Preparing Financial Statements

Preparing financial statements requires preparing an adjusted trial balance, translating it into financial reports, and auditing them.

Learning Objective

Explain the necessary steps to take before preparing the financial statements and the purpose of the statements

Key Points

The purpose of financial statements are to provide both business insiders and outsiders a concise, clear picture of the current financial status in the business. Therefore, the people who use the statements must be confident in its accuracy.
Closing the books is simply a matter of ensuring that transactions that take place after the business's financial period are not included in the financial statements.
Adjusting entries are generally made in relation to prepaid expenses, prepayments, accruals, estimates and inventory.
When an audit is completed, the auditor will issue a report regarding whether the statements are accurate. To ensure a positive reports, some companies try to participate in opinion shopping. This practice is generally prohibited..

Terms

audit
An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures
adjusting entry
Journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred.
opinion shopping
The process of contracting or rejecting auditors based on the type of opinion report they will issue on the auditee.

Example

Financial statements for Highland Yoga for each period would appear as follows:

Full Text

Preparing Financial Statements

When a business enterprise presents all the relevant financial information in a structured and easy to understand manner, it is called a financial statement. The purpose of financial statements are to provide both business insiders and outsiders a concise, clear picture of the current financial status in the business. Therefore, the people who use the statements must be confident in its accuracy.

Adjusted Trial Balance - Closing the Books

The process of preparing the financial statements begins with the adjusted trial balance. Preparing the adjusted trial balance requires "closing" the book and making the necessary adjusting entries to align the financial records with the true financial activity of the business.

Closing the books is simply a matter of ensuring that transactions that take place after the business's financial period are not included in the financial statements. For example, assume a business is preparing its financial statements with a December 31^st year end. It acquires some property on January 14th. If the books are properly closed, that property will not be included on the balance sheet that is being prepared for the period on December 31st.

Adjusted Trial Balance - Adjusting Entries

An adjusting entry is a journal entry made at the end of an accounting period that allocates income and expenditure to the appropriate years. Adjusting entries are generally made in relation to prepaid expenses, prepayments, accruals, estimates and inventory. Throughout the year, a business may spend funds or make assumptions that might not be accurate regarding the use of a good or service during the accounting period. Adjusting entries allow the company to go back and adjust those balances to reflect the actual financial activity during the accounting period. Failure to record the adjusting entries can result in understatement of expenses and overstatement of income, which ultimately can affect the amount of taxes paid.

For example, assume a company purchases 100 units of raw material that it expects to use up during the current accounting period. As a result, it immediately expenses the cost of the material. However, at the end of the year the company discovers it only used 50 units. The company must then make an adjusting entry to reflect that, and decrease the amount of the expense and increase the amount of inventory accordingly.

Translate the Adjusted Trial Balance to Financial Statements

Using the trial balance, the company then prepares the four financial statements. These statements are:

The Balance Sheet: A summary of the company's assets, liabilities and equity;
The Income Statement: A summary of the business's income, expenses, and profits
The Statement of Cash Flows: A report on a company's cash flow activities, particularly its operating, investing and financing activities; and
The Statement of Changes in Equity: A report that explains the changes of the company's equity throughout the reporting period

Information flows from the unadjusted trial balance to the trial balance then to the income statement.

The company may also provide Notes to the Financial Statements, which are disclosures regarding key details about the company's operations that may not be evident from the financial statements.

Wachovia National Bank 1906 financial statement

Audit the Financial Statements

Once the company prepares its financial statements, it will contract an outside third party to audit it. An audit is an independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures. It is the audit that assures outside investors and interested parties that the content of the statements are correct.

When an audit is completed, the auditor will issue a report with the findings. The findings can state anything from the statements are accurate to statements are misleading. To ensure a positive reports, some companies try to participate in opinion shopping. This is the process that businesses use to ensure it gets a positive review. Since Enron and the accounting scandals of the early 2000s, this practice has been prohibited.

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