Extended trial balance and statements - Statement of profit ...

Learning Outcomes

After reading this article, you will be able to prepare a statement of profit or loss for a sole trader using the extended trial balance. You will learn to identify income and expense items correctly, apply key year-end adjustments, and explain the impact of adjustments on reported profit or loss, all within ACCA FA2 requirements.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand the extraction of a statement of profit or loss from an extended trial balance for a sole trader, including adjustments and presentation. When revising this topic, focus on:

• The process for preparing a statement of profit or loss from a trial balance or extended trial balance
• Correct classification of income and expenses
• Recording and adjusting for closing and opening inventory, accruals, prepayments, depreciation, and irrecoverable debts
• The impact of adjustments on profit or loss
• Presentation and disclosure requirements for sole trader financial statements

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which class of item is correctly debited in the statement of profit or loss for a sole trader?
   1. Revenue
   2. Capital
   3. Expenses
   4. Drawings
2. Before preparing the statement of profit or loss, which of the following must be calculated and entered as a year-end adjustment?
   1. Interest on overdue payables
   2. Closing inventory
   3. Opening capital
   4. Purchase returns

3. True or False? "Depreciation adjustments reduce the reported profit for the accounting period."

4. Briefly explain how a prepayment for rent affects the profit for a period in the statement of profit or loss.

5. What is the impact on net profit if closing inventory is understated in the trial balance?

Introduction

Every set of final accounts for a sole trader includes a statement of profit or loss. This statement shows how much profit or loss the business made by summarising its income and expenses for the period. Before it can be completed, adjustments such as accruals, prepayments, inventory, depreciation, and irrecoverable debts must be made in the extended trial balance.

This article explains how to build a statement of profit or loss from an extended trial balance, highlights correct item classification, shows essential adjustments, and presents tips and examples to help you answer typical ACCA FA2 questions.

Key Term: statement of profit or loss
A financial statement that summarizes a sole trader's revenues and expenses for a period, showing the net profit or net loss.

PREPARING THE STATEMENT OF PROFIT OR LOSS

The Role of the Extended Trial Balance

The extended trial balance is a tool used to incorporate necessary year-end adjustments before final accounts are prepared. It shows the original balances of income, expense, asset, and liability accounts, plus columns for adjustments and columns that split items between the statement of profit or loss and the statement of financial position.

The key task is to ensure all income and expense account balances are correctly adjusted and transferred to the statement of profit or loss section. Assets, liabilities, and capital balances transfer to the statement of financial position.

Key Term: extended trial balance
An expanded version of the trial balance that includes columns for year-end adjustments and allocations to the statement of profit or loss or statement of financial position sections.

INCOME AND EXPENSE CLASSIFICATION

Correctly classifying trial balance accounts as income or expenses is fundamental.

• Income: Sales revenue, interest received, commission income, discount received, and miscellaneous income.
• Expenses: Purchases (goods for resale), wages and salaries, rent, electricity, insurance, depreciation, irrecoverable debts, and all other operating costs.

Each account is transferred to the statement of profit or loss with income as credits and expenses as debits. Closing off these balances will result in a net figure: either a profit (credit balance) or loss (debit balance).

Key Term: expense
A decrease in assets or an increase in liabilities resulting in a reduction in a sole trader's capital, recorded in the statement of profit or loss.

Key Term: income
An increase in assets or a decrease in liabilities that increases the owner's capital, usually from sales or services.

YEAR-END ADJUSTMENTS IN THE EXTENDED TRIAL BALANCE

Accruals and Prepayments

The accruals basis requires that all income and expenses are matched to the period they relate to, not necessarily when cash was paid or received.

• Accrued expense: An expense incurred during the period but not yet paid or recorded.
• Prepaid expense: An expense paid in advance for a future period.

Adjustments for these ensure reported profit reflects the period's true costs.

Key Term: accrual
An expense that has been incurred but not yet paid or recorded at the period end.

Key Term: prepayment
An expense paid in advance; the benefit relates to a future period.

Inventory

Inventory affects both the statement of profit or loss and the statement of financial position. The year starts with opening inventory (carried from the prior period) and ends with closing inventory (unsold goods at year end). Only the cost of goods sold is expensed.

