Accounting (9215) | Prepare and comment on income statements and statements of financial position from a trial balance including adjustments from the application of accounting concepts

Welcome to Financial Statements: The Grand Finale!

Welcome! If you've made it this far, you've mastered the building blocks of accounting. This chapter is the exciting conclusion where we take all the transactions and rules we've learned and present them in the two most important financial reports: the Income Statement (IS) and the Statement of Financial Position (SFP).

Think of the Trial Balance (TB) as a messy pile of ingredients. Our job in this chapter is to follow the recipe (accounting concepts) to turn those ingredients into a delicious, perfectly structured financial meal.

We will learn how to handle tricky adjustments and, crucially, how to comment on what the final statements actually tell us about the business's health.

Key Learning Objectives for This Chapter:

• Understand why adjustments are necessary (hint: Accounting Concepts!).
• Prepare the Income Statement step-by-step.
• Prepare the Statement of Financial Position step-by-step.
• Interpret and comment on the financial results.

Section 1: The Trial Balance and the Necessity of Concepts

The Trial Balance (TB) is simply a list of all ledger balances at a specific date. We rely on the TB because the total Debits should always equal the total Credits. However, a TB alone is incomplete because it doesn't account for events that have occurred but haven't yet been recorded as cash transactions.

The Accounting Concepts Driving Adjustments

To ensure our final statements show a true and fair view, we must apply core accounting concepts:

1. The Accruals (Matching) Concept

The most crucial concept here is that expenses and revenues must be recognized in the accounting period they relate to, regardless of when the cash is received or paid.
Analogy: Imagine you hire a gardener in December, but you only pay them in January. Under the Accruals Concept, the expense must be recorded in the December Income Statement because that is when the gardening service (expense) was consumed.

2. The Prudence (Conservatism) Concept

This means we should be cautious. We should record expenses and losses as soon as they are likely, but only record revenues and profits when they are certain.
Application: This concept requires us to record depreciation (a certain loss of value) and use the lower of cost or Net Realisable Value (NRV) for closing inventory.

Section 2: Mastering the Adjustments

Adjustments modify the figures from the Trial Balance before they are transferred to the Income Statement (IS) or Statement of Financial Position (SFP).

Adjustment A: Accruals and Prepayments (Timing Adjustments)

1. Accrued Expenses (Accruals)

Definition: Expenses that have been incurred (used/consumed) during the period but have not yet been paid by the end of the period.
Example: Electricity bill for December (used) arriving in January (paid).

• Impact on Income Statement (IS): The expense increases (add the accrued amount).
• Impact on Statement of Financial Position (SFP): Creates a Current Liability (we owe the money).

2. Prepaid Expenses (Prepayments)

Definition: Expenses that have been paid in advance for a future period.
Example: Paying $1,200 for a 12-month insurance policy on 1 October, but the year-end is 31 December. Three months are used ($300), nine months ($900) are prepaid.

• Impact on Income Statement (IS): The expense decreases (subtract the prepaid amount).
• Impact on Statement of Financial Position (SFP): Creates a Current Asset (we own the right to use the service in the future).

Adjustment B: Depreciation (Usage Adjustment)

Depreciation is the process of allocating the cost of a Non-Current Asset (like machinery or vehicles) over its useful economic life. It is not valuing the asset; it is matching the cost of using the asset against the revenue it helps generate.

Straight-Line Method (The 9215 Focus)

This method spreads the cost evenly over the asset’s life.

$$ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life (Years)}} $$

If the policy is a fixed percentage, simply multiply the percentage by the cost: $$ \text{Annual Depreciation} = \text{Cost} \times \text{Percentage Rate} $$

The Two Impacts of Depreciation:

1. The Charge for the Year: This is an expense. It goes into the Income Statement, reducing Net Profit.
2. Accumulated Depreciation: This is the total depreciation charged since the asset was purchased. It is deducted from the Cost of the Non-Current Asset in the Statement of Financial Position.

Section 3: Preparing the Income Statement (IS)

The Income Statement (formerly called the Trading and Profit and Loss Account) calculates the profit a business has earned over a specific period (usually 12 months).

Structure Reminder: Sales Revenue – Cost of Sales = Gross Profit. Gross Profit – Expenses = Net Profit.

Step-by-Step IS Preparation

Step 1: Calculate Revenue

Take the Revenue figure from the TB and subtract any Sales Returns (Returns Inwards).

Step 2: Calculate Cost of Sales (COS)

This is the most detailed part of the IS. It calculates the cost of the goods actually sold during the period.

