Statement of Stockholders' Equity

The fourth financial statement is the statement of stockholders' equity. This statement lists the changes to the stockholders' equity section of the balance sheet during the current accounting period.

A common format of the statement of stockholders' equity is shown here:

To see additional examples of the statement of stockholders' equity we recommend that you identify a few U.S. corporations with stock that is publicly traded. On each corporation's website, select Investor Relations and then select each corporation's Form 10-K (the annual report to the Securities and Exchange Commission). Go to the section of the 10-K which presents the corporation's financial statements and view the statement of stockholders' equity.

Closing Cut-Off

At a minimum of once per year, companies must prepare financial statements. In addition companies often prepare quarterly and monthly financial statements which are referred to as interim financial statements.

For any of the financial statements to be accurate it is necessary to have a proper cut-off. This means including all of a company's business transactions in the proper accounting period. For example, the electricity bill arriving on January 10 might be the cost of the electricity that was actually used in December. (The time lag resulted from the utility company reading the electric meters and preparing and mailing the bill.) Hence under the accrual method of accounting, the bill received on January 10 needs to be included in December's expenses and must also be reported by the company as a liability as of December 31. Similarly, the hourly payroll processed during the first few days in January and paid on January 6 is likely to include the cost of employees working during the last few days in December. The cost of the hours worked through December 31 must be included in the company's December expenses and in the liabilities as of December 31.

As you read the previous paragraph, you may have been reminded of our discussion of adjusting entries. That's because the adjusting entries are part of each period's closing process. The adjusting entries are prepared in order to report a company's revenues and expenses in the proper accounting period.

The closing process

To achieve a proper cut-off and to distribute the financial statements in a timely manner, it is helpful to have a timeline (or PERT chart) that indicates the necessary steps in the closing process. The timeline will indicate what needs to be done and the sequence in which things need to occur. It will also reveal what is preventing the financial statements from being distributed sooner.

In addition, a checklist of the closing tasks should be prepared and distributed to the appropriate employees as to what is required, who is responsible, and the day it is due.

If some journal entries must be written every month, it is helpful to assign journal entry numbers to these standard journal entries or recurring journal entries. For example, a company may designate JE33 (Journal Entry #33) to be the recurring accrual of expenses that have occurred but have not yet been recorded in Accounts Payable as of the end of a month. Perhaps the timeline/checklist will indicate that JE33 must be submitted by the accounts payable clerk six days after each month ends. The company may also have its computer automatically prepare JE34 which is the entry that automatically reverses the previous month's accrual entry JE33.

Some recurring journal entries will have the same amount each month. For example, a company's JE10 might be $10,800 every month of the year for the company's depreciation expense. (Some companies will refer to the entries that have the same amounts and accounts every month as standard entries.)

Another recurring entry may involve the same accounts each month, but the amounts will vary from month to month. For example, a company's JE03 might be the recurring monthly entry for bad debts expense. The company has determined in advance that the amount of JE03 will be 0.002 of the company's monthly credit sales. Since the amount of sales is different every month, the amounts on JE03 will be different each month.

Having entry numbers and standard entries should help to make the monthly closings more routine and efficient.

 While the balance sheet and the income statement are the most frequently referenced financial statements, the statement of cash flows or cash flow statement is a very important financial statement.

The cash flow statement is important because the income statement and balance sheet are normally prepared using the accrual method of accounting. Hence the revenues reported on the income statement were earned but the company may not have received the money from its customers. (Many times companies allow customers to pay in 30 days or 60 days and often customers pay later than the agreed upon terms.) Similarly the expenses that are reported on the income statement have occurred, but the company may not have paid for the expense in the same period. In order to understand how cash has changed, and because many believe that "cash is king" the cash flow statement should be distributed and read at the same time as the income statement and balance sheet.

Format of the Cash Flow Statement

Within the cash flow statement, the cash receipts or cash inflows are reported as positive amounts. The cash paid out or cash outflows are reported as negative amounts.

