CHAPTER 5

PREPARING BASIC
FINANCIAL STATEMENTS
 PREPARING BASIC FINANCIAL STATEMENTS

Topic list

• The trial balance

1

• Balancing off ledger accounts

2

• Preparing the statement of profit or loss

3

• Preparing the statement of financial position

4

• Preparing basic financial statements

5
 PREPARING BASIC FINANCIAL STATEMENTS

Trial Balance

A list of nominal ledger account

balances shown in debit and
credit columns at a point in time,
usually the end of the accounting
year.

It is the starting point to preparing

the financial statements.
 PREPARING BASIC FINANCIAL STATEMENTS

Trial Balance
 PREPARING BASIC FINANCIAL STATEMENTS
The Extended Trial Balance (ETB)

• This has debit and credit

columns for the initial

trial balance, plus debit

and credit columns for

adjustment journals.

• A revised trial balance is

then created by cross-

casting horizontally.
 PREPARING BASIC FINANCIAL STATEMENTS
Errors

TB can not itself detect following errors:

• Omission errors: a transaction is completely omitted, either in the nominal

ledger, or the trial balance itself, so neither a debit nor a credit is made.
• Commission errors: a debit or credit is posted to the correct side of the
nominal ledger, but to a wrong account. Eg, wages paid are debited to the
rent account instead of the wages account.
• Compensating errors: one error is exactly cancelled by another error
elsewhere.
• Errors of principle, such as cash from receivables being debited to trade
receivables and credited to cash at bank instead of the other way round.
• A transposition error is a simple error of data entry that occurs when two
digits that are either individual or part of a larger sequence of numbers are
accidentally reversed (transposed) when posting a transaction.
 PREPARING BASIC FINANCIAL STATEMENTS
Errors
Example:
If a business receives an invoice from
a supplier for $250, the transaction
might be omitted from the books
entirely. As a result, both the total
debits and the total credits of the
business will be incorrect by $250.
If a business receives an invoice from
a supplier for $300, the payables
control account might be credited, but
the debit entry in the purchases
account might be omitted. In this case,
the total credits would not equal total
debits (because total debits are $300
less than they ought to be).
 PREPARING BASIC FINANCIAL STATEMENTS

Errors
Example:

• For example, repairs to a machine costing $150 should be treated as revenue expenditure, and debited to a
repairs account. If, instead, the repair costs are added to the cost of the non-current asset (capital
expenditure) an error of principle would have occurred. As a result, although total debits still equal total
credits, the repairs account is $150 less than it should be and the cost of the non-current asset is $150
greater than it should be.

• Putting a debit entry or a credit entry in the wrong account. For example, if telephone expenses of $540 are
debited to the electricity expenses account, an error of commission would have occurred. The result is that
although total debits and total credits balance, telephone expenses are understated by $540 and electricity
expenses are overstated by the same amount.
 PREPARING BASIC FINANCIAL STATEMENTS

Errors
Example:

• For example, although unlikely, in theory two transposition errors of $540 might occur in extracting ledger
balances, one on each side of the double entry. In the administration expenses account, $2,282 might be
written instead of $2,822 while, in the sundry income account, $8,391 might be written instead of $8,931.
Both the debits and the credits would be $540 too low, and the mistake would not be apparent when the
trial balance is cast. Consequently, compensating errors hide the fact that there are errors in the trial
balance.

• For example, suppose that a sale is recorded in the sales account as $6,843, but it has been incorrectly
recorded in the total receivables account as $6,483. The error is the transposition of the 4 and the 8. The
consequence is that total debits will not be equal to total credits. You can often detect a transposition error
by checking whether the difference between debits and credits can be divided exactly by 9. For example:
$6,843 – $6,483 = $360; $360/9 = 40.
 PREPARING BASIC FINANCIAL STATEMENTS

Balancing off ledger account

At the end of a reporting period, when all adjustment journals
have been posted, each nominal ledger account must be
balanced off.

• For income or expense accounts, the balance is transferred to

a profit and loss ledger account, leaving a nil balance in the
income or expense account.

• For asset, liability or capital accounts, the balance on the

account is carried down and brought down to give the
opening balance for the next accounting period
 Balancing off ledger account
Sales PL account Rent expenses

Cash 5,000 Rent 4,000Sales 13,000 Cash 3,000

Receivables 8,000 Capital 9,000 Cash 1,000
PL 13,000 PL 4,000

Dr Sale: 13,000 Dr PL: 9,000 Dr PL: 4,000

Cr PL: 13,000 Cr Capital: 9,000 Cr Rent: 4,000

Car at Cost Car at Cost

next period
Cash 100,000 Balance b/f 100,000
Balance c/f 100,000
 PREPARING BASIC FINANCIAL STATEMENTS

Preparing the statement of profit or loss

Create a new ledger account

2 Identify the ledger accounts
1 in the nominal ledger, called
which relate to income and
the profit and loss ledger
expenses.
account.

