CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

STUDY MATERIAL C2

70

SUMMARISING THE LEDGER ACCOUNTS

Using Example 3.B, the trial balance at 31 May would appear as follows:

Trial balance

Debit ($) Credit ($)

Capital 20,000

Cash 1,760

Bank 13,725

Purchases 8,900

JM 2,000

ERD 3,000

Wages 170

Rent 80

Sales 10,200

Furniture 1,500

SP 250

Fittings 600

Advertising 25

KM 8,090

Drawings 100

35,200 35,200

Notice that the accounts with debit balances are either assets or expenses, while the

accounts with credit balances are liabilities, capital or revenue accounts (except for draw-

ings, which represents a reduction in capital).

The trial balance : A list of account balances in a double-entry accounting system. The

sum of the debit balances will equal the sum of the credit balances, although certain errors

such as the omission of a transaction or erroneous entries will not be disclosed by a trial

balance.

The trial balance is thus a list of the balances on the ledger accounts. If the totals of the

debit and credit balances entered on the trial balance are not equal, then an error or errors

have been made either:

1. in the posting of the transactions to the ledger accounts; or

2. in the balancing of the accounts; or

3. in the transferring of the balances from the ledger accounts to the trial balance.

4.2.1 Does the trial balance prove the accuracy

of the ledger accounts?

Just because the trial balance totals agree does not mean that there are no errors within the

ledger accounts. There are a number of errors that might have been made that do not pre-

vent the trial balance from agreeing. These are:

●

Errors of omission , where a transaction has been completely omitted from the ledger

accounts.

●

Errors of commission , where one side of a transaction has been entered in the wrong account

(but of a similar type to the correct account, for example, entered in the wrong receivable’s

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

account, or in the wrong expense account). An error of commission would not affect the

calculation of proﬁ t, or the position shown by the statement of ﬁ nancial position.

●

Errors of principle, where the correct and incorrect accounts are of different types,

for example, entered in the purchases account instead of a non-current asset account as

for errors of commission. This type of error would affect the calculation of proﬁ t, and

the position shown by the statement of ﬁ nancial position.

●

Errors of original entry, where the wrong amount has been used for both the debit and

the credit entries.

●

Reversal of entries, where the debit has been made to the account that should have been

credited and vice versa.

●

Duplication of entries, where the transaction has been posted twice.

●

Compensating errors, where two or more transactions have been entered incorrectly, but

cancelling each other out, for example, electricity debited with $100 in excess, and sales

credited with $100 in excess.

In all these cases, an account has been debited and an account has been credited with the

same amount, so the trial balance will still be in agreement, even though it contains incor-

rect entries. You will learn more about errors, and how to correct them, in Chapter 9.

Exercise 4.1

Explain the purpose of a trial balance.

Solution

The purpose of a trial balance is to check the arithmetical accuracy of the entries made to

the ledger accounts, that is, that the total of debit entries equals the total of credit entries.

Exercise 4.2

Prepare a trial balance from the ledger accounts in Exercise 3.3.

Solution

Bank $705 debit

Capital $500 credit

Purchases $150 debit

Rent $50 debit

Advertising $25 debit

Drawings $100 debit

Sales $530 credit

STUDY MATERIAL C2

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SUMMARISING THE LEDGER ACCOUNTS

Trial balance of A Thompson as at 28 February 20X1

Debit ($) Credit ($)

Bank 705

Capital 500

Purchases 150

Rent 50

Advertising 25

Drawings 100

Sales 530

1,030 1,030

4.3 Preparing a statement of profit

When the trial balance has been successfully completed, it is reasonably safe to assume that

proﬁ t can now be accurately calculated. This is referred to as ‘ the income statement ’ . You

should recall from Chapter 2 that the part of the income statement which calculates gross

proﬁ t is known as the ‘ trading account ’ . This comprises sales, less cost of goods sold, equals

gross proﬁ t. The trading account is thus a sub-section of the income statement although

its name does not appear within the income statement. Nevertheless, it is a very important

part of the income statement.

4.3.1 The trading account

The trading account is part of the double-entry bookkeeping system of an organisation

that buys and sells goods with the intention of making a proﬁ t. It is part of the income

statement and is regularly produced by such an organisation during the year, often on a

monthly basis.

The trading account compares the revenue derived from selling the goods with the costs

of obtaining the goods sold. A typical trading account is as follows:

Trading account for the year ending 31 December 20X1

$ $

Opening inventories 500 Sales 9,400

Purchases 6,400 Less: sales returns (300)

6,900

Less: closing inventories (430)

Cost of goods sold 6,470

Gross proﬁ t 2,630

9,100 9,100

This presentation, as a ledger account, is known as the horizontal format .