The following table provides various ways for you to think of the positive and negative amounts that are shown on the cash flow statement:

The net total of all of the positive and negative amounts reported on the cash flow statement should equal the change in the amount of the company's cash and cash equivalents. (The company's cash and cash equivalents are reported on its balance sheets.)

The cash inflows and cash outflows which explain the change in a company's cash and cash equivalents are reported in three main sections of the cash flow statement:

1. Operating activities
2. Investing activities
3. Financing activities

In addition to the three main sections, the cash flow statement requires the following disclosures:

• the amount of interest paid
• the amount of income taxes paid
• exchanges of major items that did not involve cash (such as exchanging land for common stock, converting bonds into common stock, etc.).

1. Operating activities

The cash flows reported in the operating activities section of the cash flow statement can be presented using one of two methods:

• Direct method
• Indirect method

The direct method is recommended by the FASB. However, a survey of 500 annual reports of large U.S. corporations revealed that only about 1% had used the recommended direct method. Nearly all of the U.S. corporations in the survey used the indirect method. Hence, we will limit our discussion to the indirect method.

Indirect method, Cash Flows from Operating Activities

When the indirect method is used, the first section of the cash flow statement, Cash Flows from Operating Activities, begins with the company's net income (which is the bottom line of the income statement). Since the net income was computed using the accrual method of accounting, it needs to be adjusted in order to reflect the cash received and paid.

The very first adjustment involves depreciation. The amount of Depreciation Expense reported on the income statement had reduced the company's net income, but the depreciation entry did not involve cash. (The journal entry for the current period's depreciation was a debit to Depreciation Expense and a credit to Accumulated Depreciation. Cash was not used.) Since the depreciation expense reduced net income, but did not use any cash, the amount of depreciation expense is added back to the net income amount.

So far, the Cash Flows from Operating Activities is $28,000

Any amortization or depletion expense is also added back.

Next, the operating activities will adjust the net income to reflect the changes in the amounts of current assets and current liabilities during the accounting period. For example, if accounts receivable increased from $9,500 to $9,800 during the period, we conclude that the company did not collect cash for all of the sales revenues shown on the income statement. Not collecting all of the sales amounts (or seeing accounts receivable increase) is viewed as negative for the company's cash. Hence the $300 increase in accounts receivable is shown as a negative adjustment of $300:

So far, the Cash Flows from Operating Activities is $27,700

If accounts payable increased from $3,100 to $3,350 during the period, that indicates that the company did not pay all of its expenses. Not paying the bills is good for the company's cash. Hence, the $250 increase in accounts payable will be shown as a positive amount:

So far, the Cash Flows from Operating Activities is $27,950

The changes in the current asset and the current liability accounts are reported as adjustments to the company's net income in the operating activities section—except that the change in short-term notes payable will be reported in the financing activities section.

2. Investing activities

The purchasing and selling of long-term assets are reported in the second section of the cash flow statement, investing activities.

The cash flows that involve long-term assets include:

• The cash received from selling long-term assets. These are reported as positive amounts.
• The cash used to purchase long-term assets. These are reported as negative amounts.

3. Financing activities

The changes in the noncurrent liabilities, stockholders' (or owner's) equity, and short-term loans are reported in the financing activities section of the cash flow statement.

The positive amounts in the financing activities section could indicate that cash was received from:

• Issuing bonds payable
• Borrowing through other long-term loans
• Issuing shares of stock
• Borrowing through short-term loans

The negative amounts indicate that cash was used for:

• Retiring (paying off) long-term debt
• Purchasing shares of the company's stock (treasury stock)
• Paying dividends to stockholders
• Repaying short-term loans

Other

At the bottom of the cash flow statement, the net totals of the three sections are reconciled with the change in the cash and cash equivalents that are reported on the company's balance sheet.

