Video Transcript
GAAP and the Financial Statements
Hello there! My name is Mrs. GAAP, and today I am going to teach you how to prepare two basic financial statements: the income statement and the statement of retained earnings. I bet you wonder how I know so much about the financial statements, don't you? Well, the answer is simple. My name, GAAP, stands for generally accepted accounting principles. I give guidance on how to prepare the financial statements. For the next few minutes, I would like for you to sit back and relax as we journey into the world of financial statements.
What Are the Financial Statements?
First, let me tell you what the financial statements are. The financial statements are a set of four reports generated at the end of the accounting cycle. These four reports are prepared in a very specific order.
Why, you wonder? The simple reason is that each statement, with the exception of the income statement, relies on information from the previous statement for completion. The four financial statements are the income statement, statement of retained earnings, balance sheet, and the statement of cash flows. For this lesson, we are going to discuss the first two - the income statement and the statement of retained earnings.
The income statement is the financial report that tells whether or not a company made or lost money in a given time period.
The statement of retained earnings tells how much money that a company made was retained and reinvested in the company.
Preparing the Income Statement
Now that you know what each of the financial statements are, let's discuss the basic way to prepare them. The income statement is the first statement prepared. It follows the formula:
Total Revenue - Total Expenses = Net Income or Net Loss
Total revenue is the sum of all the money that has been brought into a company in an accounting period. Total expenses is the sum of all money that was paid out by the company. Net income occurs if total revenue exceeds total expenses. Net loss occurs when the total expenses are more than total revenue.
All the information that is found on the income statement is listed in a certain order. Let's go through an example, and I will show you where items belong.
Bill owns a pet shop. For the first three months of the year, Bill had $20,000 in sales. He also had the following expenses: building rent was $3,000; utilities were $1,500; inventory and supplies were $11,000. What is his net income?
The first thing that you do when creating an income statement is to center the company name on the first line. On the second line, you put the title of the financial statement. The third line tells what the time frame is for the income statement. For Bill's Pet Shop, financial statements are created every three months, or every quarter.
The first line in the body of the basic income statement is where you put total sales. For Bill's Pet Shop, his total sales were $20,000.
Following the total sales line on the income statement is the area for total expenses. This section of the income statement should have each expense listed and then totaled at the bottom. For Bill's Pet Shop, he had rent expense of $3,000, utilities expense of $1,500, and supplies expense of $11,000. The total of these expenses is $15,500.
Once all the expenses have been listed and totaled, the expenses are deducted from the total sales to get the company's net income for the accounting period. If expenses exceed total sales, then a net loss has occurred.
Preparing the Statement of Retained Earnings
The second financial statement that's prepared is the statement of retained earnings. The term retained earnings refers to the amount of net income that is left in a company after dividends have been paid to shareholders, if there are any, and after the owner has withdrawn money for himself. This statement follows the formula:
Beginning Retained Earnings + Net Income (or - Net Loss) - Dividends and/or Owner's Withdrawals = Ending Retained Earnings
Let's continue to use Bill's Pet Shop as an example. From the income statement, we already know that the company had a net income of $4,500 for the quarter ending March 31, 2013. At the beginning of this quarter, the balance in the retained earnings account was $5,000. Bill doesn't have any investors in the company, so he has no dividends to pay, but he does withdraw $2,500 a year to put into his daughter's college fund. What would be the balance in the retained earnings account at the end of March 2013?
Like the income statement heading, the statement of retained earnings heading begins with the company name centered on the first line. The second line will say, 'Statement of Retained Earnings,' which is also centered. The third line will list the time period that the statement is for.
The body of the financial statement begins with the beginning retained earnings for the period that you are working. For Bill's Pet Shop, the beginning retained earnings were $5,000.
Next, the net income is added to the beginning retained earnings. To record this step, you need to write the actual words, 'Plus: Net Income' directly under the words, 'Retained Earnings,' and the $4,500 amount directly under the $5,000. Below that, on the next line, add the two. For Bill's Pet Shop, the total is $9,500.
Now that you have the total of the retained earnings and net income, it is time to subtract what Bill draws out to put into his daughter's college fund. This is shown by writing, 'Minus: Withdrawal by Owner' and the amount of $2,500.
The last line of the statement of retained earnings shows the amount of retained earnings at this point in time. The total amount of retained earnings for Bill's Pet Shop is $7,000.
Lesson Summary
Let's review what we have talked about in this lesson. The financial statements are a set of four reports that are generated at the end of an accounting period. They are prepared in a specific order and according to GAAP guidelines.
The income statement, which is the statement that tells whether or not a company made or lost money, is the first financial statement prepared. It follows the formula:
Total Revenue - Total Expenses = Net Income or Net Loss
Net income occurs if the amount of total revenue exceeds total expenses. Net loss occurs if the amount of total expenses exceeds total revenue.
The second statement that is prepared is the statement of retained earnings. This financial statement tells how much of the money that was made was retained and reinvested in the company. The statement of retained earnings follows the formula:
Beginning Retained Earnings + Net Income (or - Net Loss) - Dividends and/or Owner's Withdrawals = Ending Retained Earnings
One important note on the statement of retained earnings is that it relies on the retained earnings reported in the prior period to calculate what the current retained earnings balance is. Both of these financial statements are important to potential creditors and investors, current creditors and investors, and company leaders.
Learning Outcomes
Following this lesson, you will be able to:
- Define financial statements and summarize why they are prepared in a specific order
- Name the four reports that make up the financial statements
- Understand the purposes of the income statement and statement of retained earnings
- Identify the formulas for the income statement and the statement of retained earnings
- Explain how to prepare the income statement and the statement of retained earnings
