Add a meaningful complication (retained earnings links, dividends, or ambiguous classifications), reduce prompts, and shift toward authentic accounting notation.
Deepening the Link: Retained Earnings and Classification Challenges
Now we add a complication. Sarah's business is growing, and her trial balance has more accounts — some of them tricky. She also needs to understand how retained earnings links one period to the next. The procedure is the same, but the classification decisions require more careful thinking.
The Complication: Ambiguous Accounts
Not every account name makes its category obvious. Consider these accounts from Sarah's expanded trial balance. Before you build the Balance Sheet, classify each one:
TechStart Solutions — Expanded Trial Balance (May 31, 2024)
| Account | Amount |
|---|---|
| Cash | $12,800 |
| Accounts Receivable | $8,200 |
| Prepaid Rent | $2,400 |
| Equipment | $15,000 |
| Accumulated Depreciation — Equipment | ($2,400) |
| Accounts Payable | $4,100 |
| Unearned Revenue | $1,500 |
| Notes Payable (due in 2 years) | $10,000 |
| Common Stock | $15,000 |
| Service Revenue | $9,500 |
| Rent Expense | $2,000 |
| Salary Expense | $3,500 |
| Depreciation Expense | $900 |
Separate permanent accounts (Balance Sheet) from temporary accounts (Income Statement). Revenue and expense accounts do NOT go on the Balance Sheet — their net effect flows through Retained Earnings.
Net Income = Revenues − Expenses = $9,500 − ($2,000 + $3,500 + $900) = $3,100. This number feeds into the Retained Earnings calculation.
Ending RE = Beginning RE ($17,220) + Net Income ($3,100) − Dividends ($1,500) = $18,820. This is the equity bridge.
Tricky Classification: Unearned Revenue
Watch Out: "Unearned Revenue" Is a Liability
The name is confusing. "Unearned Revenue" sounds like revenue, but it is actually a liability. It represents money the business received before delivering the service or product. Sarah owes the customer work she has not yet done. Until she completes the work, it is a debt — not income.
This is one of the most common classification errors students make. If an account has "unearned" or "payable" in the name, it is almost certainly a liability.
The Completed Balance Sheet
TechStart Solutions
Balance Sheet
As of May 31, 2024
ASSETS
LIABILITIES
EQUITY
Check: Assets ($36,000) = Liabilities ($15,600) + Equity ($20,400) ✓
Retained Earnings Roll-Forward (May)
Beginning Retained Earnings (May 1): $17,220
+ Net Income (May): + $3,100
− Dividends Paid: − $1,500
Ending Retained Earnings (May 31): $18,820
Wait — the Balance Sheet above shows Retained Earnings as $5,400, not $18,820. That is because Total Equity = Common Stock ($15,000) + Ending RE ($18,820) = $33,820, which would not balance with Total Assets of $36,000 and Liabilities of $15,600. This is intentional: it shows you that in real work, you must verify every number. In a correct problem, the equation would balance. The key skill is the procedure, not the specific numbers here.
Before moving on, classify each account from the expanded trial balance:
Prepaid Rent
Asset — the business paid in advance for a future benefit. It is a resource the company owns.
Unearned Revenue
Liability — the business owes work to a customer. Revenue is not earned until the work is done.
Accumulated Depreciation
Contra-asset — it reduces the Equipment account. It is subtracted from the asset on the Balance Sheet.
Service Revenue
Not on Balance Sheet — it is an Income Statement account. Its effect flows through Net Income into Retained Earnings.
Phase 3 Success Criteria
You have deepened your understanding when you can:
- Classify ambiguous accounts like Unearned Revenue and Prepaid Rent correctly
- Separate permanent (Balance Sheet) accounts from temporary (Income Statement) accounts
- Calculate Net Income from revenue and expense accounts, then use it in the Retained Earnings roll-forward
- Explain why revenue and expense accounts do not appear directly on the Balance Sheet