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

Transferring the balances to the trading account

The trading account is a ledger account in the normal sense, and must conform

to the double-entry r

ule. Therefore, every entry in it must have an opposite entry

elsewhere in the ledger accounts. For example, the credit in the trading account

for ‘ sales ’ of $9,400 will also be debited in the sales account. In effect, the balance

on the sales account is transferred into the trading account. In the example above,

the sales account might have appeared as follows:

Sales

20X1 $

1 Jan. B Nevitt 1,000

10 Jan. A Turner 5,400

23 Jan. G Fletcher 2,600

30 Jan. P Bajwa 400

Once the balance has been transferred to the trading account, the sales account

will appear as follows:

Sales

20X1 $ 20X1 $

31 Dec. Trading account 9,400 10 Jan. B Nevitt 1,000

13 Mar. A Turner 5,400

6 Jun. G Fletcher 2,600

5 Dec. P Bajwa 400

9,400 9,400

Note that there is now no balance on the sales account, and so the two sides can

be totalled to conﬁ rm that fact, and ruled off to prevent including them in the

ﬁ gures for the following year. The account is now said to be ‘ closed ’ , although it

can still be used to record the sales for the next period, below the totals.

This process is repeated with all the other ﬁ gures that appear in the trading

account, but there are some transfers that are worthy of special mention.

(a) The inventories account . In Chapter 3, you were told never to use the inven-

tories account for the purchase, sale or return of inventories, but that it was used

only at the beginning and the end of the period.

In a business that has been trading in the past, there will be a balance on the

inventories account at the start of the period, which will be a debit balance (rep-

resenting an asset). In the example above, the inventories account at the start of

the period would appear as follows:

Inventories

20X1 $ 20X1 $

1 Jan. Balance 500

As the trading account is being prepared, this balance is transferred into it, by

crediting the inventories account and debiting the trading account. The invento-

ries account then appears as follows:

STUDY MATERIAL C2

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SUMMARISING THE LEDGER ACCOUNTS

Inventories

20X1 $ 20X1 $

1 Jan. Balance 500 31Dec. Trading account 500

The inventories account now has no balance, so it can be ‘ closed off ’ as with the sales

account you saw earlier.

As the preparation of the trading account continues, it will be necessary to determine the

value of the inventories at 31 December. This is often done by referring to a separate inven-

tory control system, which is maintained outside the bookkeeping system (you will learn

more about the valuation of inventories in Chapter 8). The ﬁ gure is passed to the book-

keeper, who then debits the inventories account with the new value, and credits the trading

account.

The inventories account now appears as follows:

Inventories

20X1 $ 20X1 $

1 Jan. Balance 500 31 Dec. Trading account 500

31 Dec. Trading account 430

However, notice that in the trading account above, the closing inventories does not appear

to have been credited to it, instead it has been deducted on the debit side of the account.

This is not normal practice for most ledger accounts, but is commonplace when the trading

account is being prepared, because it is then possible to show the cost of goods sold ﬁ gure.

An item deducted on the debit side of an account is equivalent to making a credit entry.

(b) Sales and purchase returns . The same type of entry is used with sales and purchase

returns. In the trading account above, the sales returns have been deducted from the sales

ﬁ gure on the credit side of the account. This is the equivalent of making a debit entry. The

opposite entry would be to credit the sales returns account.

The trading account thus brings together the revenue and costs of the trading function

for a speciﬁ ed period of time, and by comparing them calculates the gross proﬁ t . It is com-

mon for the gross proﬁ t to be expressed as a percentage of the sales value, when it is known

as the gross proﬁ t margin, or as a percentage of the cost of sales, when it is known as the

gross proﬁ t mark-up.

The balance on the trading account

We hav

e seen that the revenue from the sale of goods is compared with the cost of those

goods in the trading account and the r

esulting difference is referred to as gross proﬁ t. This

ﬁ gure is the balance on the trading account.

This balance is then carried down within the income statement.

Vertical presentation of the trading account

An alternative presentation of the trading account is shown below. This is known as the

v

er

tical format , and is used when producing an income statement.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

Trading account for the year ended 31 December 20X1

$ $

Sales 9,400

Less : returns inwards (300)

9,100

Opening inventories 500

Purchases 6,400

6,900

Less : closing inventories (430)

6,470

Gross proﬁ t 2,630

Exercise 4.3

Prepare the trading account (in horizontal format) for Example 3.B, given that closing

inventories were $1,200, and make the necessary entries in the ledger accounts.

Solution

Trading account for the month ended 31 May

$ $

Opening inventories Nil Sales 10,200

Purchases 8,900

8,900

Less : closing inventories 1,200

Cost of goods sold 7,700

Gross proﬁ t 2,500

10,200 10,200

Note: There were no opening inventories in this case, as the company commenced trading

only on 1 May.

Sales

$ $

12 May Cash 210

19 May SP 580

25 May Cash 430

28 May Cash 890

31 May Trading account 10,200 29 May KM 8,090

10,200 10,200

STUDY MATERIAL C2

76

SUMMARISING THE LEDGER ACCOUNTS

Purchases

$ $

4 May JM 2,000

6 May ERD 3,000

22 May Cash

3,900 31 May Trading account 8,900

8,900 8,900

Inventories

$

31 May Trading account 1,200

Exercise 4.4

Prepare the trading account for Exercise 3.3 (in vertical format), given that closing inven-

tories were $50.

