1.
From Transactions to Financial Statements

Introduction

This workbook develops accounting as a system of structured reasoning.

You will move from transaction-level mechanics to financial statements, from performance measurement to equity movement, and from technical calculation to judgement and stewardship.

The goal is not simply to memorise accounting steps, but to understand how accounting works and why it matters. If you can explain the reasoning behind a journal entry or a financial statement, you will be better able to tackle unfamiliar problems with confidence, rather than relying only on memorised examples.

1 The accounting system

1.1 The accounting cycle

The accounting cycle diagram shown in Figure 1 demonstrates the process of accounting as both sequential and continuous.

Each accounting year (\(Y_t\)) begins with opening balances brought down from the previous year’s (\(Y_{(t−1)}\)) closing balances, where applicable (i.e., not in the first year of operations).

Step 1 records transactions using double entry.

Step 2 transfers these balances to the trial balance (see section 2).

Step 3 records year-end adjustments.

Step 4 reflects the impact of these adjustments in the adjusted trial balance.

Step 5 financial statements can now be prepared (see section 3).

Step 6 closing balances at the end of the period are then brought down as opening balance for the next accounting period (\(Y_{(t+1)}\)) (see section 5).

This workbook takes you through the steps of the accounting cycle, providing guided practice to build skills and confidence.

1.2 The accounting equation

Debits and credits are explained as a logical system in Figure 8.4. This ensures that we maintain the accounting equation. As a reminder, some common transaction examples are outlined below.

1.3 From source documents to journal entries

Question 1

For each transaction, select the source document that provides the most appropriate evidence.

2 Recording transactions (double entry)

2.1 Guided practice on double entry

Question 2

For the following transactions, select the accounts impacted.

An owner invests CU 8,000 cash into their business bank account.

The business makes a cash sale of services of CU 2,500.

The business pays a bill for insurance for Year 1 of CU 600.

The business purchases some supplies for CU 450 cash.

2.2 Credit transactions and settlement

Question 3

For the following credit and settlement transactions, select the accounts impacted.

Sell goods on credit for CU 1,750.

Receive CU 1,750 from customers later.

Purchase inventory on credit CU 3,200.

Settle the supplier account in full.

Now attempt Practice Question 1 and Practice Question 2 in the Practice Questions section.

2.3 From journal to ledger to trial balance

Worked example 1

Your friend has recently set up a business, and the following transactions took place in its first month. They have asked you to show them how to account for these transactions and ensure that everything balances in preparation for creating the accounts.

1. The owner invests CU 20,000 cash into the business.
2. The business purchases equipment for CU 6,000 cash.
3. The business purchases inventory on credit for CU 2,000.
4. The business makes cash sales of CU 3,500.
5. The business pays CU 1,200 in rent in cash.
6. The business pays CU 1,000 to suppliers in partial payment of the sum owed.
7. The owner withdraws CU 800 cash for personal use.

Step 1: Establish the accounts impacted.

Step 2: Create the T-accounts.

Step 3: Transfer balances to the trial balance.

Click through the accompanying slides that work through the example step by step and give the solutions.

Just because the trial balance balances does not mean it is correct. Several types of error may occur in the preparation of the trial balance. They are outlined in Figure 3.

2.4 Practice questions

Attempt Practice Questions 1 to 4 in the Additional Practice Questions section.

These four introductory trial balance practice questions are designed to help you apply the concepts involved in preparing a trial balance (TB). They build skills progressively.

3 Year-end adjustments (with calculations)

3.1 Depreciation (non-cash charge)

Depreciation is a non-cash charge that spreads the cost of non-current assets over their estimated useful economic lives. It is normally recorded as a year-end adjustment to the accounts:

Debit: Depreciation expense (SoPL)

Credit: Accumulated depreciation (SoFP)

3.2 Accruals (expense incurred, not yet paid)

Worked example 2

Wages of CU 1,200 relate to this period but are unpaid at year-end.

1. Identify the amount relating to the current period: 1,200.
2. Recognise the expense now (matching the period).
3. Recognise a liability because the business owes this amount at year-end.

Record the adjustment:

Debit: Wages expense 1,200

Credit: Wages payable (accrued expenses) 1,200

3.3 Prepayments (cash paid, expense belongs to the future)

Worked example 3

Rent of CU 900 has been paid in advance and relates to the next period.

1. Identify the amount that relates to a future period: 900.
2. Remove it from this period’s expenses.
3. Recognise an asset (prepaid rent) because it represents a future benefit.

Record the adjustment:

Debit: Prepaid rent 900

Credit: Rent expense 900

3.4 Inventory and cost of sales

This workbook uses the periodic inventory method unless stated otherwise. Purchases are recorded in a purchases account during the year, and cost of sales is calculated at year-end.

Worked example 4

Figure 4 below shows how inventory connects the SoPL and the SoFP. The closing inventory of CU 30,000 reported in the SoPL is the same amount reported as inventory under current assets in the SoFP.

