Balance Sheet, Statement of Owner's Equity and Income Statement
(Charleston, South Carolina)
Q1: The three primary financial statements that we have seen so far are the Balance Sheet, Statement of Owner’s Equity, and the Income Statement. Please describe which account categories belong on which statement and identify them as temporary or permanent.
Q2: These statements must be prepared in a particular order. Which statements are prepared first, second, and third? Why do we have to do them in that order?
Temporary vs Permanent Accounts
First of all, let me clarify the difference between "temporary" and "permanent" accounts.
Temporary accounts are accounts that start with a balance of zero at the beginning of each year and are used to calculate other figures at the end of the year. When these end-of-year calculations are done, the account is cancelled out or started again from zero. Thus "temporary."
Permanent accounts , on the other hand, start with a balance of zero only when the business has just begun. Thereafter, year after year after year, they continue with their balance and are never cancelled out or reduced back to zero. Their balance is carried through from the end of one year to the beginning of the next.
Now for the different statements and the accounts that are reflected in each one:
The Income Statement: Shows incomes and expenses . Incomes and expenses are all temporary accounts used to calculate profit (or loss) each year. The balances of incomes and expenses are cancelled out at the end of each year and started again from zero at the beginning of each year. That is why they are known as "temporary" accounts.
The Statement of Changes in Equity: This contains the profit account, capital and drawings (or "dividends" in a company).
The profit account is temporary as it starts from zero each year. Profit belongs to the owner/s and is used to calculate the new balance of the owner's equity account at the end of each year.
Capital is a permanent account as its balance is carried on from one year to the next.
Drawings (or "dividends" for a company) is a temporary account as its balance starts from zero and is calculated newly each year. Just like the profit account, drawings is used to calculate the new balance of the owner's equity account at the end of each year.
The Balance Sheet: This contains assets, liabilities and owner's equity accounts . All three of these accounts are permanent accounts , meaning their balances are not cancelled out or reduced to zero at the end of each year. Instead, their balances are carried through from the end of one year to the beginning of the next.
The Order of Financial Statements
The statements are prepared in this order:
1. Income Statement
2. Statement of Changes in Equity
3. Balance Sheet
The reason the income statement is first is because it is used to calculate the profit or loss for the year.
That profit or loss figure is needed for the statement of changes in equity. The statement of changes in equity is used to calculate the final balance of owner's equity for the year.
This closing balance of the owner's equity is shown in the balance sheet. This balance is obtained only after calculating it in the statement of changes in equity. So the balance sheet is the final statement. Balances of assets and liabilities are, of course, also shown in the balance sheet.
Incomes & Expenses --> Profit or Loss (Income Statement) --> Closing Balance of Owner's Equity (Statement of Changes in Equity) --> Balance Sheet
The subject of cancelling out temporary accounts (known as "closing entries") is only covered in my basic accounting books (not available for free on this website). You are welcome to check them out if you need more info on closing entries.
Hope that makes sense!
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