The reporting requirements for the cash flow statement also include disclosing the amounts paid for interest and income taxes and significant noncash investing and financing activities. (Two examples of noncash investing and financing activities are converting bonds to common stock and exchanging bonds payable for land.)

 The balance sheet is one of the four main financial statements of a business:

• Balance Sheet
• Income Statement
• Cash Flow Statement
• Statement of Stockholders' Equity

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a moment in time. (The other three financial statements report amounts for a period of time such as a year, quarter, month, etc.) The balance sheet is also known as the statement of financial position and it reflects the accounting equation:

Assets = Liabilities + Stockholders' Equity.

Bankers will look at the balance sheet to determine the amount of a company's working capital, which is the amount of current assets minus the amount of current liabilities. They will also review the assets and the liabilities and compare these amounts to the amount of stockholders' equity.

When a balance sheet reports at least one additional column of amounts from an earlier balance sheet date, it is referred to as a comparative balance sheet.

Balance Sheet Classifications

Typically, companies issue a classified balance sheet. This means that the amounts are presented according to the following classifications:

Descriptions of the balance sheet classifications

The following are brief descriptions of the classifications usually found on a company's balance sheet.

Current assets
Generally, current assets include cash and other assets that are expected to turn to cash within one year of the date of the balance sheet. Examples of current assets are cash and cash equivalents, short-term investments, accounts receivable, inventory and prepaid expenses.

Investments
This classification is the first of the noncurrent or long-term assets. Included are long-term investments in other companies, the cash surrender value of life insurance, bond sinking funds, real estate held for sale, and cash that is restricted for construction of plant and equipment.

Property, plant and equipment
This category of noncurrent assets includes the cost of land, buildings, machinery, equipment, furniture, fixtures, and vehicles used in the operations of a business. Except for land, these assets will be depreciated over their useful lives.

Intangible assets
Intangible assets include goodwill, trademarks, patents, copyrights and other non-physical assets that were acquired at a cost. The amount reported is their cost to acquire minus any amortization or write-down due to impairment. Valuable trademarks and logos that were developed by a company through years of advertising are not reported because they were not purchased from another person or company.

Other assets
This category often includes costs that have been paid but are being expensed over a period greater than one year. Examples include bond issue costs and certain deferred income taxes.

Current liabilities
Current liabilities are obligations of a company that are payable within one year of the date of the balance sheet (and will require the use of a current asset or will be replaced with another current liability).

Current liabilities include loans payable that will be due within one year of the balance sheet date, the current portion of long-term debt, accounts payable, income taxes payable and liabilities for accrued expenses.

Noncurrent liabilities
These are also referred to as long-term liabilities. In other words, these obligations will not be due within one year of the balance sheet date. Examples include portions of automobile loans, portions of mortgage loans, bonds payable, and deferred income taxes.

Stockholders' equity
This section of the balance sheet consists of the following major sections:

• Paid-in capital (the amounts paid by investors when the original shares of a corporation were issued)
• Retained earnings (the earnings of the corporation since it began minus the amounts that were distributed in the form of dividends to the stockholders)
• Treasury stock (a subtraction that represents the amount paid to repurchase the corporation's own stock)

Recording Transactions

With sophisticated accounting software and inexpensive computers, it is no longer practical for most businesses to manually enter transactions into journals and then to post to the general ledger accounts and subsidiary ledger accounts. Today, software such as QuickBooks* will update the relevant accounts and provide more information with a minimum of data entry.

*QuickBooks is a registered trademark of Intuit Inc. AccountingCoach LLC is not affiliated with Intuit Inc. and does not receive any affiliate marketing commissions from Intuit.

In this section we will highlight how the accounting software will capture financial transactions and then automatically update the general ledger and store the information for management's future use.

Accounts payable
When accounting software is used to enter the invoices received from suppliers (vendor invoices), the software will update Accounts Payable and will require that the account or accounts that should be debited be entered as well. The accounting software's vendor files also allow a company to prepare purchase orders, receiving tickets and to pay the vendors' invoices.

