Topic 7 OF ACCONTING

THE PREPARATION OF FINANCIAL STATEMENTS (FINAL ACCOUNTS)
Learning Objectives
By the end of this section you should be able to;
1. Explain what is meant by preparation of financial statements
2. Prepare each of the three basic financial statements (cash flow statement is not
covered in this course) in the standard format
3. Correctly determine the income for sole traders
4. Correctly list long-erm and short-term assets in the balance sheet
5. Prepare financial statements given adjustments required on the trial balance
Introduction. Learning Objective 1

Preparation of the financial statements is the ‘end’ of the accounting process. It is the
second last activity in the accounting process before closing the accounts. In this section
of the course, we focus on how the financial statements are preparing.
What do we mean by ‘financial statements?’ Learning Objective 1

The financial statements (also referred to as final accounts) refer to:
1. The income statement (also called the Profit and Loss statement, the statement of
financial performance, or trading, profit, and loss account) for the period.
2. The Statement of Changes in Equity (or statement of changes in capital) for the
period.
3. The Balance Sheet (also called the statement of financial position) as at the end
of period.
4. The Cash Flow statement for the period.
These statements are prepared using the adjusted trial balance in the order shown in the
diagram below.
The preparation of the cash flow statement is covered in a future as it is beyond the scope
of this course. The first statement to be prepared is the income statement.
© Henry K Mburu (2020). This document is for individual class use only. It must not be uploaded
to any repository or website or made available for public use.
Income Statement (Statement of financial performance) Learning Objective 2 and 3
This statement indicates the financial performance of the business for a period. Of the
five elements of financial statements, only two appear in the income statement; income
(revenue) items and expense items. Income earned from non-operating activities (e.g.
from disposal - selling of long-term assets) is termed “other income” and it is shown
separately in the income statement. Income earned, and expenses incurred during the
period even if cash has not been received or paid are shown, consistent with the revenue
and expense recognition principles.
The general form of this statement (for a trading business) is as shown below:
Name of the Business

Income Statement for the period ending ----
Sh.
Sales x
Less cost of sales (x)
Gross profit xx
Add other income
Dividends received x
Discounts received x
Less Expenses
Rent x
Insurance x
Depreciation x
Bad debts x (x)
Net Profit xx
Net profit is also referred to as net income. Sales may sometimes be adjusted for sales
returns and allowances and sales discounts as follows;
Sales revenue x
Less sales returns and allowances (x)
Less sales discounts (x)
Net sales xx
The cost of sales (cost of goods sold) is the total cost of what was sold. It is determined
as follows:
Opening stock x
Add purchases x
Cost of goods available for sale xx
Less closing stock (x)
Cost of sales xx
Where there are items of purchase returns and allowances, purchase discounts, and
carriage-in (freight-in), the cost of sales is determined as follows:
Opening stock x
Purchases x
Less purchase returns and allowances (x)
Less purchase discounts (x)
Net purchases x
Add carriage-in x
Cost of goods purchased x
Cost of goods available for sale x
Less closing stock (x)
Cost of goods sold xx
A service business has a much simpler income statement (single-step income

statement) as opposed to the multi-step income statement as indicated above.
Service revenue x
Less Expenses
Rent x
Insurance x
Depreciation x
Bad debts x (x)
Net Profit xx
Statement of changes in capital Learning Objective 2

The statement of changes in capital is the second statement to be prepared. It shows
how capital has changed over the period. The general form of the statement of changes
in capital is as shown below;

Statement of changes in capital for the period ending ----
Capital at the start of period x

Retained earnings b/f x
Add net income for the year x
x
Less Drawings (x)
Retained earnings c/f x
Capital at the end of the period xx
The figure for the net income for the year is taken from the income statement. The
statement shows how capital increases through normal operations (by earning revenue)
or through capital addition or injection. It also shows how capital decreases through
normal operations (by incurring expenses) or through drawings. The figure for net
income combines the effect of earning revenues and incurring expenses. The portion of
net income ploughed back to the business and not taken by the owner(s) is called
retained earnings. The figure of capital at the end of the period is taken to the balance
sheet.
The balance sheet (statement of financial position) Learning Objectives 2 and 4
The balance sheet is the accounting equation expressed as a statement. It shows the
financial position of the business at a point in time. The assets, liabilities, and capital
appear on the balance sheet. The assets should be balanced (equal) with the total of
liabilities and capital. However, the balance sheet may be prepared in any other form of
the balance sheet equation, i.e.
Assets – liabilities = net assets = Capital
To make the statement better understood, long-term assets, short-term assets, and
liabilities are classified separately.
Long-term assets are listed first starting with the one with the longest life, e.g. land to
the one with the shortest life, e.g. computers. In addition, long-term assets (except
land) are shown net of accumulated depreciation, i.e. WDV – written down value or
NBV- net book value).
Long-term assets: Cost Accumulated Depreciation WDV
Fittings 21,000 4,200 16,800
Or,
Long-term assets: Sh Sh
Fittings at cost 21,000
Less accumulated depreciation-fittings (4.200) 16,800
Short-term assets are listed next. The short-term assets are listed based on liquidity
(ease of converting to cash). Current assets which are least liquid are listed first and last
the most liquid asset (cash). The current asset, receivable, is shown net of provisions
for doubtful debts.
Short-term assets: Sh Sh
Inventory 23,000
Receivables 50,000
Less provisions for doubtful debts (8,500) 41,500
Total short-term assets 64,500
The format of the balance sheet may be as shown below. This example uses
hypothetical figures not related to any of the above examples.
Balance sheet as at ----
(Sh.) (Sh.) Sh.

