Chapter 4 - Trial Balance and Financial Statements

Question 1

Financial Statements

Answer 1

They enable a business to establish if they are operating profitably.

Question 2

Financial statements - sole traders

Answer 2

1. Income statement - which shows financial performance
2. Statement of Financial Position

Sole traders aren’t incorporated as larger companies are, so company law doesn’t regulate them.
They are not registered in the Companies House, so they aren’t required to file annual accounts.
But they need to produce these statements to support any personal self-assessment tax returns they make.

Question 3

Financial statements - frequency

Answer 3

They are prepared on an annual basis, at the end of the financial year.

Larger firms will prepare interim 6 month statements, as well as monthly managed accounts (they can be financial statements that help forecast profit) for internal managerial purposes.

Question 4

Financial Reporting Standards

Answer 4

Companies of any size are bound by the FRS (Financial Reporting Standards).

Accounting is about using that terminology that everybody understands

Question 5

FRS Terminology

Answer 5

Balance Sheet - FRS: Statement of Financial Position
Trading Account - FRS: Gross Profit Calculation
Profit and Loss Account - FRS: Income Statement
Debtors - FRS: trade receivables
Creditors - FRS: trade payables
Final Accounts - FRS: Financial Statements
Fixed assets - FRS: Non- current assets
Long-term liabilities - FRS: Non-current liabilities
Sales or turnover or revenue - FRS: Sales Revenue
Stock - FRS: Inventory
Opening stick - FRS: opening inventory
Closing stock - FRS: Closing Inventory
Accrual (as in unpaid liabilities) - AFRS: accrual payables
Prepayments - FRS: prepaid receivables
Capital - FRS: Capital for sole trader; equity for a company

Question 6

Sole Traders

Drawings

Answer 6

Sole traders may hire others and pay them wages.

Their own wages are called Drawings.
Drawings are deducted from Capital.

Statement of financial position will show as follows:
Capital: £10,000
Net profit from Income Statement: £2,000
Drawings: (£5,000)
Total: £7,000

Question 7

Examples of information contained in financial statements

Answer 7

• if firm has made profit or loss;
• value or worth of company is established (assets and their values; amounts owed to 3rd parties);
• amount of capital tied in the business, and return made;
• HM revenue and Customs will require details of income (sole traders) and profit (companies) in order to determine tax liability;
• information will help investors decide if they want to invest in the company;
• how creditworthy the company is:
• allows comparisons with previous years’ performances and the results of similar other companies;
• assists those planning the future of the business

Question 8

The Trial Balance as a financial statement platform

Answer 8

The Trial Balance is construed with the final balances of all accounts in the ledger.
If mathematically all entries have been done correctly, debit and credit columns will agree.

Debit balances: Assets and Expenses
Credit Balances: Liabilities, Income, Capital

Question 9

Income Statement

Answer 9

Includes Income and Expenses.

Income - Expenses = Profit

Question 10

Statement of Financial Position

Answer 10

Assets - Liabilities = Net Worth

Question 11

Treatment of Inventory in the Financial Statements

Answer 11

Income Statement: deduct from ‘cost of sales’

Statement of Financial Position: Include as a ‘current asset’

Question 12

Income Statement: 2 Sections

Answer 12

• Calculation of Gross Profit

- Calculation of Net Profit (in companies ‘operating profit/)

Question 13

Gross Profit

Answer 13

profit earned from the firm’s trading activities during the financial year.

It is the value of what was sold to customers (net sales_ less the cost of buying those goods or manufacturing them.
The difference between these 2 figures sets out the gross profit.

Question 14

Opening Inventory

Answer 14

Business that buy and sell goods don’t allow themselves to run out of stock, therefore at the beginning of each financial year there will be an opening inventory, which is brought forward from the previous year. It will be included in the Trial Balance.

Question 15

Cost of Sales Calculation

Answer 15

Opening Inventory + Purchases - Closing Inventory = Cost of Sales

Question 16

Gross Profit Calculation

Answer 16

Gross profit is the surplus made after the cost of buying (or manufacturing) from what was sold:

Sales Revenue - Cost of Sales = Gross Profit

Question 17

Closing Inventory

Answer 17

At the end of each financial year there is a physical stock take and it’s valued at cost price.

It is important that it is accurate, as overstating it, will mean that the gross profit will be overstated too, as the cost of sales will be reduced,

Question 18

The Income Statement

Answer 18

Shows the net profit calculation of the business.

