Chapter 5 - Preparing Basic Financial Statements Flashcards
What is the initial trial balance?
Initial 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. The initial trial balance is not part of the double entry system, it is extracted from the double entry system. It is the starting point to preparing the financial statements.
Computerised accounting systems will ensure the initial trial balance will always balance. However, this does not mean the nominal ledger accounts are complete and error-free. What should an accountant do here?
An accountant would be expected to exercise professional scepticism when reviewing the trial balance to check for the reasonableness of each nominal ledger account balance. This reasonableness check can help to identify any errors or omissions that may have occurred in the accounting process.
Name the types of error that could occur even when the trial balance (TB) balances (5)
Even when the trial balance balances, the following error types may still have arisen in the ledger accounts.
1. Transposition errors: two digits in an amount are accidently recorded the wrong way round.
2. 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.
3. 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.
4. Compensating errors: one error is exactly cancelled by another error elsewhere.
5. Errors of principle: such as cash paid in respect of machinery maintenance (an expense) being debited to machinery cost (an asset).
When are adjustments made to the TB? How are they made?
Adjustments may be required to the initial trial balance to correct for errors or omissions and to record period end adjustments.
Adjustments are made using adjustment/correcting journals which are processed against the initial trial balance to create a final trial balance. Financial statements are prepared from the final trial balance.
How can you present the adjustment to a TB?
An alternative way of presenting the adjustments is using a columnar approach whereby an additional debit column and an additional credit column are created alongside the initial trial balance. A final trial balance is then created by adding across.
- To a debit balance in the trial balance, add debits and subtract credits. If the result is positive, insert it in the debit column of the final trial balance. If it is negative, insert it in the credit column of the final trial balance.
- To a credit balance in the trial balance, subtract debits and add credits. If the answer is positive, insert it in the credit column of the final trial balance. If it is negative, insert it in the debit column of the final trial balance.
See page 165/526 in ICAEW workbook for example
How can you balance nominal ledger accounts? (5)
- In a T account total up both sides the debit and credit
- Enter the bigger number into the total boxes on both sides
- Find the balancing figure
- Label it as balancing figure
- Add narrative
If it is an Expense or Income you can write the narrative ‘to the Profit/Loss (p/l) ledger’ - this leaves a nil balance in the income or expense account.
If it is an Asset, Drawing, Liability, Capital you can write the narrative ‘Balance carried forward (c/f)’ - In our SOFP we use the balance c/f figures - these are the opening balance for the next account period.
When is the term Balance b/d used?
The balance carried down at the end of one reporting period becomes the balance brought down (Balance b/d) at the start of the following reporting period.
- A debit balance brought down denotes an asset.
- A credit balance brought down denotes a liability.
What steps are needed to prepare for the statement of profit or loss and statement of financial position? (7)
To prepare the statement of profit or loss and statement of financial position together, you need to methodically follow the steps involved:
1. calculate balances on all nominal ledger accounts
2. prepare the initial trial balance to check accuracy
3. prepare and process journals in respect of any adjustments to create the final trial balance
4. transfer income and expense balances to the profit and loss ledger account and calculate the profit/(loss) for the period
5. transfer the profit and loss ledger account and drawings balance to capital account
6. prepare the statement of profit or loss
7. prepare the statement of financial position
Alternatively, the financial statements can also be prepared using the trial balance without the need to create a profit and loss ledger account.
What is the difference between the profit and loss ledger account and the statement of profit or loss?
The profit and loss ledger account contains the same information as the statement of profit or loss, and there are very few differences between the two. However, the statement of profit or loss lays the information out differently.
- Sales and purchases are included in calculating gross profit.
- All other income is added, and all other expenses are deducted, to arrive at profit for the period.
How to use the TB to created the SOFP and SPL
The trial balance can be used to draw up a statement of profit or loss and a statement of financial position, without the 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.
