Unit 1 · Why Accounting Exists
1-5 From Trial Balance to Financial Statements
Transactions were recorded. Accounts were balanced. Errors were checked. The trial balance confirmed internal consistency. Now the question becomes the one Mariam asked in lesson 1-1 and could not answer: what does the business actually look like?
Guiding question
How do four statements turn a list of balances into an answer — and what happens when the list is incomplete? (pp.22–26)
Learning outcome. By the end you can prepare all four statements from a trial balance in the right order, explain what each one measures and why it depends on the one before, and explain why an unbalanced trial balance always produces an unbalanced statement of financial position by exactly the same amount.
Each one depends on the one before it
The book is precise about this: for a sole trader the information is presented through four interrelated statements, and “each statement/account depends on the one before it” (p.22). That dependency is the reason for the order, and it is the reason you cannot start in the middle.
1 · Trading account
measures: Gross profit
Sales minus the cost of the goods sold. Core trading only — buying and selling, nothing else.
2 · Profit and loss account
measures: Net profit
Starts from the gross profit above, then takes off the operating expenses: rent, salaries, insurance, utilities, depreciation.
3 · Statement of changes in capital
measures: Closing capital
Opening capital, plus the net profit above, minus drawings. This is where profit turns into the owner’s claim.
4 · Statement of financial position
measures: What it owns and owes
Assets on one side; liabilities and the closing capital above on the other. The accounting equation, at a date.
Follow the chain: gross profit is an input to statement 2, net profit is an input to statement 3, and closing capital is an input to statement 4. Get one wrong and the three after it are wrong too — which is exactly why an exam gives part marks for a correct method carried forward from a wrong figure.
Net Profit = Gross Profit − Operating Expenses (p.23)
Gross profit answers: are we selling the goods for more than they cost us? It says nothing about rent or wages. Net profit answers: and after everything else it takes to run the place, is there anything left?
A business can have a healthy gross profit and a net loss — that is a business selling at a good margin in a shop it cannot afford. The two figures are asking different questions, which is why the book keeps them in separate statements instead of one long sum.
Below is the same machine run over three sets of books: Omar Trading (the book’s fully worked example, p.24), Salma Stores (the book’s exercise on p.27, which it leaves blank), and Mariam’s bakery — the ledger you built yourself across lessons 1-3 and 1-4.
Work through the six steps for Omar first. Then switch business and do it again. The last step is the one the book does not include.
One machine, three sets of books
Every statement below is worked out from the trial balance above it — nothing is typed in twice. Run the same four steps over three different businesses and watch what happens at the end.
the book’s fully worked example, p.24. The book prepares all four statements from this and then points out that the position statement does not balance.
Trial balance of Omar Trading
as at 31 December
| Account | Debit | Credit |
|---|---|---|
| Cash | 25,000 | |
| Equipment | 60,000 | |
| Inventory | 15,000 | |
| Purchases | 70,000 | |
| Rent expense | 10,000 | |
| Salaries expense | 12,000 | |
| Utilities expense | 3,000 | |
| Drawings | 5,000 | |
| Bank loan | 20,000 | |
| Capital | 55,000 | |
| Sales | 120,000 | |
| Total | 200,000 | 195,000 |
The two columns do NOT agree. The debits exceed the other side by 5,000.
Hold on to that number. It is going to come back at step 4, and the book never tells you that it will.
| Business | Gross profit | Net profit | Closing capital | Out by |
|---|---|---|---|---|
| Omar Trading | 50,000 | 25,000 | 75,000 | 5,000 |
| Salma Stores | 40,000 | 22,000 | 63,000 | 8,000 |
| Mariam’s bakery | 45,000 | 18,000 | 64,000 | balances |
Only one of the three balances — and it is the one where you posted every transaction yourself and left nothing out. The other two are the book’s own examples, and both are incomplete by design. That is the lesson: the statements do not create the problem, they reveal one that was already there.
🧮 Omar Trading, worked the way the book works it — then one step further
- 1
Check the trial balance first. Debits 200,000; credits 195,000. It is 5,000 out, with the debits larger.
Why this step: The book does this on p.25 and states it plainly: “This Trial Balance is not internally balanced.” Doing it FIRST matters, because everything after this point is built on a list that is already known to be incomplete.
Most people slip here: Notice the book still prepares all four statements anyway. That is deliberate — it is showing you what an incomplete set of books produces, not making a mistake.
- 2
Trading account: sales 120,000 less purchases 70,000 gives a gross profit of 50,000.
Why this step: Only the buying and selling. The rent, salaries and utilities are all sitting in the trial balance and none of them belongs here — they are costs of running the business, not costs of the goods.
- 3
Profit and loss: gross profit 50,000 less rent 10,000, salaries 12,000 and utilities 3,000 — total expenses 25,000 — gives a net profit of 25,000.
Why this step: The gross profit is carried DOWN into this statement as its opening line. That is the dependency the book means: statement 2 cannot start until statement 1 has finished.
