1.7 The Accounting Equation
1.7.3 Retained Earnings Statement
The retained earnings statement is a report that shows the change in the
Retained Earnings account balance from the beginning of the month to the end
of the month due to net income (or loss) and any cash dividends declared during the accounting period.
Sample Retained Earnings Statement
1. Start with Retained Earnings balance at the beginning of the month.
2. Add net income form the current month’s income statement.
3. Subtract from net income any dividends declared during the month.
4. End with new Retained Earnings balance at the end of the month.
Profit is such an important concept in business that two financial statements are devoted to talking about it. The income statement reports net income for one period, such as a month or a year. The retained earnings statement deals with a company’s net income over the entire life of the business.
The retained earnings statement is a bridge between the income statement and the balance sheet. The net income amount that appears on the retained earnings statement comes from the income statement ($13,000 in the sample above). The ending retained earnings balance ($40,000 in the sample above) feeds to the stockholders’ equity section of the balance sheet.
BALANCING YOUR BANK STATEMENT
The retained earnings statement includes elements similar to those in a monthly bank statement Both statements report a beginning balance, additions, subtractions, and an ending balance.
Bank Statement
(tracks your cash)
Retained Earnings Statement
(tracks a corporation’s accumulated profit) Balance at the beginning of the month Balance at the beginning of the month
1.7.4 Balance Sheet
The balance sheet is a report that summarizes a business’s financial position as of a specific date. It is the culmination of all the financial information about the business—everything else done in the accounting cycle leads up to it.
The balance sheet is an expanded version of the accounting equation: Assets
= Liabilities + Stockholders’ Equity. The balance sheet lists and summarizes
asset, liability, and stockholders’ equity accounts and their ledger balances as of a point in time. Assets are listed first. Liabilities and stockholders’ equity accounts follow, and these amounts are added together.
The only exception is that the amount reported on the balance sheet for Retained Earnings comes from the ending balance on the retained earnings statement rather than from its ledger. Note that Cash Dividends is not listed at all on the balance sheet.
SAMPLE BALANCE SHEET
BALANCE SHEET FORMATTING
Heading: Company Name, Name of Financial Statement, Date Two columns: left for listing items to be subtotaled; right for results Dollar signs go at the top number of a list to be calculated
Category headings for each account category
Single underline below a list of numbers to be totaled
Double underline below the final results (total assets AND Total labilities and stockholders’ equity) Dollar sign on final result number
Financial Reporting
The life of an ongoing business can be divided into artificial time periods for the purpose of providing periodic reports on its financial activities.
Financial Statements Connected
Three financial statements are prepared at the end of each accounting period. First, the income statement shows net income for the month. Next, the statement of retained earnings shows the beginning and ending Retained Earnings balances and the reasons for any change in this balance. Finally, the balance sheet presents asset, liability, and stockholders’ equity account balances. #1 The income statement is prepared first. It summarizes revenue and expenses for the month. Amounts come from the ledger balances. The result is either net income or net loss.
Jonick Company Income Statement
For the Month Ended June 30, 2018
Fees Earned $30,000 Operating Expenses: Salaries expense $2,500 Wages expense 2,200 Rent expense 2,000 Insurance expense 1,900 Supplies expense 1,800 Advertising expense 1,700 Maintenance expense 1,600 Utilities expense 1,400 Vehicle expense 1,100 Miscellaneous expense 800
Total operation expenses 17,000
Net Income 13,000
#2 The retained earnings statement is next. It adjusts the month’s beginning retained earnings balance by adding net income from the income statement and subtracting out dividends declared. The net income of $13,000 comes from the income statement. The result is a new retained earnings balance at the end of the month.
Jonick Company Retained Earnings Statement For the Month Ended June 30, 2018
Retained earnings, June 1, 2018 $30,000 Net income 13,000
Less: cash dividends 3,000
Increase in retained earnings 10,000
Retained earnings, June 30, 2018 $40,000
#3 The balance sheet is prepared last. It shows assets, liabilities, and stockholders’ equity as of the last day of the month. All amounts except retained earnings come from the ledger balances. The Retained Earnings amount comes from the ending amount on the retained earnings statement - in this case $40,000. The balance sheet is an exploded version of the accounting equation!
Jonick Company Balance Sheet
June 30, 2018
Assets Liabilities
Cash $15,000 Accounts payable $5,000 Accounts receivable 10,000
1.8 CHANGES IN STOCKHOLDERS’ EQUITY
Any change in the Common Stock, Retained Earnings, or Cash Dividends accounts affects total stockholders’ equity.
Common Stock + Retained Earnings = Total Stockholders’ Equity
Stockholders’ equity increases due to additional stock investments or additional net income. It decreases due to a net loss or dividend payouts. Retained earnings increases when revenue accounts are closed out into it and decreases when expense accounts and cash dividends are closed out into it.
The following examples illustrate journal entries that can cause stockholders’ equity to change.
