Chapter 5: Final Accounts preparation

Question 1

5.1 Progressing from the trial balance to the P+L account and balance sheet

Answer 1

Once you have the ledger accounts in the form of the trial balance, you need all income and expense accounts in one place to calculate the profit or loss. You transfer all the balances on income and expense ledger accounts to a new ledger account, the Profit and Loss account. Examples may be the ledger accounts of sales, purchases and rent. 
When you look at the P+L ledger account, the amount for closing stock is missing. The stock at the end of the period is found by a physical number of goods still in store at the end of the trading period, these are then valued at cost. These goods were an asset of the business; however, they have already been accounted for as an expense account (purchases). Therefore, you need to open a ledger account for closing stock. A P+L would look like this:
				£				£
Sales 								550
Less:
Cost of sales			600				
Closing stock			(200)
								(400)
Gross Profit							150
Less:
Expenses – rent							(40)
Net Profit							110

Question 2

5.1 Progressing from the trial balance to the P+L account and balance sheet - balance sheet

Answer 2

The balance sheet – final step in accounts preparation is the construction of the balance sheet. This is not an account and is not part of the double entry system, it is derived from the double entry system since it is a summary of the balances carried down on the T accounts representing assets and liabilities.
The order of the balance sheet is fixed assets, current assets less creditors to find the net assets. Then capital introduced, profit less drawings equals proprietor’s funds. Net assets should equal proprietor’s funds.
Closing the capital section – the capital section shows profit and drawings for the first period. In the next period we will wish to show the profit and drawings for that period only, this is achieved by transferring the balances on the profit and loss and drawings T accounts to the capital account and by starting next years financed by section with opening capital with last year’s figure.
Opening stock – on the last day of the period there is a debit of the stock (asset) account. This represented the closing stock at the end of the first accounting period and it appears on the balance sheet as an asset.
At the end of the second period of trading the transfer between the profit and loss account and the stock account is reversed as follows.
There is a debit entry in the profit and loss account that reflects that the opening stock is an expense, it is part of the cost of the goods that have been sold in the period and so increases the cost of sales expense on the face of the profit and loss account pro forma.
The credit entry in the stock account reflects that the opening stock has been sold in the period and so is no longer an asset in the stock account at the end of the second period of trading.

Question 3

5.2 Capital and revenue Expenditure

Answer 3

We only charge revenue expenditure to the profit and loss account. This is incurred in:
• The acquisition of assets required for conversion into cash (for example goods for resale)
• The manufacturing, selling and distribution and the day-to-day administration of the business
• The maintenance of the revenue earning capacity of the fixed assets (for example repairs)
The amount of revenue expenditure charged against the profits for a year is the amount which is incurred for the period irrespective of whether cash has been paid or not. Similarly, all sales made during the period under review will be included in the trading account even though all cash may not have been received. This is the accruals basis accounting concept.
In contrast capital expenditure is held in the balance sheet. For example, the purchase of a motor car. Capital expenditure is expenditure incurred in:
• The initial setting up of the business
• The acquisition of fixed assets required for use in the business and not for resale
• The alteration or improvement of assets for the purpose of increasing their revenue earning capacity
Capital expenditures benefit of the use of asset is spread over a considerable period of time; therefore, it is not charged to the P+L. The cost will be charged over the periods in which the assets depreciate.

Question 4

5.3 Detailed pro forma profit and loss account and balance sheet

Answer 4

• At the start of the period it is likely to have opening stock from last year, the stock will be sold this year and must be included in the cost of goods sold, since it will not be included in this year’s purchases
• A useful calculation is the gross profit margin or mark up. The gross profit margin is calculated by the gross profit divided by the revenue times 100.
• A business may have other sources of income that do not arise from trading, this is called sundry income. This is shown separately for tax purposes as it is taxed differently from trading income
Discounts allowed and received – there are two types of discounts a business may choose to allow its customers:
• Trade discounts
• Settlement discounts
Trade discounts are offered to special customers or for bulk buying and are reflected in a reduced selling price. A normal double-entry is recorded for the cash or credit sale.
Settlement discounts are offered to credit customers to encourage prompt payment. If a business allows a 3o day credit period to debtors, they may offer a 5% settlement discount if the debtor pays within 10 days. The business does not know if the customer will use the settlement discount at the point of sale, so must record the full value of the sale in its books. Only when payment is received from the debtor does the business know whether or not the customer has taken advantage of the settlement discount.