Lesson 4

From trial balance to financial statements

TOPIC LIST

1 The trial balance

2 The statement of profit or loss
3 The statement of financial position
4 Balancing accounts and preparing financial statements
1 The trial balance

At suitable intervals, the entries in each ledger account are totalled and a balance is struck.
Balances are usually collected in a trial balance which is then used as a basis for preparing a
statement of profit or loss and a statement of financial position.
You have a list of transactions, and have been asked to post them to the relevant ledger accounts.
You do it as quickly as possible and find that you have a little time left over at the end of the day.
How do you check that you have posted all the debit and credit entries properly? There is no
foolproof method, but a technique which shows up the more obvious mistakes is to prepare a
trial balance.

A trial balance is a list of ledger balances shown in debit and credit columns.
Before you draw up a list of account balances, you must have a collection of ledger accounts.
Balancing ledger accounts

At the end of an accounting period, a balance is struck on each account in turn. This means that
all the debits on the account are totalled and so are all the credits. If the total debits exceed the
total credits there is said to be a debit balance on the account; if the credits exceed the
debits then the account has a credit balance.
A trial balance can be used to test the accuracy of the double entry accounting records. It
works by listing the balances on ledger accounts, some of which are debits and some credits.
Total debits should equal total credits.
If the two columns of the list are not equal, there must be an error in recording the transactions in
the accounts. A list of account balances, however, will not disclose the following types of errors.
(a) The complete omission of a transaction, because neither a debit nor a credit is made
(b) The posting of a debit or credit to the correct side of the ledger, but to a wrong account
(c) Compensating errors (eg an error of $100 is exactly cancelled by another $100 error
elsewhere)
(d) Errors of principle (eg cash from receivables being debited to trade accounts receivable and
credited to cash at bank instead of the other way round)
The trial balance should reveal errors where the rules of double entry have been broken, such as:
(a) One-sided entries
(b) Where an entry has been posted as a credit to one account and a credit to a second account
and
no debit entry has been made (or two debits and no credits)
Example: trial balance
As at 30.3.20X7, your business has the following balances on its ledger accounts.

Accounts
Balance

$
Bank loan
12,000
Cash at bank
11,700
Capital
13,000
Local business taxes
1,880
Trade accounts payable
11,200
Purchases
12,400
Sales
14,600
Sundry payables
1,620
Trade accounts receivable
12,000
Bank loan interest
1,400
Other expenses
11,020
Vehicles
2,020

During 31.3.20X7, the business made the following transactions.

(a) Bought materials for $1,000, half for cash and half on credit
(b) Made $1,040 sales, $800 of which was for credit
(c) Paid wages to shop assistants of $260 in cash
You are required to draw up a trial balance showing the balances as at the end of 31.3.20X7.
Solution
First it is necessary to decide which of the original balances are debits and which are credits.
Account Dr Cr
$ $
Bank loan (liability) 12,000
Cash at bank (asset; overdraft = liability) 11,700
Capital (liability) 13,000
Local taxes (expense) 1,880
Trade accounts payable (liability) 11,200
Purchases (expense) 12,400
Sales (revenue) 14,600
Sundry payables (liability) 1,620
Trade accounts receivable (asset) 12,000
Bank loan interest (expenses) 1,400
Other expenses 11,020
Vehicles (non-current asset) 2,020
52,420 52,420
Now we must take account of the effects of the three transactions which took place on
31.3.20X7.
$ $
(a) DEBIT Purchases 1,000
CREDIT Cash at bank 500
Trade accounts payable 500
(b) DEBIT Cash at bank 240
Trade accounts receivable 800
CREDIT Sales 1,040
(c) DEBIT Other expenses 260
CREDIT Cash at bank 260

When these figures are included in the trial balance, it becomes:

Account Dr
Cr
$
$
Bank loan
12,000
Cash at bank (11,700 + 240 – 500 – 260) 11,180
Capital
13,000
Local taxes 1,880
Trade accounts payable (11,200 + 500) 11,700
Purchases (12,400 + 1,000) 13,400
Sales (14,600 + 1,040)
15,640
Sundry payables
1,620
Trade accounts receivable (12,000 + 800) 12,800
Bank loan interest 1,400
Other expenses (11,020 + 260) 11,280
Vehicles 2,020
53,960
53,960
2. The statement of profit or loss
A profit or loss ledger account is opened up to gather all items relating to income and expenses.
When rearranged, these items make up the statement of profit or loss.
The first step in the process of preparing the financial statements is to open up another ledger
account, called the profit or loss account. In it a business summarises its results for the period
by gathering together all the ledger account balances relating to the statement of profit or loss.
This account is still part of the double entry system, so the basic rule of double entry still applies:
every debit must have an equal and opposite credit entry.
This profit or loss account contains the same information as the financial statement we are
aiming for, ie the statement of profit or loss, and in fact there are very few differences between
the two. However, the statement of profit or loss lays the information out differently and it may
be much less detailed.
So what do we do with this new ledger account? The first step is to look through the ledger
accounts and identify which ones relate to income and expenses. In the case of Ron Knuckle,
these accounts consist of purchases, rent, sales, bank loan interest and other expenses.
The balances on these accounts are transferred to the new profit or loss account. For example, the
balance on the purchases account is $5,000 DR. To balance this to zero, we write in $5,000 CR.
But to comply with the rule of double entry, there has to be a debit entry somewhere, so we write
$5,000
DR in the profit or loss (P/L) account. Now the balance on the purchases account has been
moved to the P/L account.
If we do the same thing with all the separate accounts of Ron Knuckle dealing with income and
expenses, the result is as follows.
(Note that the P/L account has not yet been balanced off but we will return to that later.)
If you look at the items we have gathered together in the P/L account, they should strike a chord
in your memory. They are the same items that we need to draw up the statement of profit or loss.