Fixed assets: Cost Accum. Dep. WDV
Fittings 21,000 4,200 16,800
Computers 50,000 10,000 40,000
Total fixed assets 71,000 14,200 56,800
Current Assets:
Stock 52,000
Debtors 82,500
Less provisions for doubtful debts (2,500) 80,000
Prepayments 500
Cash 20,000
Total current assets 152,500
Total assets 209,300
Financed by:
Capital 130,000
Long-term liabilities;
15-year (6%) loan 40,000
Current Liabilities:
Creditors 30,000
Accruals 9,300
Total current liabilities 39,300
Total liabilities and capital 209,300
In this balance sheet, the total assets (209,300) balances (equal) the total of capital
(130,000) and liabilities (79,300). We say the balance sheet is balanced. Note the sub-
totals for total long-term assets, total current assets, and the total assets are shown.
Also note how the long-term assets are shown at cost and then accumulated
depreciation for each category of asset is subtracted to get the net book value. In
addition, note how the debtors are shown net of provisions for doubtful debts. The
figure for capital is the one determined in the statement of changes in capital.
Example 1 Learning Objectives 2 and 3
The following balances were extracted from Mashambani School Canteen ledger
accounts as at 28 February 2018.
Sh.
Bank 13,000
Cash 2,000
Capital 15,000
Creditors 4,000
Debtors 10,000
Drawings 5,000
Electricity 4,000
Sh.
Furniture 7,000
Office 3,000
expenses
Purchases 50,000
Sales 100,000
Wages 25,000
Required:
a) Compile Mashambani School Canteen’s trial balance as at 28.2.2018.
b) Prepare the income statement for the period ended 28.2.2018.
c) Prepare the statement of changes in capital for the year ended 28.2.2018
d) Prepare the balance sheet as at 28.2.2018.
e)
Solution
a) To compile the trial balance, you need to remember the accounts have normal debit
balances (i.e. assets, expenses, drawings, purchases, etc.) and those which have
normal credit balances (sales, revenues, liabilities, capital, etc.).
Mashambani School Canteen
Trial Balance as at 28 February 2018
Dr (Sh) Cr (Sh)
Bank 13,000
Cash 2,000
Capital 15,000
Creditors 4,000
Debtors 10,000
Drawings 5,000
Electricity 4,000
Furniture 7,000
Office expenses 3,000
Purchases 50,000
Sales 100,000
Wages 25,000 ________
119,000 119,000
b)
Income Statement for period ended 28.2.2018
(Sh) (Sh)
Sales 100,000
Purchases (50,000)
Gross profit 50,000
Expenses
Electricity 4,000
Office expenses 3,000
Wages 25,000 (32,000)
Net Income 18,000
The items used in preparation of the income statement are called “profit and loss items,
or income items” they are revenue items, and expense items. The remaining items on
the trial balance are “balance sheet items,” they are assets, liabilities, and capital. The
former always appear on the profit and loss account while the latter appear on the balance
sheet.
In this example, there were no opening or closing stocks provided and, therefore,
purchases was equal to cost of sales.
(c)
Statement of changes in capital for period ended 28.2.2018
(Sh) (Sh)
Capital at 1.3.2017 15,000
Retained earnings b/f 0
Add net income for the year 18,000
Less drawings 5,000
Retained earnings c/f 13,000
Capital at 28.2.18 28,000
Note that the net income determined in the income statement is used in the statement of
changes in capital. The portion of net income that is not taken by the owners as drawings
(or dividends in case of companies) is ploughed back to the business and is called
retained earnings.
d)
Balance Sheet as at 28.2.2018
(Sh) (Sh)
Fixed Assets:
Furniture 7,000
Current Assets:
Debtors 10,000
Bank 13,000
Cash 2,000
25,000
Creditors (4,000)
Net current assets 21,000
Net assets employed 28,000
Financed by:
Capital 28,000
In the balance sheet, the fixed (long-term or non-current assets) are listed in order of
decreasing expected life. For example, land, buildings, vehicles, computers. The current
assets (short-term assets) are listed in order of decreasing liquidity (nearness to cash);
so, stock (or inventory) is listed first and then last is cash 1. This balance sheet is in the
form; assets – liabilities = capital.
Example 2 Learning Objectives 2-4
Niceta extracted the following trial balance from her ledgers on 31 March 2018.
Dr Cr
(Sh) (Sh)
Lighting 1,000
Debtors 82,500
Sales 253,750
Wages 82,370
Drawings 35,000
Rent 5,000
Postage and Stationery 7,270
Capital at 1 April 2017 182,500
Purchases 172,800
Stock 41,000
Creditors 72,470
Fittings at cost 21,000
Cash 60,780 _______
508,720 508,720
Additional information:
- Stock at 31 March 2018 was valued at Sh 52,000.
- Rent had been prepaid by Sh 500.
- Wages were accruing by Sh 1,000.
- Fittings are to be depreciated at 20% straight line basis.
Required: Prepare the financial statements for Niceta.
Solution
Financial statements refer to the income statement, statement of changes in capital, and
the balance sheet.
Additional information is given and, therefore, we must use it to get the adjusted figures
to be included in the statements i.e. to make end-of-year adjustments to the figures in the
draft trial balance. Any item mentioned in the additional information must be adjusted
accordingly and we cannot use the figure given in the trial balance before the adjustments.
1
This listing is the one used when the International Financial Reporting Standards (IFRS) are in use. In
the US, where different standards are used, cash is listed first and inventory last.
Workings
1. Stock: The figure given in the trial balance is the opening stock. Closing stock is
always given as additional information. The closing stock will be shown in the balance
sheet as a current asset in addition to being used to work out the cost of sales.
2. Rent: The prepayment of Sh.500 means that the figure in the trial balance includes
some amount for the next period. Hence the amount to be used in the profit statement
will be:
Sh.5,000 – 500 = Sh.4,500.
[Use the ledger account method to work it out!]
The amount prepaid will also be shown in the balance sheet as a current asset.
3. Wages: Some amount was accruing. This means the amount shown on the trial
balance is not the total amount incurred during the period. The amount to be used in
the profit statement will be:
Sh.82,370 + 1,000 = Sh.83,370.
[Use the ledger account method to work it out!]
The amount accrued will also be shown in the balance sheet as a current liability.
4. Depreciation = 20% x cost = 20%x 21,000 = Sh.4,200
This amount will be shown in:

