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Part 2. The Reporting Cycle

7. Preparing Financial Statements

In the previous chapter, you learned all about adjustments that might be needed at the end of each accounting period. These adjustments were necessary to bring a company's books and records current in anticipation of calculating and reporting its income and financial position. However, Chapter 3 did not illustrate how those adjustments would be used to actually prepare the financial statements. This chapter will begin with that task.

7.1. An Illustration

To illustrate the process for preparing financial statements, let's look at some facts for England Tours Company. England began operation early in 20x3. In the process of preparing its financial statements for the year ending December 31, 20x3, England determined that the following adjusting entries were needed. The numbers are all "assumed" and you should not be concerned about that. But, if you are unclear as to why any one of these entries might be needed, you should definitely review the detailed discussion of adjusting entries from the previous chapter.

12-31-X3

Depreciation Expense

5,000

Accumulated Depreciation

5,000

To record annual depreciation expense for equipment with a 9-year life ($45,000/9)

12-31-X3

Salaries Expense

2,000

Salaries Payable

2,000

To record accrued salaries due to employees at the end of December

12-31-X3

Interest Expense

1,200

Interest Payable

1,200

To record accrued interest on note payable ($20,000 X 6%)

12-31-X3

Unearned Revenue

1,800

Revenue

1,800

Year-end adjusting entry to reflect "earned" portion of tours sold in advance

Below is a graphic showing England's trial balance before the above adjusting entries, and after the adjusting entries. If England had prepared its financial statements based only on the unadjusted trial balance, the reported information would be incomplete and incorrect. Instead, it is necessary to utilize the adjusted trial balance because it has been updated to reflect the year-end adjusting entries.

7.2. Considering the Actual Process for Adjustments

Most of the time, a company will prepare its trial balance, analyze the trial balance for potential adjustments, and develop a list of necessary adjusting entries. Knowing what to adjust is not necessarily intuitive. It usually requires hands-on review by someone who is very knowledgeable about the business and accounting. As a practical matter, a company should not allow anyone and everyone to have access to the accounting system for purposes of entering year-end adjustments; too many errors and rogue entries will appear. Instead, a company will usually have a defined process where proposed entries are documented on a form (sometimes called a journal voucher). These forms are submitted to a chief accountant/controller who reviews and approves such proposed entries. The approved journal vouchers then serve as supporting documents to authorize data entry into the accounting system. The adjusting entries are entered in the journal, posted to the appropriate ledger accounts, and then the adjusted trial balance can be prepared from the up-to-date ledger.

7.3. Financial Statements

The adjusted trial balance is ordinarily sufficient to facilitate preparation of financial statements. You should take time to trace the amounts from England's adjusted trial balance to the financial statements that follow:

Financial Statements

7.4. Computerization

The financial statement preparation process is mostly mechanical, and easily automated. Once the adjusting entries have been prepared and entered, every accounting software package will race through the steps of processing the data to produce the financial statements. As such, you may be inclined to discount your need to understand how to move amounts from an adjusted trial balance into a set of financial statements. In some respects that is true, just as it is true that you do not need to know how to add and subtract if you own a calculator. Of course, you probably see the value of understanding addition and subtraction even if you use a calculator. In the same light, please consider that understanding the flow of transactions into financial statements is an essential foundation for furthering your knowledge of accounting.

 
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