Part C The use of double
entry and accounting systems
6: From trial balance to financial statements
105
part of the double entry system, so the basic rule of double entry still applies: every debit must have an
equal and opposite credit entry.
This income and expense account contains the same information as the financial statement we are aiming
for, ie the income statement, and in fact there are very few differences between the two. However, the
income statement lays the information out differently and it may be much less detailed.
So what do we do with this new ledger account? The first step is to look through the ledger accounts and
identify which ones relate to income and expenses. In the case of Ron Knuckle, these accounts consist of
purchases, rent, sales, bank loan interest, and other expenses.
The balances on these accounts are transferred to the new income and expense account. For example, the
balance on the purchases account is $5,000 DR. To balance this to zero, we write in $5,000 CR. But to
comply with the rule of double entry, there has to be a debit entry somewhere, so we write $5,000 DR in
the income and expense (I & E) account. Now the balance on the purchases account has been moved to
the income and expense account.
If we do the same thing with all the separate accounts of Ron Knuckle dealing with income and expenses,
the result is as follows.
PURCHASES
$
$
Trade account payables
5,000 I & E a/c
5,000
RENT
$
$
Cash at bank
3,500 I & E a/c
3,500
SALES
$
$
I & E a/c
12,500
Cash
at bank
10,000
Trade accounts receivable
2,500
12,500
12,500
BANK LOAN INTEREST
$
$
Cash at bank
100 I & E a/c
100
OTHER EXPENSES
$
$
Cash at bank
1,900 I & E a/c
1,900
INCOME AND EXPENSE ACCOUNT
$
$
Purchases 5,000
Sales
12,500
Rent 3,500
Bank loan interest
100
Other expenses
1,900
(Note that the income and expense account has not yet been balanced off but we will return to that later.)
If you look at the items we have gathered together in the income and expense account, they should strike
a chord in your memory. They are the same items that we need to draw up the income statement.
Question
Income statement
Draw up Ron Knuckle's income statement.
106
6: From trial balance to financial statements Part C The use of double entry and accounting systems
Answer
RON KNUCKLE: INCOME STATEMENT
$
$
Sales
12,500
Trading
Cost of sales (= purchases in this case)
(5,000) account
Gross profit
7,500
Expenses
Rent
3,500
Income
and
Bank loan interest
100
expenditure
Other
expenses
1,900
account
(5,500)
Net profit
2,000
3 The statement of financial position
The balances on all remaining ledger accounts (including the income and expense account) can be listed
and rearranged to form the
statement of financial position.
Look back at the ledger accounts of Ron Knuckle. Now that we have dealt with those relating to income
and expenses, which ones are left? The answer is that we still have to find out what to do with the cash,
capital, bank loan, trade accounts payable, shop fittings, trade accounts receivable and the drawings
accounts.
Are these the only ledger accounts left? No: don't forget there is still the last one we opened up, called the
income and expense account. The balance on this account represents the profit earned by the business,
and if you go through the arithmetic, you will find that it has a credit balance – a profit – of $2,000. (Not
surprisingly, this is the figure that is shown in the income statement.)
These remaining accounts must also be balanced and ruled off, but since they represent assets and
liabilities of the business (not income and expenses) their balances are not transferred to the income and
expense account. Instead they are carried down in the books of the business. This means that they
become opening balances for the next accounting period and indicate the value of the assets and liabilities
at the end of one period and the beginning of the next.
The conventional method of ruling off a ledger account at the end of an accounting period is illustrated by
the bank loan account in Ron Knuckle's books.
BANK LOAN ACCOUNT
$
$
Balance carried down (c/d)
1,000
Cash (D)
1,000
Balance brought down (b/d)
1,000
Ron Knuckle therefore begins the new accounting period with a credit balance of $1,000 on this account.
A
credit balance brought down denotes a liability. An asset would be represented by a
debit balance
brought down.
One further point is worth noting before we move on to complete this example. You will remember that a
proprietor's capital comprises any cash introduced by him, plus any profits made by the business, less
any drawings made by him. At the stage we have now reached, these three elements are contained in
different ledger accounts: cash introduced of $7,000 appears in the capital account; drawings of $1,500
appear in drawings; and the profit made by the business is represented by the $2,000 credit balance on
the income and expense account. It is convenient to gather together all these amounts into one
capital
account, in the same way as we earlier gathered together income and expense accounts into one income
and expense account.
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