i) The profit statement as an expense.
ii) The balance sheet as a reduction in the value of fittings.
Niceta
The income statement for the year ended 31 March 2018
(Sh) (Sh)
Sales 253,750
Less cost of sales:
Opening stock 41,000
Purchases 172,800
213,800
Less closing stock 52,000
Cost of sales (161,800)
Gross profit 91,950
Less expenses:
Depreciation 4,200
Postage & stationery 7,270
Rent 4,500
Light 1,000
Wages 83,370 (100,340)
Net loss 8,390
Niceta’s expenses exceed her gross profit and, therefore, she made a loss.
Niceta
The statement of changes in capital for the year ended 31 March 2018
(Sh.) (Sh.)
Capital b/f 182,500
Net income for the year (8,390)
Less drawings 35,000
Retained earnings (43,390)
Capital c/f 139,110
Niceta
Balance sheet as at 31 March 2018
(Sh.) (Sh.) Sh.

Fixed assets: Cost Accum. Dep. WDV
Fittings 21,000 4,200 16,800
Current Assets:
Stock 52,000
Debtors 82,500
Prepayments 500
Cash 60,780
Total current assets 195,780
Creditors 72,470
Accruals 1,000
Total current liabilities (73,470)
Net current assets 122,310
Total Net assets 139,110
Financed by:
Capital 139,110
Note that the figure for income in the statement of changes in capital is drawn from the
income statement while the figure for capital in the balance sheet is drawn from the
statement of changes in capital. Therefore, the income statement has to be prepared first,
then statement of changes in capital, and lastly the balance sheet.
Some notes:
1. The non-current asset is recorded in the balance sheet at the written down value
(WDV). This is also referred to Net Book Value (NBV) or simply book value.
WDV = Cost – accumulated depreciation.
Accumulated depreciation is the total depreciation of an asset since it was bought.

It is the total portion of the ‘asset used up.’
2. The accruals and prepayments are recorded at their rightful place i.e. accrual as
current liabilities and prepayments as current assets.
3. The profit in this case was negative i.e. loss and, therefore, instead of increasing the
original capital it reduced.
4. The format used here should be adopted, note especially the use of different columns
to show different workings.

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THE PREPARATION OF FINANCIAL STATEMENTS (FINAL ACCOUNTS)

Introduction. Learning Objective 1

What do we mean by ‘financial statements?’ Learning Objective 1

Name of the Business

A service business has a much simpler income statement (single-step income

Statement of changes in capital Learning Objective 2

Name of the Business

Capital at the start of period x

(Sh.) (Sh.) Sh.

Example 2 Learning Objectives 2-4

Required: Prepare the financial statements for Niceta.

This amount will be shown in:

(Sh.) (Sh.) Sh.

WDV = Cost – accumulated depreciation.

Accumulated depreciation is the total depreciation of an asset since it was bought.

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