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Constructing accounts

Syllabus objectives

4.1 Describe the basic construction of accounts of different types and the role and
principal features of the accounts of a company.

6. Construct simple statements of financial position and statements of profit or

loss.

7. Explain cashflow statements.

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0 Introduction

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We previously studied the structure of the main accounts. In this chapter, we are going to look at

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how to construct the statement of financial position and the statement of profit or loss from
information contained in the trial balance.

The practice questions at the end of this chapter provide a good opportunity for you to develop the
skills required to produce accounts.

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1 The trial balance

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1.1 Description of the trial balance

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The statement of profit or loss and statement of financial position are prepared from the
underlying bookkeeping records. All transactions are recorded during the year and are
entered into a double entry bookkeeping system. This generates a table called a trial
balance.

The double-entry system of bookkeeping is used to create a number of balancing accounts. These
accounts are held together in a ledger, and all of the accounts can be used to create a trial
balance.

The trial balance is simply a list of all the accounts in the ledger and the balances in each account.

You will not be required to construct a trial balance but you do have to know how to use a trial
balance to construct a statement of financial position and a statement of profit or loss.

The trial balance can be presented in a number of ways:

1. as a simple list of numbers
2. as a list of positive and negative numbers adding to zero
3. as two columns (debits and credits) giving the same total.

If it is presented as a list of numbers, you are given no clue as to whether the accounts are debits
or credits.

If it is presented as a list of numbers adding to zero, the credit items are positive and the debit
items are negative.

The credit items consist of revenue (for the statement of profit or loss) and liabilities and capital
(for the statement of financial position); and the debit items consist of expenses (for the
statement of profit or loss) and assets (for the statement of financial position).

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As an example, assume that the following balances have been extracted from the books of

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JK plc, as at 31 March 20X1:

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£000

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Administrative expenses 150
Advertising 70
Cash at bank 10
Trade payables (Creditors) 45
Trade receivables (Debtors) 115
Directors’ remuneration 75
Interest on long-term loans 4
Inventory at 31 March 20X0 130
Investment income 18
Investments (short-term) 350
Long-term loans 200
Ordinary dividend paid 30
Ordinary share capital, issued and fully paid 700
Plant and machinery  cost 210

Plant and machinery  depreciation at 31 March 20X0 95

Premises  cost 950

Premises  depreciation at 31 March 20X0 20

Purchases 600
Retained earnings at 31 March 20X0 236

Sales (Revenue) 1,760

Shareholder reserves 50
Wages and salaries  administrative staff 160

Wages and salaries  manufacturing staff 190

Wages and salaries  sales staff 80

Additional information:
1. Inventory at 31 March 20X1 was valued at £185,000.
2. Provision is to be made for administrative expenses owing at 31 March 20X1
amounting to £12,000.
3. Premises are to be depreciated at the rate of 2% on cost, and plant and machinery at
25% reducing balance.
4. Advertising paid in advance at the end of the year amounted to £9,000.
5. Corporation tax based on the year’s profit is estimated at £15,000.
6. The company’s ordinary share capital is 700,000 £1 ordinary shares, fully paid.

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1.2 Awkward items in the trial balance

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Depreciation

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Non-current assets pose a slight problem. This is because of an issue called depreciation
which was discussed in the last chapter. For now, it is worth noting that it is the net figure
which is shown in the statement of financial position for each category of non-current
assets. Thus, the value of premises is £950,000  £20,000 = £930,000.

The trial balance does not contain information on this year’s depreciation. Thus, the book value
of the premises at the beginning of this accounting year is £930,000.

This year’s depreciation is given in a note at the bottom of the trial balance.

You will need this year’s depreciation for the statement of profit or loss and you will also need it
to find the book value of the non-current assets at the end of the accounting year for the
statement of financial position.

Retained earnings
The retained earnings reserve in the trial balance is for the beginning of the accounting year.

The retained profit for the period is added to the retained earnings reserve in order to complete
the statement of financial position.

Inventories (Stocks)
The figure for inventories in the trial balance is also at the beginning of the accounting year
(ie opening inventory).

Inventories are a current asset of the business, but the opening inventory is not used in the end of
year statement of financial position.

The figure for closing inventory is noted below the trial balance. This figure is needed for the end
of year statement of financial position.

Both opening inventory and closing inventory are needed, along with purchases of new inventory,
to find the cost of inventory sold for the statement of profit or loss.