3.5 Inventory write-down to net realisable value (NRV)

Inventory must be valued at the lower of cost and net realisable value (NRV).

Worked example 5

The closing inventory has a cost of CU 5,000 and an NRV of CU 4,300. Determine and record the required inventory write-down adjustment.

Step-by-step calculation:

1. Determine carrying amount at cost: 5,000.
2. Determine the NRV (expected selling price less cost to sell): 4,300.
3. Compare: inventory must be stated at the lower of cost and NRV.
4. Calculate the required write-down: 5,000 − 4,300 = 700.

Record the adjustment:

Debit: Inventory write-down expense (or cost of sales) 700

Credit: Inventory (or allowance for inventory write-down) 700

3.6 Specific bad debt (confirmed irrecoverable)

Worked example 6

A customer owing CU 150 has gone into liquidation. As a result, the CU 150 is irrecoverable (will never be received).

Step-by-step calculation:

1. Identify the specific receivable that is expected to be irrecoverable: 150.
2. Recognise the expense (loss) in the period identified.
3. Remove this from the accounts receivable balance.

Record the adjustment:

Debit: Bad debt expense 150

Credit: Accounts receivable 150

3.7 Expected credit losses (loss allowance)

Worked example 7

Accounts receivable total 10,000. You estimate that 5% of this total will be uncollectible.

1. Identify the receivables balance to assess: 10,000.
2. Apply the expected percentage: 5%.
3. Calculate expected credit losses: 10,000 × 5% = 500.

Record the adjustment:

Debit: Expected credit loss expense 500

Credit: Loss allowance 500

Where an existing allowance exists, any adjustment must be accounted for as follows:

Adjustment = required closing allowance – existing allowance

3.8 Provisions (uncertain liabilities)

Worked example 8

A legal claim raised by a customer, estimated at CU 20,000, is likely to be lost by the company. Record the adjustment:

Debit: Legal expense 20,000

Credit: Provision for legal claim 20,000

Worked example 9

Complete the full cycle: journal entries → ledger → trial balance → adjustments → brief statements.

Transactions

1. Owner invests CU 10,000 cash.
2. Buy inventory CU 3,000 cash.
3. Credit sales CU 4,000.
4. Pay wages of CU 1,200.

Adjustments

5. An amount of CU 300 is accrued for utilities.
6. Closing inventory is CU 1,000.
7. Some damaged inventory is identified, and an inventory write-down of CU 200 is recognised.
8. Create a 5% allowance for expected credit losses on remaining receivables.

Step 1: Record the transactions in the T-accounts.

Remember that T-accounts and journal entries contain the same information, so you may find it helpful to first write the journal entry and then post it to the T-accounts.

Step 2: Draw up the trial balance.

Step 3: Include the adjustments.

Step 4: Prepare the statements.

3.9 Practice questions

Attempt Practice Questions 5 to 8 in the Additional Practice Questions section.

The four practice questions for this section help to build your skills in applying adjustments to the trial balance.

4 Performance, equity and distribution

This section explains what happens after the Statement of Profit and Loss has been prepared:

• profit is transferred into equity
• equity may then be distributed (drawings or dividends)
• the remainder is retained in the business

4.1 Retained earnings and appropriation of profit

Revenue and expense accounts reset each year because they measure performance for a defined period. Retained earnings accumulate performance across years.

Here is an example of retained earnings movement.

4.2 Drawings (sole trader)

Worked example 10

The owner withdraws CU 1,000 cash for personal use.

Double entry:

Debit: Drawings 1,000

Credit: Cash 1,000

At year-end, drawings are closed to capital (sole trader):

Debit: Capital 1,000

Credit: Drawings 1,000

This reduces owner’s equity but does not affect profit.

Question 4

The owner withdraws inventory worth CU 300 for personal use. What are the entries at the point of withdrawal?

What entries are required at year-end?

Important distinction: Expenses reduce profit. Drawings reduce equity directly. Confusing the two overstates expenses and understates performance.

4.3 Dividends (companies)

Worked example 11

Step 1: Declaration of dividend.

The company declares a dividend of CU 5,000.

Double entry at declaration:

Debit: Retained earnings 5,000

Credit: Dividends payable 5,000

Step 2: Payment of dividend.

When the dividend is paid:

Debit: Dividends payable 5,000

Credit: Cash 5,000

Question 5

A dividend of CU 2,500 is declared and will be paid later. Select the accounts impacted.

On declaration:

On payment:

4.4 Comparison: Drawings versus dividends

4.5 Practice questions

Now attempt Practice Question 11 and Practice Question 12 in the Practice Questions section.

5 Balances brought forward (Year 2 and Beyond)

5.1 Recording transaction in Year 2

The following worked example shows how transactions are recorded in Year 2, from understanding the opening SoFP balances to closing the accounts at the end of the year.