• Cost of sales calculation: Opening inventory + Purchases – Closing inventory

Key Term: closing inventory
The value of unsold goods at the end of the accounting period, shown as an asset and deducted from cost of sales.

Depreciation

Non-current assets must be depreciated to reflect the portion of their cost used during the period.

• Depreciation charges reduce reported profit.
• Depreciation expense is added to the statement of profit or loss; a corresponding amount is accumulated in the statement of financial position.

Key Term: depreciation
The systematic allocation of the cost of a tangible non-current asset over its useful life as an expense in the statement of profit or loss.

Irrecoverable Debts

Amounts owed by customers that are considered uncollectable are written off as expenses and reduce profit.

Key Term: irrecoverable debt
A receivable that is deemed impossible to collect and is written off as an expense.

Allowance for Receivables

If there is doubt about collecting some receivables, an allowance is created and treated as an expense, reducing reported profit.

Key Term: allowance for receivables
An estimated amount set aside to cover doubtful customer debts that may become irrecoverable.

FORMAT OF THE STATEMENT OF PROFIT OR LOSS (SOLE TRADER)

The standard layout for a sole trader’s statement of profit or loss is as follows:

Worked Example 1.1

A trader’s trial balance shows:

• Sales: $120,000
• Purchases: $70,000
• Opening inventory: $5,000
• Closing inventory: $7,000
• Wages: $25,000
• Rent: $4,000
• Depreciation: $3,000

Required: Calculate gross profit and net profit for the period using the standard SOPL format.

Answer:
Gross profit calculation: Opening inventory $5,000 + Purchases $70,000 = $75,000. Subtract closing inventory $7,000: Cost of sales = $68,000.
Gross profit = Revenue $120,000 – Cost of sales $68,000 = $52,000. Net profit calculation: Deduct expenses: Wages $25,000, Rent $4,000, Depreciation $3,000.
Total expenses = $32,000.
Net profit = Gross profit $52,000 – Expenses $32,000 = $20,000.

YEAR-END PROCEDURE AND PRESENTATION

After incorporating all adjustment columns and allocating balances to the profit or loss column in the extended trial balance:

1. Add up all income and expense accounts.
2. Calculate the difference: if credits (income) exceed debits (expenses), the result is profit; if not, it’s a loss.
3. Transfer the net profit or loss to the capital account in the statement of financial position.

Worked Example 1.2

A sole trader’s extended trial balance includes:

• Total income allocated to profit or loss: $85,000
• Total expenses allocated to profit or loss: $64,000

Required: Show the final step to complete the SOPL and state the next accounting entry.

Answer:
Profit for the year = $85,000 (income) – $64,000 (expenses) = $21,000 profit.
Transfer this $21,000 to the capital account in the statement of financial position.

Exam Warning

Items must appear in the correct section—do not include opening inventory, accruals, or prepayments directly as income or expenses without making the correct adjusting entries. Misclassification is a common exam error.

Revision Tip

Practise preparing a statement of profit or loss from a trial balance and extended trial balance under time pressure. Always check adjustments carry through to the SOPL in your workings.

Summary

The statement of profit or loss for a sole trader summarises income and expense items, incorporating adjustments for closing inventory, accruals, prepayments, depreciation, and irrecoverable debts. Preparing it from an extended trial balance ensures all adjustments are included, resulting in an accurate measure of profit or loss for the period.

Key Point Checklist

This article has covered the following key knowledge points:

• The purpose and layout of the statement of profit or loss for a sole trader
• The structure and role of the extended trial balance in compiling the SOPL
• Methods for correctly classifying and transferring trial balance accounts
• Typical year-end adjustments (inventory, accruals, prepayments, depreciation, irrecoverable debts)
• Calculating and presenting gross profit and net profit
• The link between the SOPL and the capital account in the statement of financial position

Key Terms and Concepts

• statement of profit or loss
• extended trial balance
• expense
• income
• accrual
• prepayment
• closing inventory
• depreciation
• irrecoverable debt
• allowance for receivables