3 Transfer these balances to the 4 Sales and purchases are

profit and loss ledger account. included in gross profit.

All other income is added, and

5 all other expenses are
deducted, to arrive at profit
for the period.
 PREPARING BASIC FINANCIAL STATEMENTS

Preparing the statement of financial position

The profit and loss ledger account balance is transferred to the capital ledger
1 account.

All the remaining balances (on the asset, capital and liabilities accounts) in the
nominal ledger are then listed out in the vertical format statement of financial
2 position to show: non-current and current assets (total assets), which are equal to
capital plus non-current and current liabilities (total capital and liabilities).

Accounts represent assets, capital and liabilities of the business (not income and
3 expenses) , their balances are carried down in the books of the business. They
become opening balances for the next reporting period.
 PREPARING BASIC FINANCIAL STATEMENTS

Preparing basic financial statements

To prepare the statement of profit or loss and statement of financial position

together, you need to follow through methodically the steps involved:
• Calculate balances on all nominal ledger accounts
• Prepare trial balance
• Transfer income and expense balances to the profit and loss ledger account
and calculate profit/(loss) for the period
• Prepare statement of profit or loss
• Transfer profit and loss ledger account and drawings balance to capital
account
• Prepare statement of financial position
 PREPARING BASIC FINANCIAL STATEMENTS
Preparing basic financial statements – using TB

No need to create a profit and loss ledger account.

To produce a statement of profit or loss, transfer each income and expense

figure from the trial balance to the statement of profit or loss pro forma.
Then add down to calculate the profit (or loss) for the year.

To produce a statement of financial position, transfer the balance for each asset,
liability and capital account to a statement of financial position pro forma. In the
equity section, record the profit for the year (as per the statement of profit or
loss). Finally, add down the asset section and add down the equity and liabilities
section of the statement of financial position to show the subtotals and total
figures where appropriate.
 PREPARING BASIC FINANCIAL STATEMENTS

Preparing basic financial statements

Record the transactions
1. Establishing business 2,000 Dr Cash/Cr Capital: 2,000
2. Credit purchases: 4,300 Dr Purchases/Cr Payables: 4,300
3. Payments to suppliers: 3,600 Dr Payables/Cr Cash: 3,600
4. Credit sales: 5,800 Dr Receivalbes/Cr Sales: 5,800
5. Payments from customers: 3,200 Dr Cash/Cr Receivables: 3,200
6. Purchases non-current assets for cash Dr NCA/Cr Cash: 1,500
7. Other cash expenses: 900 Dr Other expenses/Cr Cash: 900
Post to the ledger accounts (T accounts)
Non-curent assets Cash
Cash 1,500 Capital 2,000Payables 3,600
Balance c/f 1,500 Receivables 3,200NCA 1,500
Balance b/f 1,500 Other exp 900
Balance c/f 800
Receivables 6,000 6,000
Sales 5,800Cash 3,200 Balance b/f 800*
Balance c/f 2,600
5,800 5,800
Balance b/f 2,600 * A credit balance b/f on the Cash ledger
account means that this item is a liability, not an
Payables asset. This indicates a bank over draft of £ 800.
Cash 3,600Purchases 4,300
Balance c/f 700
4,300 4,300
Balance b/f 700
 Sales P/L ledger account
P/L 5,800Receivables 5,800 Sales 5,800
Purchases 4,300
Purchases Other exp 900
Payables 4,300P/L 4,300 Profit for the year 600

Other expenses Capital

Cash 900P/L 900 Cash 2,000
Balance c/f 2,600P/L (Profit for the year) 600

STATEMENT OF PROFIT OR LOSS STATEMENT OF FINANCIAL POSITION

Sales 5,800 Assets

Cost of sales (Purchases) (4,300) NCA 1,500
Gross profit 1,500 Trade receivables 2,600
Expenses (900) Total assets 4,100
Profit for the year 600
Capital and liabilities
Capital
At start of period 2,000
Profit for the year 600
At the end of period 2,600
Liabilities
Bank overdraft 800
Payables 700
Total capital and liabilities 4,100