Adjustments for the accruals concept

Remember that the statement of profit or loss records cost items when they are incurred (even if
the company has not yet paid for them or has paid for them in advance).

Notes will be made at the bottom of the trial balance to take account of any adjustments
necessary.

For example, if corporation tax is incurred in this accounting year, it should be in this year’s
statement of profit or loss, even if it has not yet been paid. It will be recorded as a current liability
in the statement of financial position if it has not been paid.

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Dividends

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Any dividends shown in the trial balance will have been actually paid to shareholders during the

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year. Some or all of these dividends paid will be in respect of the previous financial year.

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Dividends paid will be:
 shown as a note at the bottom of the statement of profit or loss
 deducted from the retained earnings in the statement of financial position
 disclosed in the notes to the accounts and will affect the statement of changes in equity
and cashflow statement.

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2 Using the trial balance

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The preparation of a set of financial statements can be a complex affair. Degree courses in

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accountancy devote at least one course every year to this subject and it is a major

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component of the professional courses taken by trainee accountants.

This section is intended to give only a brief overview of the mechanics of preparing a
statement of profit or loss, statement of financial position and understanding and
interpreting a cashflow statement.

As we have seen, the trial balance consists of accounts that are needed for:
 the statement of profit or loss (ie revenue and expenses)
 the statement of financial position (ie assets, liabilities and capital).

Every figure in the trial balance is used once in the preparation of either the statement of
profit or loss or the statement of financial position.

Question

Prepare the statement of profit or loss for JK plc for the year ended 31 March 20X1.

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Solution

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The statement of profit or loss (set out in the same format as in Chapter 10) would be

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prepared by extracting the income and expense figures and rearranging them as follows

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JK plc
Statement of profit or loss for the year ended 31 March 20X1
£000
Revenue 1,760
Cost of sales (783)
Gross profit 977
Distribution costs (141)
Administrative expenses (397)
Operating profit 439
Finance income 18
Finance costs (4)
Profit before tax 453
Tax expense (15)
Profit for year 438
Profit for the year attributable to equity holders of the company 438
Earnings per share for profit attributable to equity holders 63 pence

In order to prepare these reported figures, supplementary working needs to be done, as

follows:

Workings £000
Cost of sales
Opening inventory 130
Purchases 600
Closing inventory (185)
Depreciation – premises 19
Depreciation – plant and machinery 29
Wages and salaries 190
783

Distribution costs
Advertising 70
Less – prepaid (9)
Wages and salaries 80
141

Administrative expenses
Administrative expenses 150
Add – accrual 12
Directors’ remuneration 75
Wages and salaries 160
397

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Question

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Prepare the statement of financial position as at 31 March 20X1.

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Solution

The remainder of the figures are reorganised to give a statement of financial position (set
out in the same format as in Chapter 10):

JK plc

Statement of financial position at 31 March 20X1

ASSETS £000
Non-current assets 997
Current assets
Inventories 185
Trade receivables 115
Other current assets 359
Cash 10
669
Total assets 1,666

EQUITY AND LIABILITIES

Share capital 700
Other reserves 50
Retained earnings 644
Total equity 1,394

Non-current liabilities
Long-term borrowings 200
Total non-current liabilities 200
Current liabilities
Trade and other payables 57
Current tax payable 15
Total current liabilities 72

Total liabilities 272

Total equity and liabilities 1,666

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In order to prepare these reported figures, supplementary working needs to be done, as

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follows:

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Workings

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£000s
Non-current assets
Cost Aggregate Net book
depreciation value

Premises 950 39 911

Plant and machinery 210 124 86
1,160 163 997

Other current assets

Investments (short-term) 350
Pre-paid expense 9
359

Retained earnings
Retained earnings at 31 March 20X0 236
Retained earnings for year to 31 March 20X1 438
Dividends paid (30)
644

Trade and other payables

Creditors (trade payables) 45
Administrative expenses 12
57

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Chapter 12 Summary

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The statement of profit or loss (income statement) and the statement of financial position

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(SFP) (balance sheet) are derived from the underlying bookkeeping records, in particular from
the information in the trial balance.

Each figure in the trial balance is used once in this preparation of the statement of financial
position and the profit or loss.

Debit items in the trial balance are expense items for the profit of loss and assets for the SFP.
Credit items in the trial balance are revenue items for the profit or loss and capital and
liabilities for the SFP.

Notes at the bottom of the trial balance give information on:

 inventories at the end of the year, ie closing stock
 this year’s depreciation
 adjustments for the accruals concept.

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