- 4
Changes in capital: opening capital 55,000, add net profit 25,000, less drawings 5,000, giving closing capital of 75,000.
Why this step: This is where profit becomes part of the owner’s claim. Drawings come off — they are not an expense, so they never appeared in statements 1 or 2, and this is the only statement that sees them.
Most people slip here: Drawings appear in the trial balance as a DEBIT of 5,000 and are subtracted here. If you also treated them as an expense you would count them twice and understate profit.
- 5
Financial position: assets are cash 25,000 + equipment 60,000 + inventory 15,000 = 100,000. Liabilities and capital are bank loan 20,000 + closing capital 75,000 = 95,000.
Why this step: And it does not balance. 100,000 against 95,000. The book stops here and says: “Students must now investigate.”
- 6
Now the step the book leaves out. The position statement is 5,000 out — and so was the trial balance, in the same direction.
Why this step: That is not a coincidence. Assets, purchases, expenses and drawings are the debits; liabilities, capital and sales are the credits. The statements only rearrange those same figures, so whatever the two columns were out by at the start, the position statement is out by at the end. The imbalance was findable on p.24, before any statement existed.
Most people slip here: This means preparing four statements to discover an imbalance is the slow way round. The trial balance told you two pages earlier — and lesson 1-4 told you what it can and cannot detect.
- Current assets
- — Cash and items expected to be converted into cash within one year or less. (p.24)
- Non-current assets
- — Long-term resources such as buildings and equipment. (p.24)
- Current and non-current liabilities
- — Obligations classified in the same way, according to their maturity dates — when they fall due. (p.24)
- Owner’s equity in the statement
- — Capital, plus net profit, minus withdrawals. (p.24)
Where the comparison breaks down: A photograph is complete in itself. A position statement is not — it depends on the P&L that came before it, because the closing capital on it contains the period’s profit. The two are not independent records of the same business.
Mark each statement ○ if it is true or × if it is false. Decide before you press.
Gross profit is calculated after deducting rent and salaries.
The profit and loss account begins with the gross profit from the trading account.
Drawings are deducted in the profit and loss account.
Net profit increases owner’s equity.
If the trial balance does not balance, the statement of financial position may still balance.
A business with a high gross profit is definitely doing well.
Match each description with the choice that fits it.
Sales minus the cost of goods sold.
Gross profit minus rent, salaries and utilities.
Opening capital plus net profit minus drawings.
Assets set against liabilities and closing capital at a date.
Exam-style — the book’s Salma Stores exercise, worked in full (p.27)
Trial Balance of Salma Stores as at 31 December. Cash 18,000 · Equipment 40,000 · Inventory 12,000 · Purchases 50,000 · Rent expense 8,000 · Salaries expense 10,000 · Drawings 4,000 · Bank loan 15,000 · Capital 45,000 · Sales 90,000.
A. Verify whether the two sides balance. B. Prepare the trading account, the profit and loss account, the statement of changes in capital and the statement of financial position. C. Is the statement of financial position balanced, and what does that tell you?
One of you names a figure from a trial balance — drawings, purchases, bank loan, inventory, utilities. The other says which of the four statements it appears in, and which it does not. The two that catch people are drawings (statement 3 only, never the P&L) and inventory (statement 4 only, in this simplified version).
How the real paper is built
The ministry sets half multiple choice and half written answer in every subject. The two halves are not the same skill. In the multiple-choice half you have to spot the wrong options quickly — and the wrong options are built out of the mistakes students really make. In the written half nobody gives you the answer to recognise; you have to produce it, in your own words, with a reason.
Practise both. Being good at one half and weak at the other costs you exactly half the paper.
In a New Context
A trader gives you this list: cash 12,000 · equipment 35,000 · inventory 8,000 · purchases 40,000 · rent 6,000 · wages 9,000 · drawings 3,000 · bank loan 10,000 · capital 30,000 · sales 70,000.
Prepare all four statements. Then, before you reach the last one, work out from the trial balance alone whether the statement of financial position will balance — and by how much it will be out if it does not. Say which side is likely to be missing something, and why.
Lesson Question — Answered
How do four statements turn a list of balances into an answer — and what happens when the list is incomplete?
Each statement takes the one before it as its starting point. The trading account compares sales with the cost of the goods and produces gross profit. The profit and loss account takes that figure, deducts the cost of running the business, and produces net profit. The statement of changes in capital adds that profit to the owner’s opening claim and takes off drawings, producing closing capital. The statement of financial position sets the assets against the liabilities and that closing capital. Four steps, and the answer to Mariam’s original question at the end of them.
And when the list is incomplete, the statements do not fix it and do not hide it — they carry it through unchanged. Omar’s trial balance was 5,000 out and his position statement is 5,000 out; Salma’s is 8,000 out in the other direction and so is hers. That is guaranteed, because the statements only regroup the same figures. Mariam’s balances, and the only thing different about her books is that nothing was left out of them. As the book says: financial statements must reconcile with the accounting equation, and any imbalance demands investigation (p.26).
Keep reading — this lesson marks itself done automatically.