post the Adjusting entries to the Ledger accounts

Prepare an Adjusted Trial Balance to prove that the Debits and Credits still
match

For a teaching lesson plan for this lesson see:

Accrual Accounting And Adjusting Entries Lesson Plan

Calculating Depreciation Straight-Line and

Accelerated
Assets that a company owns, which are expected to last more than one year,
are called Fixed Assets. These assets include such things as automobiles,
computers, furniture, office buildings, and equipment. These fixed assets
that a company owns have a set amount of useful life. This means that a
fixed asset is not expected to last forever, and thus its value depreciates
over time. The definition of depreciation is the decline in the useful life of a
fixed asset.

The only fixed asset that does not decline, except in very
rare circumstances, is land. Land retains its value and most often
appreciates, so deprecation is not applicable in most cases.
Depreciation represents an expense for a business. The business fixed
assets are decreased by a certain value each year and because the
accounting equation must always remain in balance, this decrease must be
accounted for somehow. Even though the dollar amount of depreciation is
not paid for in cash, the loss in value of the fixed asset must be balanced out
and this is done by using two accounts:

Depreciation Expense

Accumulated Depreciation

The Depreciation Expense account is used to capture the dollar value of

depreciation for an accounting period.
Accumulated Depreciation is used to show a running total of how much a
fixed asset has depreciated.
This account is called a contra account because it relates to an asset
account. In the case of accumulated deprecation, the account is called a
contra-asset account and it always has a credit value. The balance in the
accumulated depreciation account is the amount of the fixed asset that has
already expired. Rather than simply decrease the value of the original asset
account, the accumulated depreciation account is used.

When a company purchases a fixed asset, the purchase amount is posted to

the fixed asset account and that original purchase price is recorded on the
balance sheet. When a reader looks at the financial statements, he or she
wants to know both the original purchase price and the amount of
depreciation that has been accounted for. The reason for this is that the
amount for a fixed asset shown on the Balance Sheet is not the market price
or the amount that asset is worth. It is the amount, which was originally paid
less the accumulated deprecation.
Example:
Teds trucking has a truck that was purchased for $15,000 on January 1,
2005. As of December 31, the truck has depreciated $1500. The following
shows the journal entries involved:
Original entry Jan 1
DR Truck $15,000
CR Cash $15,000
Purchased truck
Adjusting entry Dec 31
DR Depreciation Expense $1500
CR Accumulated Depreciation $1500
To record depreciation for the year
After this transaction, the balance in the Truck account is still $15,000 and
therefore the amount on the Balance Sheet is $15,000 but the net value of
the Truck is $13,500. This is shown on the Balance Sheet like this:
Fixed Assets
Truck

$15,000

Less: Accumulated Depreciation

1,500

Net Truck

$13,500

The net value of an asset is called its book value. This is the value it has on
the balance sheet. This has nothing to do with how much the asset costs,
how much it is worth, or how much you would earn from selling it.
Calculating Depreciation
Depreciation is calculated in two main ways:
Straight-line depreciation: This method assumes equal amounts of
depreciation over an assets useful life. This translates to equal depreciation
expense amounts every period.
The formula for calculating straight-line depreciation is:
Cost Saving Value
Useful Life
Where:
Cost = purchase price
Useful Life = estimated amount of time that the asset will be used by the
company. This is sometimes called service life.
Salvage value = estimated amount the asset can be sold for at it end of its
useful life. This is sometimes called residual value.
Example:
The truck that Teds Trucking purchased for $15,000 is expected to be used
by the company for 8 years and then sold for $3,000. Depreciation is
calculated as follows:
Depreciation per year = 15000 -13000 = $1500
8

Accelerated depreciation: Under this method, the asset depreciates at a

greater rate at the beginning of its life and the rate slows as the asset ages.
Depreciation expense is greater up front.
There are many ways to calculate accelerated deprecation but one common
method is to develop a table of declining depreciation values. The total
depreciation remains the same but the yearly deprecation expense is
gradually lessened as follows:
Year
1
2
3
4
5
6
7
8
Total

Accel. Dep.
$4,000
3,000
2,000
1,000
500
500
500
500
12,000

The reason for using accelerated depreciation is for income tax purposes to
lessen net income. This makes sense because the higher the expenses in a
given period the lower the net income.

For a teaching lesson plan for this lesson see:

Depreciation Lesson Plan and Worksheet

ACCOUNTING BASICS:

CLOSING THE BOOKS

Topic: Preparing Closing Entries
Concept: Understanding how and why the books must be closed every period and
learning the exact steps to do so.
Objectives

Understand what a closing entry is

Understand the Retained Earnings account

Understand the purpose of temporary accounts

Understand the purpose of the Income Summary account and its relationship
to net income and retained earnings.

Know how to prepare closing entries

CLOSING THE BOOKS LESSON PLAN

Teaching Materials

Lesson - Closing the Books (see below for printable lesson)

Overhead

Prepared Examples

Lesson Activity
1. Introduce closing entries

Stress the need to return account to a zero balance

2. Introduce temporary accounts

Explain what they are accumulate a balance for one accounting period

Give examples

3. Discuss Permanent accounts

Explain that these account balances carry over accounting periods

Mention retained earnings as the fourth type of permanent account

4. Discuss retained earnings

Relate concept to net income

Discuss placement on the Balance Sheet

Use a detailed example to demonstrate

5. Present how to prepare a Statement of Retained Earnings

Continue with detailed example to illustrate

6. Discuss Closing entries

Explain the Income Summary account

Present closing entries for revenues, expenses, and income summary using
detailed examples

7. Next steps

Talk about the Post Closing Trial Balance