A company should have internal controls so that only legitimate invoices are recorded and paid.

Check writing
When the accounting software is used to write checks, the software will automatically credit the Cash account and will require that another account be designated for the debit. An additional benefit is that the amounts will move electronically and the account balances will be automatically calculated with speed and accuracy.

Again, a company should have internal controls to ensure that only legitimate payments are processed.

Sales on credit
When the accounting software is used to prepare a sales invoice for a customer who purchased on credit, the customer's detail will be updated, the general ledger account Sales will be credited and the general ledger account Accounts Receivable will be debited. Statements for each customer and an aging of all of the accounts receivable can be printed with the click of a button.

Payroll
Another source of financial transactions is the company's payroll. While many companies process payroll on their accounting software, others opt to outsource payroll to companies such as ADP, Paychex, Intuit, or local firms.

(AccountingCoach is not affiliated with any of these companies and it does not receive affiliate marketing commissions from any of them.)

To learn more about payroll use any of the following links:

• Explanation
• Quiz
• Questions and Answers (Q&A)
• Crossword Puzzles

Bank Reconciliation

The purpose of the bank reconciliation is to be certain that the financial statements are reporting the correct amount of cash and the proper amounts for any related accounts (since every transaction affects a minimum of two accounts).

The bank reconciliation process involves:

1. Comparing the following amounts
   • The balance on the bank statement
   • The balance in the company's general ledger account. (The account title might be Cash - checking.)
2. Determining the reasons for the difference in the amounts shown in 1.

The common reasons for a difference between the bank balance and the general ledger book balance are:

• Outstanding checks (checks written but not yet clearing the bank)
• Deposits in transit (company receipts that are not yet deposited in the bank)
• Bank service charges and other bank fees
• Check printing charges
• Errors in entering amounts in the company's general ledger

The outstanding checks and deposits in transit do not involve errors by either the company or the bank. Since these items are already recorded in the company's accounts, no additional entries to the company's general ledger accounts will be needed.

Bank charges, check printing fees and errors in the company's accounts do require the company to make accounting entries. The company should make the entries before the financial statements are prepared since a minimum of two accounts have the incorrect balances (due to double-entry accounting). Here is an entry for a bank service charge that was listed on the bank statement:

If the reconciliation reveals that an incorrect amount has been recorded in the company's Cash account, perhaps the easiest way to correct the error is to remove the incorrect amount and then enter the correct amount.

Accounting software is likely to include a feature for reconciling the bank statement.

Adjusting Entries

Why adjusting entries are needed

In order for a company's financial statements to be complete and to reflect the accrual method of accounting, adjusting entries must be processed before the financial statements are issued. Here are three situations that describe why adjusting entries are needed:

Situation 1

Not all of a company's financial transactions that pertain to an accounting period will have been processed by the accounting software as of the end of the accounting period. For example, the bill for the electricity used during December might not arrive until January 10. (The reason for the 10-day lag is that the electric utility reads the meters on January 1 in order to compute the electricity actually used in December. Next the utility has to prepare the bill and mail it to the company.)

Situation 2

Sometimes a bill is processed during the accounting period, but the amount represents the expense for one or more future accounting periods. For example, the bill for the insurance on the company's vehicles might be $6,000 and covers the six-month period of January 1 through June 30. If the company is required to pay the $6,000 in advance at the end of December, the expense needs to be deferred so that $1,000 will appear on each of the monthly income statements for January through June.

Situation 3

Something similar to Situation 2 occurs when a company purchases equipment to be used in the business. Let's assume that the equipment is acquired, paid for, and put into service on May 1. However, the equipment is expected to be used for ten years. If the cost of the equipment is $120,000 and will have no salvage value, then each month's income statement needs to report $1,000 for 120 months in order to report depreciation expense under the straight-line method.

