Preparing Financial Statements
Stages in Preparing Financial Statements
Financial Statements can be prepared whenever it is required and needed by the management of the business. However, usually, financial statements are prepared after a specific interval and with a predetermined frequency. It is a common practice to prepare quarterly, semi-annually, and annually financial statements.
Financial Statements are prepared at the end of a period by closing all the ledger accounts maintained by a business. The balances of all nominal ledgers are posted into the Trading and Profit & Loss accounts whereas the balances of real and personal ledgers are carried forward to the next year and presented in the Balance sheet of the period. Since the process of preparing a Financial Statement requires the closing of all the ledger accounts, therefore Financial Statements are often called “ Financial Accounts”.
Every business has unique requirements and dynamics therefore there is no fit for all rules or checklists to prepare and finalize financial statements, however, for the understanding of the readers, the steps involved in the preparation of financial statements are illustrated in the following paragraphs.
1. Schedules of closing entries
Accruals and prepayments.
At the end of each period especially while preparing the financial statements, accounting entries with respect to accruals and prepayments are recorded. There may be many accruals and prepayments being recorded by a business but the most common type of accruals and prepayments are insurance premiums, office rents, provisions for future expenses and mark-up costs, etc.
Adjustment Entries
After the accrual and prepayment have been recorded, various adjustment entries are posted. adjustment entries are those accounting entries that are required to reflect the true affairs of any ledger account at the end of the accounting period. Examples of adjustment entries are
- Recording the closing stock of various goods and materials at period and.
- Recording depreciation and amortization expenses for the period.
- Recording gain and Loss on Disposal of Assets.
- Gain and loss of translation of assets and liabilities in foreign currency.
2. Initial/ Draft Trial Balance
After recording closing/ adjustment entries, the trial balance is prepared and reviewed critically for:
- Completeness and to ensure that all the accounts being maintained by the business have been properly closed and their balances have been reflected into the trial balance.
- Arithmetical accuracy to ensure that closing balances being carried forward are properly calculated and the total of debit and credit columns of trial balance has been accurately added up.
3. Errors and Suspense Account
In accordance with the requirement of the accounting equation, the total of both debit and credit columns of the trial balance shall be equal. In case of disagreement, a suspense account is created and the differential amount is added to the column with a lower balance.
For example, the total debit side of the trial balance was calculated to be $115,000 whereas the total credit side of the trial balance came to $110,000. The difference of $ 5,000 will be added to the credit side of the suspense account and the closing balance of the suspense account will result in the agreement of the trial balance.
The reasons for this difference in the trial balance are critically examined and all the possible errors are identified and adjusted accordingly.
4. Final Trial Balance and Financial Statements
After all the errors have been identified and the trial balance has come into agreement, the balances of the nominal accounts are closed and transferred to Trading and Profit & Loss accounts.
The Net Balance of Profit & Loss account is transferred to retained earnings.
Accounting Entries for Posting Profit and Loss for the period
If the Profit & Loss Account has a debit balance, it means the business made a loss during the period. The debit balance of the Profit & Loss Account will be transferred to Retained Earnings as a loss through the following accounting entry.
Dr. Retained Earning XXX (Decreasing capital of the business)
Cr. Profit & Loss Account XXX
(Loss for the period being posted to
Whereas, If the Profit & Loss Account has a credit balance, after posting all the nominal accounts into it, it means the business earned a profit during the accounting period. The credit balance of the Profit & Loss Account will be transferred to Retained Earnings as a profit through the following accounting entry.
Dr. Profit & Loss XXX
Cr. Retained Earning XXX (Increasing capital of the business)
After posting profit and Loss into Retained earnings Leger, the trial balance is ready for preparing all the Financial Statements.
- Balances of all the nominal accounts are reported through Profit and Loss Statements in a described format.
- Balances of all the real and nominal ledgers are reported in the Balance Sheet in a prescribed format.
- After the Balance sheet has been prepared, a cash flow statement is prepared. The cash flow statement also serves as a reconciliation between the Balance Sheet and the Profit and Loss Account.
- In the end Statement in changes in equity, starting with an opening balance of all equity accounts. Any contributions by the owners as equity during the period along with profit or loss and any drawing dividend are reported through these statements.
Note: This is a hypothetical approach to the preparation of the Financial Statements. In practice, different businesses take different approaches to preparing financial statements.
