Preparation of financial statements

Accounting AS · Financial accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Draft figures are adjusted at the year end so that the statement of profit or loss shows the income earned and the expenses incurred in the year, whether or not cash has moved. This is the matching concept. The statement of financial position then shows what is owned and owed on the last day.

A sole trader's profit all belongs to the owner. In a partnership an appropriation account shares the profit between the partners, following their agreement. In a limited company, profit not paid out as dividends is kept in reserves, which together with share capital make up equity.

Where records are incomplete, missing figures are found from the accounting equation, control accounts, or the margin or mark-up.

Rules to remember

Expense for the year = amount paid + opening prepayment − opening accrual + closing accrual − closing prepayment.
Accrued expenses and income received in advance are current liabilities. Prepaid expenses and income owing to the business are current assets.
Write off irrecoverable debts first, then calculate the allowance on the remaining trade receivables. Only the change in the allowance goes to profit or loss.
Inventory is valued at the lower of cost and net realisable value (selling price − costs still needed to sell it).
Incomplete records: profit = closing capital − opening capital + drawings − capital introduced.
Partnership: residual profit = profit for the year + interest on drawings − interest on capital − partners' salaries, then shared in the profit-sharing ratio. Interest on a partner's loan is an expense, not an appropriation.
Company: share premium = (issue price − nominal value) × number of shares. A rights issue brings in cash; a bonus issue does not. Debenture interest for the full year is a finance cost.

Common mistake

Charging the whole new allowance for irrecoverable debts as an expense. Only the increase is an expense; a decrease is added back to profit.

Worked example

Sana and Tariq are partners with capitals of $40,000 and $20,000. Profit for the year is $59,000. Interest on capital is 10% a year, Tariq has a salary of $9,000, interest on drawings is Sana $600 and Tariq $400, and residual profit is shared Sana 2 : Tariq 1. What is Tariq's total share of the profit?

Interest on capital: Sana 10% × $40,000 = $4,000; Tariq 10% × $20,000 = $2,000.
Residual profit = $59,000 + $1,000 − $6,000 − $9,000 = $45,000.
Tariq's residual share = 1/3 × $45,000 = $15,000 (Sana $30,000).
Tariq's total = $2,000 + $9,000 + $15,000 − $400 = $25,600. Check: Sana $33,400 + Tariq $25,600 = $59,000.

Answer: Tariq's total share is $25,600.

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