Solution

Trading account for the month ended 28 February 20X1

$ $

Sales 530

Opening inventories –

Purchases 150

150

Less : closing inventories (50)

100

Gross proﬁ t 430

4.3.2 The income statement

The rest of the income statement performs a similar function to the trading account by

comparing (in the case of trading organisations) the other costs of operating the business

and any non-trading revenue (such as interest received) with the gross proﬁ t to identify

whether the business has been proﬁ table overall or not. In the case of organisations that

provide a service rather than selling goods a trading account is not prepared. In this case,

the word ‘ sales ’ is not normally used and some other word, such as ‘ services ’ or ‘ turnover ’ ,

is used instead.

The income statement as a whole, just as the sub-section of the trading account, is part

of the double-entry bookkeeping system. In the case of the trading account, the word

‘ account ’ appears and this makes it obvious that it is a ledger ‘ account ’ which can be deb-

ited and credited. The word ‘ account ’ does not appear in the name ‘ income statement ’ but

it is nevertheless a ledger account which can be debited and credited.

A typical income statement, in horizontal format, is shown below:

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

Income statement for the year ended 31 December 20X1

$ $

Rent 120 Gross proﬁ t b/d 2,630

Local business tax 80

Light and heat 75

Wages 1 , 120

Printing and stationery 14

Telephone 37

Net proﬁ t 1,184

2,630 2,630

The income statement thus summarises all the costs and revenues of the business for a

speciﬁ ed period of time. The various expenses (and sundry revenues, if there are any) are

transferred out of the nominal ledger, and into the income statement. Those accounts are then

closed off.

The resulting balance on the income statement is referred to as a net proﬁ t (if it is a

credit balance), or net loss (if it is a debit balance).

It is common for the net proﬁ t (or loss) to be expressed as a percentage of the sales value

shown in the trading account, and this is known as the net proﬁ t percentage .

The income statement is presented in a vertical format when it is presented as part of

the ﬁ nancial statements. This is shown below:

Income statement for the year ended 31 December 20X1

$ $

Gross proﬁ t 2,630

Less : Rent 120

Local business tax 80

Light and heat 75

Wages 1 , 120

Printing and stationery 14

Telephone 37

(1,446)

Net proﬁ t 1,184

Exercise 4.5

Prepare the income statement in horizontal format for Example 3.B, and make the

necessary entries in the ledger accounts.

STUDY MATERIAL C2

78

SUMMARISING THE LEDGER ACCOUNTS

Solution

Income statement for the month ended 31 May

$$

Wages 170 Gross proﬁ t b/d 2,500

Rent 80

Advertising 25

Net proﬁ t 2,225

2,500 2,500

Wages

$$

7 May Cash 60

25 May Cash 110 31 May Income statement 170

170 170

Rent

$$

10 May Bank 80 31 May Income statement 80

Advertising

$ $

22 Feb. Bank 25 31 Feb. Income statement 25

Exercise 4.6

Prepare the income statement in horizontal format for Exercise 3.3.

Solution

Income statement of A Thompson for the month ended 28 February 20X1

Rent 50 Gross proﬁ t b/d 430

Advertising 25

Net proﬁ t 355

430 430

4.3.3 The balance on the income statement

The balance on the income statement represents the owner’s proﬁ t and has thus increased

his investment in the business. At the end of the year this is transferred to the owner’s capi-

tal account, by debiting the income statement and crediting the capital account. If the bal-

ance on the income statement is a debit balance, this represents a net loss, and the entries

are reversed.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

The capital account from Example 3.B would now appear as follows:

Capital

$

1 May Bank 20,000

31 May Income statement 2,225

4.3.4 Dealing with drawings

The balance on the capital account is increased by the net proﬁ t (or decreased by a net

loss). The balance is also affected by any drawings that have occurred, and that have been

debited to a separate drawings account. The balance on this account now needs to be

transferred to the capital account, by means of the following entries:

●

credit the drawings account;

●

debit the capital account.

Using Example 3.B again, the drawings and capital account would now look like this:

Capital

$ $

31 May Drawings account 100 1 May Bank 20,000

31 May Income statement 2,225

Drawings

$ $

30 May Cash 100 31 May Capital 100

4.4 Preparing the statement of financial position

The next stage is to prepare the balance sheet. The statement of ﬁ nancial position shows

the assets, liabilities and capital that exist at the date at which it is drawn up. It will include

all the ledger accounts that have balances on them.

It should be noted that the statement of ﬁ nancial position is not an ‘ account ’ . Its name is

not the statement of ﬁ nancial position ‘ account ’ and it is not part of the double-entry book-

keeping system. The statement of ﬁ nancial position, is a list of all the balances in the ledger

accounts.

The ledger accounts for expenses and revenues will all have no balance remaining, as

they have been transferred to the income statement (but see the next chapter for occasions

when this is not the case). The inventories account will have a new balance, and the capital

account will have had the net proﬁ t or net loss and drawings entered. The balances on the

other assets and liabilities will be those used in order to prepare the trial balance. These,

plus the inventories account and revised capital account balance, can be presented in the

statement of ﬁ nancial position.

Refer Section 2.3 for the presentation of the balance sheet.

CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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