1. Opening Inventory: This comes directly from the TB (it was the Closing Inventory from last year).
2. Add Purchases: Take Purchases from the TB and subtract Purchases Returns (Returns Outwards).
3. Goods Available for Sale: Sum of (1) + (2).
4. Less Closing Inventory: Crucially, this figure comes from the adjustments, not the TB. It represents goods left unsold.

$$ \text{Cost of Sales} = \text{Opening Inventory} + \text{Purchases} - \text{Closing Inventory} $$

Step 3: Calculate Gross Profit

$$ \text{Gross Profit} = \text{Revenue} - \text{Cost of Sales} $$

Step 4: Calculate Net Profit

Take Gross Profit, then:

1. Add Other Income: Things like rent received or commission received.
2. Subtract All Expenses: This includes all expenses from the TB plus any accrued expenses (accruals) and the new depreciation charge, and minus any prepaid expenses (prepayments).

Key Takeaway: The Income Statement tells the owner how profitable the business was over the year, resulting in the final figure: Net Profit for the Year.

Section 4: Preparing the Statement of Financial Position (SFP)

The Statement of Financial Position (formerly called the Balance Sheet) shows the financial health of the business at a specific point in time (e.g., 31 December 20X5).

It always follows the core accounting equation: Assets = Capital + Liabilities.

Step-by-Step SFP Preparation

Part 1: Assets (What the business owns)

Assets are listed in order of permanence (Non-Current first, then Current).

1. Non-Current Assets (NCAs)

These are items the business intends to keep and use for more than one year (e.g., land, machinery).

• List the asset at its original Cost.
• Subtract Accumulated Depreciation (the total depreciation charge up to the SFP date).
• The result is the Net Book Value (NBV).

2. Current Assets (CAs)

Items expected to be converted into cash within the next year.

• Inventory (Closing): The unsold stock (same figure used in the IS).
• Trade Receivables: Money owed to the business by customers.
• Prepaid Expenses: Money paid in advance for services not yet consumed (from Adjustment A).
• Bank/Cash: The cash balance.

Part 2: Capital and Liabilities (Where the funding came from)

3. Capital (Owner's Equity)

This represents the owner’s claim on the business assets.

$$ \text{Closing Capital} = \text{Opening Capital} + \text{Net Profit for the Year} - \text{Drawings} $$

• Opening Capital comes from the TB.
• Net Profit comes directly from the bottom of the Income Statement.
• Drawings are the owner’s cash or goods taken out of the business during the year (subtracted).

4. Non-Current Liabilities (NCLs)

Debts due for repayment after more than one year (e.g., long-term bank loans or mortgages).

5. Current Liabilities (CLs)

Debts due for repayment within one year.

• Trade Payables: Money the business owes to its suppliers.
• Accrued Expenses: Expenses incurred but not yet paid (from Adjustment A).
• Short-term loans/Bank Overdraft.

Final Check: The total of Assets MUST equal the total of (Capital + Liabilities). If it doesn't balance, check your adjustments!

Section 5: Commentary and Analysis

Preparing the statements is only half the job. You must also be able to read and comment on what the numbers mean. This is how the business makes smart decisions!

Commenting on the Income Statement (Profitability)

When commenting on the IS, focus on Net Profit and Gross Profit, and compare them to previous years (if available).

1. Was Gross Profit satisfactory?
   Focus: Did sales increase? Did the cost of goods sold increase faster than sales revenue (e.g., did supplier prices rise)?
2. Was Net Profit satisfactory?
   Focus: Look at the overall expense level. Did one specific expense (like depreciation or wages) increase significantly? High expenses reduce Net Profit even if Gross Profit is strong.

Commenting on the Statement of Financial Position (Structure and Liquidity)

The SFP commentary focuses on the business's ability to pay its short-term and long-term debts.

1. Liquidity (Short-Term Health)

Liquidity refers to the ease with which assets can be turned into cash to pay debts.

• Focus: Compare Current Assets (CAs) to Current Liabilities (CLs).
• Good Sign: CAs should be comfortably greater than CLs. This means the business has enough short-term resources to pay its short-term debts.
• Warning Sign: If CLs are higher than CAs, the business may struggle to pay bills when they fall due, potentially leading to cash flow problems.

2. Capital Structure

Look at the Capital section.

• Drawings: Are the owner’s drawings very high? If drawings exceed the Net Profit, the owner is withdrawing capital from the business, causing the Capital balance to shrink. This is unsustainable.
• Loans: If Non-Current Liabilities are very large, the business may be heavily dependent on borrowed money, which increases risk (interest payments are mandatory).

Key Takeaway: Financial statements are tools. They answer two questions: Did we make money? (IS) and Are we safe financially? (SFP).

Summary Checklist for Adjustments

Use this checklist every time you approach a financial statements problem!

You are now equipped to prepare professional financial statements. Practice integrating those adjustments carefully, and you will ace this section!