Gross profit - Total Expenses of the operating business

Question 19

The Income Statement

First top part: gross profit calculation

Answer 19

First part calculates gross profit:
Sales Revenue - Cost of Sales

Cost of sales is:
Opening Inventory + purchases - closing inventory

Question 20

The Income Statement

Second bottom part: net profit (result)

Answer 20

The bottom part of the Income Statement is the addition of all expenses: wages, rent, electricity, phone, stationery, etc.

Deduct the expenses from the gross profit.

Gross profit - expenses = net profit

Larger businesses may have an extensive analysis of with numerous expense headings.

Question 21

Statement of Financial Position

Answer 21

It shows assets, liabilities and capital of a business on a given date.

As opposed to the Income Statement, which shows the trading activity over a financial year.

Question 22

Statement of Financial Position

Sub-sections

Answer 22

Non-current Assets
Current Assets
Current Liabilities
Non-current Liabilities
Capital

It must be headed with the name of the business and the date it was drawn up,

Question 23

Statement of Financial Position

Top part calculations (assets and liabilities)

Answer 23

Add Non-Current and Current Assets

Add Liabilities

Total assets - total liabilities = Net assets

This will enable a more accurate worth of the business.

Question 24

Statement of Financial Position

Capital

Answer 24

Capital appears in the section below, headed with the title “financed by” to show where the funds have come from.

Capital + net profit
(net profit is calculated in the capital area, because it belongs to the owner

Total net assets calculated in the top part, need to equal Capital area.

Question 25

Trial Balance details in the Financial Statements

Answer 25

The figures in the Trial Balance only appear in the financial statements once (either the Income Statement or the Statement of Financial Position).

Any figures added in the notes of the Trial Balance, will appear twice (both in the Income Statement and the Statement of Financial Position).

Question 26

Other entries

Drawings

Answer 26

This will cash withdrawn by the owner (usually sole trader) for personal use. This is classed as a withdrawal from the profit.

A small owner will do this, as it will be their “salary”.

Drawings will have its own account in the Nominal Ledger.

At year end the Drawings balance is deducted from the Capital in the Financed By area.

Question 27

Other entries

Discounts Allowed

Answer 27

It’s an expense - therefore it will be included in the Income Statement

Question 28

Other entries

Discounts Received

Answer 28

It’s treated as additional income. Because it’s not originated from the regular trading activity, it’s shown as Other Income, under gross profit.

Question 29

Other Entries

Carriage Inwards

Answer 29

Cost the company incurs to transport goods purchased from suppliers. The costs are included in the invoice.
This will recorded as a particular expense in the nominal ledger.

It will be included in the gross profit calculation, as an addition to purchases, increase their cost.

Question 30

Other Entries

Carriage Outwards

Answer 30

When a company charges their customers with the costs of delivery.

This will be recorded as carriage outwards, and treated as an expense in the Income Statement.

Question 31

Other Entries

Sales and Purchase Returns

Answer 31

These are shown in the gross profit (top part of Income Statement) as deductions, so that we can get to the net figures.

Sales Returns are deducted from the Sales Revenue (right under it)
Purchase Returns are deducted from Purchases (right under it)

Question 32

Other Entries

Closing Inventory

Answer 32

Appears in both Financial Statements, as it will be given as a note.

All figures relating to Inventory will be included in the Gross profit calculation (top part of Income Statement)

Question 33

I + E = Income Statement

CAL BAL = Statement of Financial Position

Answer 33

Income Statement includes all accounts balances that are Income and Expenditure..

The Statement of Financial Position will include: Capital, Assets and Liabilities

Question 34

income Statemen - Structure

Answer 34

Sales Revenue
Less Sales Returns

Cost of Sales Area (which will be deducted from above)
Opening Inventory
Purchases
Less Purchase Returns
Carriage Inwards (which the customer had to pay from selling) —-> at this point you get the Net sales
Less Closing Inventory

Adding all of these up you get the cost of sales.

Then you deduct the Sales Revenue from the Cost of Sales, and you get the gross profit.

Other Income Area
Discounts Received (and add to the gross profit above)

Less Expenses Area
(any expenses, such as: electricity, motor expenses, salaries, carriage outwards (which the company had to pay from purchasing)

Question 35

Statement of Financial Position Structure

Answer 35

Non Current Assets
Computer
Premises
Fixtures and Fittings
vehicles
(add them all together)

Current Assets
Inventory
Receivables
Bank
Cash 
(add them all together)

Less Current Liabilities
Payables

Then you will have result for Net Current Assets: Current Assets - Current Liabilities

Then you get the Net Assets: Non Current Assets + Current Assets - Current Liabilities
This total needs to equal the Financed By area below

Financed by
Opening Capital
Net profit (from the Income Statement)
Less Drawings
(This will give the Closing Capital)

Net Assets must equal Closing Capital