QUESTION Statement of profit or loss

Draw up Ron Knuckle's statement of profit or loss.

ANSWER
RON KNUCKLE: STATEMENT OF PROFIT OR LOSS
$ $
Revenue 12,500
Cost of sales (= purchases in this case) (5,000)
Gross profit 7,500
Expenses
Rent 3,500
Bank loan interest 100
Other expenses 1,900
(5,500)
Profit for the year 2,000
3.The statement of financial position
The balances on all remaining ledger accounts (including the profit or loss account) can be
listed and rearranged to form the statement of financial position.
Are these the only ledger accounts left? No: don't forget there is still the last one we opened up,
called the profit or loss account. The balance on this account represents the profit earned by the
business and, if you go through the arithmetic, you will find that it has a credit balance – a profit
– of $2,000. (Not surprisingly, this is the figure that is shown in the statement of profit or loss.)
These remaining accounts must also be balanced and ruled off, but since they represent assets
and liabilities of the business (not income and expenses) their balances are not transferred to the
P/L account. Instead they are carried down in the books of the business. This means that they
become opening balances for the next accounting period and indicate the value of the assets and
liabilities at the end of one period and the beginning of the next.
Look back at the ledger accounts of Ron Knuckle. Now that we have dealt with those relating to
income and expenses, which ones are left? The answer is that we still have to find out what to do
with the cash, capital, bank loan, trade accounts payable, shop fittings, trade accounts receivable
and the drawings accounts.
Are these the only ledger accounts left? No: don't forget there is still the last one we opened up,
called the profit or loss account. The balance on this account represents the profit earned by the
business and, if you go through the arithmetic, you will find that it has a credit balance – a profit
– of $2,000. (Not surprisingly, this is the figure that is shown in the statement of profit or loss.)
These remaining accounts must also be balanced and ruled off, but since they represent assets
and liabilities of the business (not income and expenses) their balances are not transferred to the
P/L account. Instead they are carried down in the books of the business. This means that they
become opening balances for the next accounting period and indicate the value of the assets and
liabilities at the end of one period and the beginning of the next.
The conventional method of ruling off a ledger account at the end of an accounting period is
illustrated by the bank loan account in Ron Knuckle's books.
A credit balance brought down denotes a liability. An asset would be represented by a debit
balance brought down.
One further point is worth noting before we move on to complete this example. You will
remember that a proprietor's capital comprises any cash introduced by them, plus any profits
made by the business, less any drawings made by them. At the stage we have now reached, these
three elements are contained in different ledger accounts. Cash introduced of $7,000 appears in
the capital account. Drawings of $1,500 appear in drawings. The profit made by the business is
represented by the $2,000 credit balance on the P/L account.
It is convenient to gather together all these amounts into one capital account, in the same way as
we earlier gathered together income and expense accounts into one P/L account.
DRAWING
S
  $   $
Capita
Cash Bank 1500 l a/c 1,500
 

PROFIT OR LOSS
ACCOUNT
  $   $
Purchases 5,000 Sales 12,500
Rent 3,500
Bank loan interest 100
 Other expenses 1,900
Capital a/c 2,000
12,500 12,500

Capital

  $   $
Cash at
Drawings 1,500 bank 7,000
Balance c/d 7,500 P/L a/c 2,000
9,000 9,000
Balance
  b/d 7,500
 

QUESTION Statement of financial position

You can now complete Ron Knuckle's simple statement of financial position.

ANSWER

RON KNUCKLE
STATEMENT OF FINANCIAL POSITION AT END OF FIRST TRADING PERIOD

Assets
$
Non-current assets
Shop fittings 2,000
Current assets
Cash at bank 6,500
Total assets 8,500
Capital and liabilities
Proprietor's capital 7,500
Non-current liabilities
Bank loan 1,000
Total capital and liabilities 8,500