Extracting the statements from general ledgers

This chapter explains how general ledger accounts are closed to prepare financial statements. It also shows how the statement of profit or loss and the statement of financial position connect through the accounting equation.

Learning objective

By the end of this chapter, you should be able to:

• Explain the interrelationship between the statement of financial position and the statement of profit or loss and other comprehensive income
• Explain how the accounting equation, the business entity concept, and IFRS Accounting Standards underlie the statement of financial position.
• Prepare a statement of financial position, or extracts from it
• Prepare a statement of profit or loss, or extracts from it

General ledger accounts to financial statements

During an accounting period, transactions are recorded in journal entries and posted to the general ledger. At the end of the period, you complete a closing process so the ledger balances can be used to prepare the financial statements.

We’ll look at the process separately for:

• the statement of profit or loss (profit or loss account)
• the statement of financial position

Statement of profit or loss account

After all general ledger accounts are balanced, the income and expense accounts go through a procedure called closing entries. These accounts are closed by transferring their balances to a summary account, usually called the profit or loss account. Why close these accounts?

Income and expense accounts are temporary accounts. They measure performance for one accounting period (usually one year). To measure the next period correctly, they must start the new period with a zero balance. Assets, liabilities, and equity are different: they carry their balances forward from one period to the next.

How the closing works

1. Income accounts (which normally have credit balances) are debited to bring them to zero, with the corresponding credit posted to the profit or loss account
2. Expense accounts (which normally have debit balances) are credited to bring them to zero, with the corresponding debit posted to the profit or loss account
3. The profit or loss account then contains all incomes as credits and all expenses as debits
4. When balanced, this account reveals the net profit (if revenues exceed expenses) or net loss (if expenses exceed revenues) for the period
5. The net profit or loss is then transferred to the capital account (for sole traders and partnerships) or retained earnings (for companies), which forms part of the equity section in the statement of financial position.

Statement of financial position

The statement of financial position is prepared using the balances on asset, liability, and equity general ledger accounts.

Under the business entity concept, the statement of financial position reports only the business’s own assets, liabilities, and equity - kept separate from the owner’s personal affairs, which is why capital is shown as an amount the business owes back to the owner. The statement is presented in line with IFRS Accounting Standards (IFRS 18 governs how financial statements are presented), and it must always satisfy the accounting equation: total assets equal total equity plus total liabilities.

Remember: the net profit or net loss also affects the statement of financial position through equity (retained earnings for companies, or capital for sole traders and partnerships).

It’s important to notice that asset, liability, and equity accounts are not closed in the same way as income and expense accounts. Instead, the end-of-period balances (balance c/d becoming balance b/d in the new period) are presented on the statement of financial position and then carried forward into the next period - which is why these are called permanent accounts (or real accounts).

Illustration: general ledger to the financial statements

A sole trader started a business with $50,000 cash. During January 2024, the following transactions occurred:

1. Bought goods for cash, $15,000.
2. Purchased goods on credit from Kofi & Sons, $10,000.
3. Sold goods for cash $12,000.
4. Sold goods on credit to Ama Ltd., $8,000.
5. Paid rent by cash $2,000.
6. Paid Kofi & Sons $6,000 by cash.
7. Received $5,000 from Ama Ltd.

This question was used to illustrate the trial balance extraction in an earlier chapter. Revise the journal entries and general ledger accounts created before you proceed, as this illustration builds on that.

Extracting the profit or loss account

Step 1: Identification of the income and expense-related ledger account

List the general ledger account (s) that is (are) income-related.

Hint: Seven (7) general ledger accounts were created.

Do you know the answer?

List the general ledger account (s) that is (are) expense-related.

Step 2: Close off all the general ledger accounts in step 1 into the profit or loss account.

This automatically closes the accounts to zero for the period.

Step 3: Open the profit or loss account and post the corresponding balances using the double-entry bookkeeping principle

Notice that expenses appear on the debit side of the profit or loss account, while income appears on the credit side.

Step 4: Balance the profit or loss account

Because the debit side (expenses, $27,000) exceeds the credit side (income, $20,000) of the profit or loss account, the business made a loss of $7,000. This loss reduces the owner’s capital in the statement of financial position.

Preparation of the statement of financial position

1. All the general ledger accounts that didn’t appear in the profit or loss account are most likely to be asset, liability, and equity accounts to be used for the statement of financial position.
2. The statement of financial position is not a T-account like profit or loss. It appears in a statement form and follows the accounting equation. After incorporating the net loss, the statement is shown below.

Statement of financial position as at 31 January 2024
Assets:	$	$
Cash and bank		44,000
Receivables		3,000
Total assets		47,000
Equity:
Capital	50,000
Net loss	(7,000)
Total equity		43,000
Liabilities:
Payables		4,000
Total equity and liabilities		47,000

You can see the accounting equation balances in the statement. This is why the statement of financial position was previously referred to as a balance sheet.

Trial balance to the financial statement

The same logic applies when you prepare financial statements from a trial balance, except that:

1. General ledger accounts are typically presented to you in a trial balance format rather than as individual ledger accounts
2. The profit or loss account is prepared in a statement format rather than as a T-account

For example, the trial balance produced from the transactions above was given as:

Trial balance as at 31st January 2024
	DR	CR
	$	$
Cash and bank	44,000
Purchases	25,000
Receivables	3,000
Rent	2,000
Capital		50,000
Sales		20,000
Payables		4,000
	74,000	74,000

To prepare the statement of profit or loss, identify the expense and income accounts and use them to prepare the statement. Then use the remaining balances (assets, liabilities, and equity) to prepare the statement of financial position.

Assume all goods purchased were sold, so there is no closing inventory and cost of sales equals purchases. The profit or loss account in a statement format is presented below.

Statement of profit or loss for the month ended 31 January 2024
	$	$
Revenue		20,000
Cost of sales		(25,000)
Gross loss		(5,000)
Rent expense		(2,000)
Operating loss		(7,000)
Loss before financing and income taxes		(7,000)
Loss before income taxes		(7,000)
Loss for the period		(7,000)

IFRS 18 insight: IFRS 18, not the older IAS 1, now governs how the statement of profit or loss is presented. It requires three subtotals - operating profit or loss, profit or loss before financing and income taxes, and profit or loss for the period. The statement above also shows loss before income taxes, a subtotal the study guide asks for. There are no finance costs or income tax in this example, so loss before financing and income taxes, loss before income taxes and loss for the period all equal the operating loss. The full layout, with finance costs and income tax, is covered in The formats.