Financial statements from the adjusted trial balance

In depth

The income statement

Lantern uses a single-step format: all revenues are added together, all expenses are added together, and one subtraction gives net income. A multi-step format, which shows subtotals such as gross profit and operating income, is covered in F02. Every revenue and expense account in the adjusted trial balance appears; Dividends does not, because dividends are a distribution to owners, not a cost of earning revenue. The expenses below are listed from largest to smallest, a common convention; listing them in chart-of-accounts order is also acceptable.

Note what the income statement does not say. It doesn’t say Lantern received $7,100 in cash (it received $6,900 from customers) or that it paid $6,110 (it paid $5,950 for operating costs). It measures performance on the accrual basis of lesson 8.

The statement of changes in equity

The statement of changes in equity starts from each component of equity at the beginning of the period and shows every movement to the end. Lantern’s equity has two components: Common Stock (contributed capital) and Retained Earnings (earned capital). Companies usually present the statement in columns, one per component, with a total column. In US practice it is often called the statement of stockholders’ equity; IFRS uses the name statement of changes in equity.

Many introductory texts, including OpenStax, show only the retained earnings column as a separate statement of retained earnings. It is the same calculation for one component: beginning retained earnings, plus net income (or minus a net loss), minus dividends.

The classified balance sheet

A classified balance sheet groups assets and liabilities into current and noncurrent. A current asset is cash or an asset expected to be turned into cash or used up within a year (or the operating cycle, if longer); a current liability is one due to be settled within the same horizon. The split shows a reader at a glance whether the business can meet its near-term obligations from its near-term resources. US balance sheets usually list assets in order of liquidity, cash first; presentation order is a convention, and it varies between countries. Under IFRS the balance sheet is called the statement of financial position.

Three of Lantern’s items need care. Equipment is shown at its cost with accumulated depreciation deducted beneath it, so the reader sees the $12,000 invested and the $11,800 book value; the contra-asset is never shown among the liabilities. Unearned Revenue of $1,600 is a current liability because the two events it represents fall in April, and it will be settled by catering, not by paying cash. The $10,000 note is due on 1 March 2028, more than a year after the balance sheet date, so it is noncurrent. Ending retained earnings come from the statement of changes in equity, not from the trial balance, where Retained Earnings still shows its beginning balance of zero.

The statement of cash flows

The statement of cash flows sorts every cash receipt and payment into three groups. Operating activities are the cash effects of running the business: cash from customers and cash paid to suppliers, employees, landlords and insurers (and, under US GAAP, interest paid). Investing activities are buying and selling long-term assets such as equipment. Financing activities are raising and returning money from owners and lenders: issuing stock, borrowing, repaying loan principal and paying dividends.

Lantern uses the direct method, which lists operating cash receipts and payments by type. The indirect method, which reaches the same operating total by starting from net income and adjusting it, is covered in F02. US GAAP (ASC 230) encourages the direct method but then also requires a separate reconciliation of net income to operating cash flow; IAS 7 also allows both methods. Lantern’s twelve cash transactions (all but m5, m8 and m15) classify like this:

• Operating: deposit from Harbor Tech ($2,400, m6), workshop fees ($1,500, m9) and Meridian’s payment ($3,000, m12), together $6,900 received from customers; insurance ($1,800, m4), advertising ($350, m7), supplier ($1,000, m10), wages ($1,600, m11) and rent ($1,200, m13).
• Investing: the $4,000 paid for the espresso equipment (m3).
• Financing: Ana’s $20,000 for common stock (m1), the $10,000 bank loan (m2) and the $300 dividend (m14).

The net increase in cash, $950 - 4{,}000 + 29{,}700 = 26{,}650$, equals the change in the Cash account from $0 to $26,650. That check is the cash link between the statement of cash flows and the balance sheet. The $8,000 still owed for the equipment is left out of the statement because no cash moved, but both frameworks require investing and financing transactions without cash to be disclosed, so it appears in a note beneath. When Lantern pays the supplier in April, the payment will appear in April’s statement.

Articulation: checking that the statements fit

Because the statements are built from one set of accounts, their shared figures must agree, and checking them is the quickest test of a set of statements. Net income of $990 on the income statement must be the net income added in the statement of changes in equity. Ending equity of $20,690 there must be the equity on the balance sheet. Total assets of $42,500 must equal total liabilities of $21,810 plus equity of $20,690. Cash at the end of the statement of cash flows, $26,650, must be the cash on the balance sheet. If any link fails, something has been omitted, misclassified or copied wrongly.

Articulation also explains a fact that surprises many students: the balance sheet balances only after the statement of changes in equity has been prepared. The trial balance still shows revenue, expense and dividend accounts separately; until net income and dividends are carried into retained earnings, assets ($42,500) exceed liabilities plus contributed capital ($41,810) by exactly $990 - 300 = 690$. Lesson 11 moves those amounts into Retained Earnings in the ledger itself by closing the books.

Why operating cash flow is not net income

Net income ($990) and net cash provided by operating activities ($950) both describe running the business, so readers often expect them to match. They differ by every deferral and accrual you met in lesson 8: revenue earned but not collected (the $1,200 still owed by Meridian and the $600 Pier Nine breakfast), cash collected before it was earned (the $1,600 of Harbor Tech’s deposit still owed in events), costs paid in advance (the $1,650 of insurance for later months and $100 of supplies paid for but unused), and expenses not yet paid in cash (wages of $1,400, utilities of $260, interest of $50, depreciation of $200). The indirect method in F02 starts from net income and adjusts for exactly these items to reach operating cash flow. Over time most of these timing differences reverse, though depreciation never does, because the cash for the equipment left as an investing outflow when it was bought; within a month or a year the two figures can differ greatly, which is why both statements are required.

The notes

The four statements are not the whole report. Under the full disclosure principle, information a reader needs to understand them goes in the notes: the accounting policies used (Lantern’s straight-line depreciation with a full month in the month of purchase, for example), the terms of the bank loan, the non-cash purchase of equipment, and commitments such as a catering contract signed for a later month. A lender reading Lantern’s statements would expect at least the loan terms and the depreciation policy to be stated, because both affect how the figures should be read.

Presentation conventions

• A dollar sign goes on the first amount in each column and on totals; the amounts in between have none.
• Amounts deducted, such as accumulated depreciation, dividends and cash payments, are shown in parentheses.
• A single rule is drawn above a subtotal and a double rule under a final total, such as net income or total assets.
• Small companies show whole dollars; large companies often round to thousands or millions and say so in the heading.
• Accounts appear in statement order and with readable names (“Accounts receivable”), not in trial-balance order or with account numbers.