These three situations illustrate why adjusting entries need to be entered in the accounting software in order to have accurate financial statements. Unfortunately the accounting software cannot compute the amounts needed for the adjusting entries. A bookkeeper or accountant must review the situations and then determine the amounts needed in each adjusting entry.

Steps for Recording Adjusting Entries

Some of the necessary steps for recording adjusting entries are

• You must identify the two or more accounts involved
  • One of the accounts will be a balance sheet account
  • The other account will be an income statement account
• You must calculate the amounts for the adjusting entries
• You will enter both of the accounts and the adjustment in the general journal
• You must designate which account will be debited and which will be credited.

Types of Adjusting Entries

We will sort the adjusting entries into five categories.

1. Accrued revenues

Under the accrual method of accounting, a business is to report all of the revenues (and related receivables) that it has earned during an accounting period. A business may have earned fees from having provided services to clients, but the accounting records do not yet contain the revenues or the receivables. If that is the case, an accrual-type adjusting entry must be made in order for the financial statements to report the revenues and the related receivables.

If a business has earned $5,000 of revenues, but they are not recorded as of the end of the accounting period, the accrual-type adjusting entry will be as follows:

2. Accrued expenses

Under the accrual method of accounting, the financial statements of a business must report all of the expenses (and related payables) that it has incurred during an accounting period. For example, a business needs to report an expense that has occurred even if a supplier's invoice has not yet been received.

To illustrate, let's assume that a company utilized a worker from a temporary personnel agency on December 27. The company expects to receive an invoice on January 2 and remit payment on January 9. Since the expense and the payable occurred in December, the company needs to accrue the expense and liability as of December 31 with the following adjusting entry:

3. Deferred revenues

Under the accrual method of accounting, the amounts received in advance of being earned must be deferred to a liability account until they are earned.

Let's assume that Servco Company receives $4,000 on December 10 for services it will provide at a later date. Prior to issuing its December financial statements, Servco must determine how much of the $4,000 has been earned as of December 31. The reason is that only the amount that has been earned can be included in December's revenues. The amount that is not earned as of December 31 must be reported as a liability on the December 31 balance sheet.

If $3,000 has been earned, the Service Revenues account must include $3,000. The remaining $1,000 that has not been earned will be deferred to the following accounting period. The deferral will be evidenced by a credit of $1,000 in a liability account such as Deferred Revenues or Unearned Revenues.

The adjusting entry for this deferral depends on how the receipt of $4,000 was recorded on December 10. If the receipt of $4,000 was recorded with a credit to Service Revenues (and a debit to Cash), the December 31 adjusting entry will be:

If the entire receipt of $4,000 had been credited to Deferred Revenues on December 10 (along with a debit to Cash), the adjusting entry on December 31 would be:

4. Deferred expenses

Under the accrual method of accounting, any payments for future expenses must be deferred to an asset account until the expenses are used up or have expired.

To illustrate, let's assume that a new company pays $6,000 on December 27 for the insurance on its vehicles for the six-month period beginning January 1. For December 27 through 31, the company should have an asset Prepaid Insurance or Prepaid Expenses of $6,000.

In each of the months January through June, the company must reduce the asset account by recording the following adjusting entry:

5. Depreciation expense

Depreciation is associated with fixed assets (or plant assets) that are used in the business. Examples of fixed assets are buildings, machinery, equipment, vehicles, furniture, and other constructed assets used in a business and having a useful life of more than one year. (However, land is not depreciated.)

Depreciation allocates the asset's cost (minus any expected salvage value) to expense in the accounting periods in which the asset is used. Hence, office equipment with a useful life of 5 years and no salvage value will mean monthly depreciation expense of 1/60 of the equipment's cost. A building with a useful life of 25 years and no salvage value will result in a monthly depreciation expense of 1/300 of the building's cost.

Additional information on adjusting entries