1. Stockholders’ equity before a business opens:
Date Account Debit Credit Common Stock + Retained Earnings =
Total Stockholders’ Equity
0 + 0 = 0
2. Stockholders’ equity after 30 stockholders invest $1,000 each, for a total of $30,000:
Date Account Debit Credit Common Stock + Retained Earnings =
Total Stockholders’ Equity
6/1 Cash 30,000
Common Stock 30,000 30,000 + 0 = 30,000
Each investor is now worth $1,000 in the business.
3. Stockholders’ equity after one month of operations in which Fees Earned is $65,000 and total expenses are $5,000 (so net income is $60,000):
Date Account Debit Credit Common Stock + Retained Earnings =
Total Stockholders’ Equity
6/30 Fees Earned 65,000
Retained Earnings 65,000 30,000 + 60,000 = 90,000
6/30 Retained Earnings 5,000
Each investor is now worth $3,000 in the business. (The original $1,000 investment plus 1/30th of
the $60,000 profit, or $2,000)
ALL Expenses 5,000
4. Stockholders’ equity after one month of operations and after each of the thirty investors receives a cash dividend payment of $500:
Date Account Debit Credit Common Stock + Retained Earnings =
Total Stockholders’ Equity
7/10 Retained Earnings 15,000
Cash Dividends 15,000 30,000 + 45,000 = 75,000
Each investor is now worth $2,500 in the business. (The original $1,000 plus $2,000 profit - $500 dividends paid out)
Stockholders’ equity can increase in two ways:
1. Owners invest in stock and Common Stock is credited and increases 2. Business generates net income and Retained Earnings is credited and
increases
Stockholders’ equity can decrease in two ways:
1. Dividends are paid out and Retained Earnings is debited and decreases 2. Business experiences a loss and Retained Earnings is debited and
decreases
The following calculation example shows how stockholders’ equity can change from the beginning to the end of an accounting period.
+
+
-
Beginning stockholders’ equity Additional investments in stock
Net income (or – Net loss)
Dividends
12,000 6,000
3,000
- 1,000 = Ending stockholders’ equity 20,000
The calculation below is the same as the one above except that net income is instead presented as revenue minus expenses.
+
+ -
-
Beginning stockholders’ equity Additional investments in stock
Revenue Expenses Dividends 12,000 6,000 5,000 -2,000 - 1,000 = Ending stockholders’ equity 20,000
If net income is not given, you can solve for it algebraically using the calculations above. Assume net income is x in the first calculation above:
+
+
-
Beginning stockholders’ equity Additional investments in stock
Net income (or – Net loss)
Dividends
12,000 6,000
x
- 1,000 = Ending stockholders’ equity 20,000
Beginning stockholders’ equity + Additional investments in stock + Net income - Dividends = Ending stockholders’ equity
12,000 + 6,000 + x – 1,000 = 20,000 x = 20,000 – 12,000 – 6,000 + 1,000
Topics – The basic accounting cycle Fact Journal Entry Calculate Amount Format Business terminology x Net income x Types of accounts x Revenue accounts x Expense accounts x Income statement x x Journal x
Journalize revenue transactions for cash x
Journalize expense transactions for cash x
Post journal entries to the ledgers x
Income statement x x
Journalize closing entries x
Post closing entries to ledgers x
Journalize and post revenue transactions on account x x
Journalize expense and post transactions on account x x
Asset accounts x
Liability accounts x
Journalize purchase of an asset for cash x
Journalize purchase of an asset for a down payment and loan x
Stockholders’ equity accounts x
Journal entry for owner investment x
Journal entry for dividends x
Total stockholders’ equity x
Accounting equation x x
Changes in stockholders’ equity x
Retained earnings statement x x
Balance sheet x x
Financial statements connected x x
Accounting cycle x
LEARNING BY DOING
I learned how to drive a standard transmission car – using a stick shift – in San Francisco. My husband is an expert at this and was in the passenger seat as my instructor. In spite of the fact that he knew how to shift and clutch, and that he was telling me (rather loudly) what to do, I still rolled backward down a hill and over a motorcycle. I can drive a stick shift perfectly fine now, but it took lots of practice and stalling to get the feel of the process.
Accounting is a skills discipline; it is also something you learn by doing. Your instructor may be an expert who explains and demonstrates, but you will only truly understand the process with hands-on practice. You have to learn it by doing it to get the feel of the process. That is how you will become an expert yourself.
1.9 WRAP UP
To this point, you have been introduced to basic concepts that pertain to business and to accounting. You have learned that businesses experience financial transactions that are recorded by selecting accounts and amounts to represent these events and entering them in the journal in chronological order. Journal entries are then copied to the ledgers to reorganize the same information by account.
One of the key aspects of the process is maintaining current running balances in all of the ledger accounts. Account balances are then transferred
to the income statement, retained earnings statement, and balance sheet for a professional, well-structured summary presentation that is meaningful to those reading the reports. Finally, the temporary revenue, expense, and dividends accounts are closed to Retained Earnings at the end of the accounting period to set their balances back to zero so that the cycle can begin again.