Preparation of Financial Statements for Companies (Grade 12 NSC Matric Accounting): Revision Notes

Preparation of Financial Statements for Companies

Understanding how to prepare financial statements is a crucial skill in accounting. Companies must transform their initial trial balance through various adjustments to create accurate financial statements that reflect the true financial position and performance of the business.

What is a pre-adjustment trial balance?

Think of it as a rough draught that needs refining before it becomes the final version. The pre-adjustment trial balance shows what the accounts look like based on daily transactions, but it doesn't yet reflect important adjustments like depreciation, accrued expenses, or prepaid items.

Step-by-step process for preparing financial statements

The preparation of financial statements from a pre-adjustment trial balance follows three essential steps:

Step 1: Enter the pre-adjustment figures

Start by transferring all the account balances from the pre-adjustment trial balance into your working papers. These figures represent the starting point for your adjustments and will be modified as you work through each required adjustment.

Step 2: Process each adjustment

For every adjustment you need to make:

• Calculate the adjustment amount if it's not already provided
• Determine which accounts to debit and credit based on the nature of the adjustment
• Apply the adjustment to the pre-adjustment figures, remembering that outstanding/accrued amounts are added (+) while prepaid/advance amounts are subtracted (-)

Step 3: Calculate final figures

Once all adjustments have been processed, calculate the final balances for each account. These adjusted figures will be used to prepare your income statement and balance sheet.

Common year-end adjustments

Companies typically need to make several types of adjustments at year-end to ensure their financial statements are accurate and complete:

Prepaid expenses

When a company pays for expenses in advance (like insurance or rent), these amounts must be adjusted to show only the portion that relates to the current period. The unused portion becomes a current asset on the balance sheet.

Accrued expenses

These are expenses that have been incurred but not yet paid or recorded. Common examples include utilities still owing or wages earned but not yet paid.

Income received in advance

When customers pay for services or goods before they are delivered, this creates a liability because the company owes the service or product to the customer.

Accrued income

This represents income that has been earned but not yet received or recorded. The most common example is interest earned on investments or bank deposits.

Bank charges and interest

Bank statements often reveal charges and interest that weren't recorded in the books during the year. These must be adjusted to reflect the true financial position.

Depreciation

Fixed assets like vehicles and equipment lose value over time through use and obsolescence. Depreciation expense must be calculated and recorded each year.

Common rates:

• Vehicles: often 10% per annum at cost price
• Equipment: typically 10% per annum at carrying value (cost less accumulated depreciation)

Bad debts and provision for bad debts

Not all customers pay their debts. Companies must:

• Write off specific debts that are definitely uncollectable
• Create or adjust a provision for bad debts (usually 5% of total debtors) for amounts that might become uncollectable

Trading stock adjustments

Differences between recorded stock and actual stock on hand (revealed by stocktaking) must be adjusted. This could be due to theft, damage, or counting errors.

Interest capitalisation

When a company borrows money to purchase assets, the interest on that loan might be added to the cost of the asset rather than treated as an expense, especially during the construction or acquisition period.

Understanding adjustment calculations

When dealing with income or expenses that vary throughout the year or involve partial periods, you'll need to use specific calculation methods:

Time-based calculations

For adjustments involving partial periods, create a timeline showing:

• The financial year period
• When amounts were received or paid
• What portion applies to the current year versus future/past periods

Formula for unknown amounts

When you know the total amount and need to find the unknown portion:

$\frac{\text{Unknown \%}}{\text{Known \%}} = \frac{\text{Unknown amount}}{\text{Known total}}$

This formula helps determine how much income was received in advance or how much expense was prepaid.

Impact on financial statements

Every adjustment affects both the income statement and balance sheet:

Income statement effects

• Expenses: Adjusted for accrued amounts (increase) and prepaid amounts (decrease)
• Income: Adjusted for accrued amounts (increase) and advance amounts (decrease)

Balance sheet effects

• Assets: Include prepaid expenses and accrued income
• Liabilities: Include accrued expenses and income received in advance
• Fixed assets: Show depreciation and accumulated depreciation

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