Key takeaways
What this article covers, in order:
- Before any statement: the trial balance
- The order, and why each step depends on the last
- Worked example: Vela Translations from trial balance to cash flow
- Preparation order is not presentation order
- After the statements: closing the books
- Common mistakes with the order of financial statements
The income statement is prepared first. It comes straight from the adjusted trial balance and produces net income, which every other statement needs. The usual order is: income statement, then the statement of retained earnings (or statement of changes in equity under IFRS), then the balance sheet, and finally the statement of cash flows.
The order is not a convention for its own sake. Each statement takes a figure from the one before it, so preparing them out of order leaves a gap you cannot fill. This guide explains the chain, then follows one small company's numbers all the way through.
Before any statement: the trial balance
All four statements are built from the same source, the ledger, summarised in a trial balance. The sequence before the statements is:
- Unadjusted trial balance: every account and its balance at period end, with debits equal to credits.
- Adjusting entries: depreciation, accrued expenses, prepaid expenses, unearned revenue, and any corrections.
- Adjusted trial balance: the corrected balances, still in balance, which feed the financial statements.
Skipping the adjustments is the most common reason a set of statements is wrong. An unadjusted trial balance will usually still balance, but profit and the balance sheet will be misstated.
The order, and why each step depends on the last
1. Income statement
Take every revenue and expense account from the adjusted trial balance. Revenue minus expenses gives net income (or net loss) for the period. Nothing else is needed, which is why it comes first.
2. Statement of retained earnings or changes in equity
Opening retained earnings + net income − dividends = closing retained earnings. This statement needs net income from step 1. Under IFRS the equivalent is the statement of changes in equity, which shows the movement in every component of equity, including share capital and other reserves.
3. Balance sheet
List the asset, liability and equity accounts from the adjusted trial balance, but use closing retained earnings from step 2, not the figure on the trial balance. Until the books are closed, the trial balance still shows the opening retained earnings, with this year's profit sitting in the income and expense accounts. That is why the balance sheet cannot be finished before the first two statements.
4. Statement of cash flows
This one comes last because it draws on all the others. Under the indirect method it starts from profit (step 1), then uses the change in each balance sheet account between the opening and closing balance sheets (step 3) to work out operating, investing and financing cash flows. Dividends paid (step 2) appear in financing. The net change in cash it calculates must match the change in cash on the two balance sheets.
Worked example: Vela Translations from trial balance to cash flow
Vela Translations is a small company that provides legal and technical translation using in-house linguists and a freelance network. Its year has just ended. After posting depreciation and accruals, here is how its statements are built.
Step 1: the income statement
- Revenue: £186,000
- Freelance translator costs: £92,000
- Salaries: £38,000
- Translation software and subscriptions: £6,000
- Office rent: £12,000
- Depreciation on laptops and equipment: £3,000
- Income tax expense: £8,000
- Net income: £27,000
Step 2: the statement of retained earnings
- Opening retained earnings: £41,000
- Add net income: £27,000
- Less dividends declared and paid: £15,000
- Closing retained earnings: £53,000
Step 3: the balance sheet
Assets
- Cash: £47,000
- Accounts receivable: £31,000
- Equipment at cost £15,000, less accumulated depreciation £6,000: £9,000
- Total assets: £87,000
Liabilities and equity
- Accounts payable to freelancers: £14,000
- Income tax payable: £8,000
- Accrued expenses: £2,000
- Share capital: £10,000
- Retained earnings (from step 2): £53,000
- Total liabilities and equity: £87,000
It balances only because the closing retained earnings figure includes this year's £27,000 of profit. If you had used the £41,000 opening figure from the unadjusted ledger, liabilities and equity would come to £75,000 and you would be hunting for a missing £12,000, which is this year's profit minus the dividend.
Step 4: the statement of cash flows
Last year's closing balance sheet showed cash of £38,000, receivables of £24,000, equipment with a net book value of £8,000, payables of £11,000, income tax payable of £6,000 and accrued expenses of £2,000.
Operating activities (indirect method)
- Net income: £27,000
- Add depreciation: +£3,000
- Increase in receivables (£24,000 to £31,000): −£7,000
- Increase in payables (£11,000 to £14,000): +£3,000
- Increase in income tax payable (£6,000 to £8,000): +£2,000
- Accrued expenses unchanged: £0
- Net cash from operating activities: £28,000
Investing activities
- New laptops and a server: −£4,000 (equipment net book value went from £8,000, plus £4,000 bought, less £3,000 depreciation, to £9,000)
Financing activities
- Dividends paid: −£15,000
Net change in cash: 28,000 − 4,000 − 15,000 = £9,000. Opening cash of £38,000 plus £9,000 equals the £47,000 on this year's balance sheet. The cash flow statement reconciles, which confirms the other three statements are consistent with each other.
Notice what the cash flow statement needed: net income from step 1, dividends from step 2, and two balance sheets from step 3. It could not have been prepared any earlier.
Preparation order is not presentation order
The order accountants prepare statements in is not necessarily the order they appear in a published annual report. Many reports put the balance sheet first, and IFRS lets companies combine profit or loss and other comprehensive income into one statement or show them as two. The dependency chain behind the numbers stays the same either way.
Under IFRS, a complete set of financial statements consists of a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows, and notes. The notes are written last, once the figures are final.
After the statements: closing the books
Once the statements are final, closing entries transfer the income and expense balances into retained earnings, setting those accounts to zero for the new year. The closing balance sheet becomes the opening position for the next period. Doing the close before the statements are reviewed makes later corrections harder, so most businesses finalise and approve the statements first.
Common mistakes with the order of financial statements
- Preparing the balance sheet from the trial balance alone and forgetting to roll in current-year profit. The result will not balance by exactly the year's profit less dividends.
- Using the unadjusted trial balance, so depreciation and accruals are missing from every statement.
- Preparing the cash flow statement from one balance sheet. The indirect method needs the opening and closing positions.
- Treating dividends as an expense on the income statement rather than a reduction of retained earnings.
- Closing the books before the statements are reviewed, which forces adjustments into a locked period.
hellobooks< / a > -helps">How HelloBooks helps
In HelloBooks, the profit and loss report, balance sheet, trial balance and cash flow statement are all generated from the same double-entry ledger, so the profit on the income statement always ties to retained earnings on the balance sheet, and the cash flow statement (direct or indirect method) reconciles to the bank balance. Period-end closing posts accruals, prepayments and depreciation before you run the reports, the year-end close moves profit into retained earnings, and period locking protects the closed year. Your accountant can review the adjusted trial balance and approve journal entries before anything is finalised.