Worked example 12

Step 1: Understand the opening SoFP.

Opening balances at 1st January Year 2:

Step 2: Enter opening balances into ledger.

Opening balances are entered on the debit or credit side depending on their normal balance:

This represents the opening assets available at the start of the year.

One important example of an opening balance is inventory. The example below illustrates how balances are carried down from the previous year.

Inventory across years:

Year 1 closing inventory: CU 3,000

This becomes Year 2 opening inventory (asset).

If Year 2’s closing inventory is CU 2,500, then the reduction affects the cost of sales in Year 2.

Inventory movement = opening 3,000 – closing 2,500 = CU 500 reduction.

Step 3: Record Year 2 transactions normally.

Once balances are brought forward, Year 2 transactions are recorded exactly as before. The opening balances simply form the starting totals in each ledger.

Example transaction: Sell goods on credit for CU 1,200 in Year 2.

Step 4: Closing Year 2.

At the end of Year 2:

1. Prepare the trial balance.
2. Record adjustments (accruals, prepayments, inventory write-downs, provisions).
3. Prepare financial statements.

The closing balances become Year 3’s opening balances.

Key principle: The closing balance carried down becomes the opening balance brought down in the next period.

Worked example 13

Nexa Retail Ltd is a small retail business that completed its first year of trading on 31 December Year 1. The SoFP at that date is shown below.

Year 2 transactions:

During the year ended 31 December Year 2, the following transactions took place:

1. The company made credit sales of CU 63,000.
2. Cash sales amounted to CU 10,500.
3. Cash received from credit customers was CU 56,000.
4. Inventory was purchased on credit for CU 38,500.
5. Payments to credit suppliers amounted to CU 35,000.
6. Rent paid during the year was CU 14,000.
7. Wages paid during the year amounted to CU 21,000.

Adjustments at 31 December Year 2:

• Closing inventory was CU 14,000.
• Rent prepaid at year-end was CU 4,200.
• Wages accrued at year-end were CU 2,800.
• Depreciation on equipment for the year is CU 8,750.

Required

1. Enter the opening balances of Year 2 into the relevant ledger accounts (Step 2 of Worked example 12).
2. Record the Year 2 transactions (Step 3 of Worked example 12).
3. Prepare the trial balance including opening balances and Year 2 activity (Step 4.1 of Worked example 12).
4. Record adjustments at end of Year 2 (Step 4.2 of Worked example 12).

Solutions

1. Click through the slide deck to see the opening balances recorded in the ledger accounts.

2. Click through the slide deck to see the Year 2 transactions recorded.

3. Trial balance:

1. Adjustments at end of Year 2:

Adjustment to rent
Rent paid during the year	14,000
Add: opening prepaid rent	3,500
Less: rent prepaid at end of Year 2 (SoFP)	(4,200)
Rent expense for Year 2 (SoPL)	13,300

So, rent expense must be reduced by 700.

Adjustment to wages
Wages paid during the year	21,000
Add: wages payable at end of Year 2 (SoFP)	2,800
Less: opening wages payable balance	(3,500)
Wages for Year 2 (SoPL)	20,300

So, wages expense must be reduced by 700.

Question 6

Using the solutions for Worked example 13, prepare the SoPL and the closing SoFP for the end of Year 2 for Nexa Retail Ltd. (This is Step 4.3 of Worked example 12.)

Answer

5.2 Common mistakes with opening balances

Some of the mistakes that can occur when opening balances are brought down from the previous year include the following:

• re-recording opening balances as new transactions.
• forgetting that revenue and expenses do NOT have opening balances.
• mixing up retained earnings within capital.

Important note: Revenue and expense accounts start at zero each new period. Only asset, liability, and equity balances are brought forward.

5.3 Practice questions

Question 7

Orion Furnishings provides the following extracts from its financial statements for Year 1 and Year 2.

Additional information

• No inventory was purchased during Year 2.

6 Integrated practice

In this section, you will put together all the skills that you have learned.

Question 8

Bonjour Boulangerie is an artisan bakery operating in Paris. You have recently set up an accounting practice in the city and have been asked to prepare the business’s Year 2 accounts.

Opening statement of financial position for Bonjour Boulangerie as at 1st January Year 2:

Transactions during Year 2 (all transactions are in CU ’000):

1. The business made credit sales to trade customers of 6,000.
2. The business carried out cash purchases of 2,500.
3. Wages of 1,200 were paid.
4. The business received 3,000 from customers.

Adjustments at the end of Year 2 (all transactions are in CU ’000):

5. Inventory at year-end was 2,800.
6. The finance director wants to create an allowance for expected credit losses of 5% on closing receivables.
7. Management declared a dividend of 1,000.
8. Depreciation of 500 was charged on the equipment.

Required

Record the transactions in the T-accounts, create the trial balance and then draw up the SoFP and SoPL for the year.

Answer

T-accounts

Trial balance

Adjusted trial balance

Financial statements