Step 6: Prepare Financial Statements

At the end of the financial cycle, your bookkeeper will complete the accounting cycle by closing the books and completing step six—prepare financial statements.

There are four main financial statements to prepare.

• The income statement, also called the profit and loss (P&L)

• The balance sheet 

• The statement of equity

• The statement of cash flows 

Closing the books

Before preparing the financial statements, you reach a point where you decide no more changes or adjustments need to be made to the accounts. At that point, your bookkeeper will close the books for the accounting period.

At the end of the financial cycle, before your bookkeeper ends the accounting period, they will come to a cut-off point where they will decide all entries are complete and nothing else should be added to the accounting period. At that point, they will want to make sure that everything in the accounting period stays as it currently is.

This process, known as closing the books, helps maintain the accuracy and reliability of the statements.

NOTE: If the business staff has not submitted all feedback, to do's, clarification on transactions, or new information by this point - the bookkeeper has no choice but to close the books with the info they have at the time. Then they would have to RE-OPEN the books later to make any changes that are learned about after the period closes. This is why CHANGE ORDER charges or LATE FILING FEES may be issued by the bookkeeper for this additional effort. It means that the info they needed in order to make the correct adjusting entries for that period was given LATE, and as a result, they have to GO BACK and create additional adjusting entries and new financial reports. This means more TIME they have to spend on the bookkeeping that is OUT OF SCOPE and may affect how much time it takes to do the current period bookkeeping. This is why it is very important for the business owners and their staff to turn in their paperwork and feedback ON TIME each month BEFORE the bookkeeper finishes their month end close. As a rule of thumb, try to submit all previous month's paperwork no later than by the 5th day of the following month so that delays or re-opening closed books does not occur.

To ensure readiness for book closure, review all the previous steps of the accounting cycle and address any outstanding issues, such as reconciling, errors, or inaccuracies. 

Once the books are closed, any additional changes would need to be made in the current period (rather than in the closed one) to avoid affecting the financial statements. 

Many software programs (like QuickBooks) offer a feature to lock the books, providing a warning message so you cannot accidentally make changes after the books have been closed.

Remember, once the books are closed, you should not make any further entries to that accounting period, as it will impact the financial statements.

PROFIT AND LOSS / INCOME STATEMENT

The income statement, also known as the Profit and Loss statement, is essential for businesses as it displays their profitability by outlining revenues (income) and expenses (expenditures).

This statement offers an overview of a business's financial performance over a specific period. It details the total revenue, which encompasses all income from the sale of goods and services. It considers the total cost of goods sold, representing the expenses directly linked to producing the goods or services that generated the revenue. Gross profit is calculated by subtracting the cost of goods sold from the total revenue. 

The income statement also lists other business expenses incurred during the period, such as rent, salaries, and advertising costs. 

By deducting total expenses, including taxes, from the revenue, the income statement reveals the net profit or loss for the business. This statement is vital for assessing a business's financial health and profitability.

BALANCE SHEET The balance sheet is important because it shows what the business owns (assets), owes (liabilities), and the value to its owners (equity) at a specific time.

The balance sheet is a financial document that presents a company’s assets, liabilities, and equity at a certain moment, adhering to the accounting equation. It acts as a snapshot of your business on a specific day, assisting in tracking what the business owns (assets), what it owes (liabilities), and the remaining value for the owners (equity).

Keep in mind, assets also encompass a business’s capital, which signifies the funds the business utilizes for operations and expansion. This can include cash, debt, or equity.

Without software, the balance sheet should be organized with assets on the left and liabilities and equity on the right. However, with accounting software, the balance sheet might appear as a single list.

The balance sheet is based on the fundamental accounting equation: assets equal liabilities plus equity.

The first section of the balance sheet displays the business’s assets, which include anything of value the business owns or any valuable resource that can potentially be converted into cash. This section corresponds to the left side of the accounting equation. It starts with the most liquid assets, like cash and bank accounts, followed by accounts receivable, representing what customers owe the business.

Other assets, such as physical assets and long-term purchases like vehicles used by the business over several years, are listed afterward. It also includes unrealized gains, which are the theoretical profits a business will receive when they sell stock, commodity, or make a currency exchange. These must be recorded on the balance sheet until they are sold and the profit can be documented elsewhere.

The second section of the balance sheet concerns what the business owes and its financial resources. It includes liabilities, which align with the first part of the right side of the accounting equation. Liabilities represent what the business owes to external parties, like accounts payable. This can include current liabilities, which are immediate obligations such as unpaid bills, credit card balances, or lines of credit, as well as long-term liabilities, like larger loans that take years to repay, such as business or car loans.

The final part of a balance sheet is equity, which signifies the business's value from the owners' perspective. It reflects what the owners would retain if they sold all assets and paid off all debts. Regularly monitoring the balance sheet is essential for sustaining the overall financial health of the business.

STATEMENT OF EQUITY Owners Share In the simplest terms, equity is the money the shareholders—whether a single owner or many stockholders—have invested into the business and all the accumulated earnings of the business over time. 

The statement of equity is basically the equity portion of the balance sheet pulled out into its own financial statement. This important component of the balance sheet reflects changes in business equity over time, including contributions, withdrawals, and retained earnings. It provides insights into the business's financial performance and how it distributes profits or accumulates losses. 

Retained earnings

From the statement of equity, also shown on the balance sheet, this is accumulated net income from previous years minus any dividends paid to shareholders.

The statement of equity reports the changes in business or owner's equity during the reporting period. It shows the owner’s equity at the beginning of the reporting period, the changes that have affected that amount, and the resulting ending equity at the end of the reporting period. These changes include earned profits that have been retained by the business at the end of the year.

The statement begins with beginning capital then adds in any owner contributions and net income for total capital/income. 

It then subtracts the amount of any losses or capital withdrawals which results in the amount of equity increase or decrease over the accounting period. 

The statement of equity shows the accumulated retained earnings—the portion of a business’s net income that is not distributed to shareholders as dividends—at the end of the year.

This statement is not often used by small businesses, but it is more often shared with stock and shareholders.

STATEMENT OF CASHFLOWS The statement of cash flows provides valuable insights into a business's financial health and cash management. 

Balance sheet + income statement = statement of cash flows

The statement of cash flows combines information from the balance sheet and income statement to provide a comprehensive view of a business's cash flow activities during a specific period. 

The statement of cash flows shows where and how cash flows into and out of a business, revealing where the money comes from and how it is used. It combines information from the balance sheet and the income statement to provide a comprehensive view of cash as it moves through the business.

While the balance sheet can show cash on hand, the statement of cash flows also shows the source of the cash—so if that cash came from sales or from financing—and how it flowed through the business during the period.

Let’s look at how this works.

Consider a business with $100 in starting cash, which is the amount in their bank account at the start of the accounting period. They record sales for the period and have $200 in net income which, if that was all that happened in the business, would mean that there should be $300 in their bank account at the end of the accounting period. But that isn't always the case, is it? The situation is often far more complex. There are various factors affecting the business's financial records, depending on its intricacies. To accurately represent the reality, we must account for other changes in assets and liabilities. In this scenario, let's focus on accounts receivable, which tracks the money owed to you. If this account increases from zero to $400 during the period, that means there are outstanding payments yet to be collected. As the cash for these sales has not yet hit the bank account, we must subtract this increase of $400 from our bank account. This leads to an ending cash balance of negative $100, matching the amount listed in the balance sheet.

This example shows why keeping track of cash flow carefully is so important. Even though the business realized a net income, because the customer paid on credit, the way the cash moved through the business resulted in a cash flow problem.

As you can see, while net income equals revenue minus expenses, what is not included in this equation is changes in assets, liabilities, and equity. This is why it is so important to regularly prepare and review the statement of cash flows. It guides cash management decisions and promotes proactive financial planning by helping the business keep track of their cash, identify any cash issues, and plan their finances better.

Operating expenses

Operating expenses, also known as operating costs or operating expenditures, are the day-to-day expenses incurred as the business generates revenue. These expenses are directly associated with the core business activities. Operating expenses typically include items such as payroll, rent, utilities, insurance, marketing and advertising expenses, office supplies, insurance, maintenance and repairs, and other costs directly related to running the business. Operating profit

The profitability of a company's core operations before interest, taxes, and non-operating expenses are deducted. This is calculated by subtracting the total operating expenses from the gross profit.