Trial Balance, Financial Statements & Closing Entries

TAKEAWAYS:

• A trial balance lists all ledger accounts to check arithmetic accuracy before preparing financial statements.
• Adjusting entries correct for accruals, deferrals, and estimates (e.g., depreciation, bad debts) before closing.
• The income statement shows profitability; the balance sheet shows solvency; the cash flow statement shows liquidity.
• Closing entries transfer temporary accounts (revenues, expenses) to retained earnings and reset them to zero.
• Errors like omissions, commissions, or compensating errors can distort trial balances but may not always be caught by the trial balance itself.
• Financial statements must comply with GAAP/IFRS and reflect the accrual basis of accounting.

1. Trial Balance: The Foundation

A trial balance is a summary of all ledger accounts (debits and credits) at a point in time. It serves three key purposes:

1. Check arithmetic accuracy: Ensures total debits = total credits.
2. Identify missing entries: Highlights accounts with no balance.
3. Prepare financial statements: Provides the raw data for income statements and balance sheets.

How to Prepare a Trial Balance

1. List all ledger account names (assets, liabilities, equity, revenue, expenses).
2. Extract their debit or credit balances from the ledger.
3. Total debits and total credits must match. If not, find the error (see below).

Example: Trial Balance for "Kathmandu Book Shop" (as of 31 Dec 2023)

| **Account Name**          | **Debit (NPR)** | **Credit (NPR)** |
|---------------------------|-----------------|------------------|
| Cash at Bank              | 1,200,000       |                  |
| Accounts Receivable       | 800,000         |                  |
| Inventory                 | 1,500,000       |                  |
| Furniture & Fixtures      | 2,000,000       |                  |
| Accumulated Depreciation  |                 | 500,000          |
| Accounts Payable          |                 | 600,000          |
| Capital                   |                 | 3,000,000        |
| Sales Revenue             |                 | 5,000,000        |
| Salaries Expense          | 1,200,000       |                  |
| Rent Expense              | 300,000         |                  |
| **Total**                 | **5,800,000**   | **5,800,000**    |

Common Errors in Trial Balance

Mermaid Diagram: Trial Balance Process

flowchart TD
    A["Ledger Accounts"] --> B["Extract Debit/Credit Balances"]
    B --> C["List in Trial Balance"]
    C --> D["Total Debits = Total Credits?"]
    D -->|"Yes"| E["Proceed to Adjustments"]
    D -->|"No"| F["Find & Correct Errors"]
    F --> D

2. Adjusting Entries: Bridging the Gap

A trial balance reflects unadjusted ledger balances. Before financial statements, adjusting entries are made for:

• Accruals: Revenues earned or expenses incurred but not yet recorded (e.g., unpaid salaries, interest earned).
• Deferrals: Prepaid expenses or unearned revenues (e.g., prepaid insurance, advance rent).
• Estimates: Depreciation, bad debts, inventory obsolescence.

Example: Adjusting Entries for Kathmandu Book Shop

Assume:

• Unearned Rent Revenue: NPR 100,000 (collected in advance for next year) → Adjust to recognize earned portion.
• Depreciation: Furniture (NPR 2,000,000, 5-year life, straight-line) → Annual depreciation = $\frac{2,000,000}{5}=400,000$.
• Accrued Salaries: NPR 200,000 (not yet paid).

Adjusting Journal Entries

| **Date**       | **Account**               | **Debit (NPR)** | **Credit (NPR)** | **Description**                     |
|----------------|---------------------------|-----------------|------------------|-------------------------------------|
| 31-Dec-2023    | Unearned Rent Revenue     | 100,000         |                  | Rent earned this year               |
| 31-Dec-2023    | Rent Revenue              |                 | 100,000          |                                     |
| 31-Dec-2023    | Depreciation Expense      | 400,000         |                  | Depreciation on furniture           |
| 31-Dec-2023    | Accumulated Depreciation  |                 | 400,000          |                                     |
| 31-Dec-2023    | Salaries Expense          | 200,000         |                  | Accrued salaries                    |
| 31-Dec-2023    | Salaries Payable          |                 | 200,000          |                                     |

Adjusted Trial Balance

After adjustments, the trial balance becomes:

| **Account Name**          | **Debit (NPR)** | **Credit (NPR)** |
|---------------------------|-----------------|------------------|
| Cash at Bank              | 1,200,000       |                  |
| Accounts Receivable       | 800,000         |                  |
| Inventory                 | 1,500,000       |                  |
| Furniture & Fixtures      | 2,000,000       |                  |
| Accumulated Depreciation  |                 | 900,000          |
| Accounts Payable          |                 | 600,000          |
| Salaries Payable          |                 | 200,000          |
| Capital                   |                 | 3,000,000        |
| Sales Revenue             |                 | 5,100,000        |
| Rent Revenue              |                 | 100,000          |
| Salaries Expense          | 1,400,000       |                  |
| Rent Expense              | 300,000         |                  |
| Depreciation Expense      | 400,000         |                  |
| **Total**                 | **6,200,000**   | **6,200,000**    |

3. Financial Statements: The Big Picture

Financial statements are prepared from the adjusted trial balance. The three primary statements are:

A. Income Statement (Profit & Loss Statement)

Shows revenue – expenses = net profit/loss for a period. Example for Kathmandu Book Shop (2023)

| **Particulars**           | **Amount (NPR)** |
|---------------------------|------------------|
| **Revenue**                |                  |
| Sales Revenue              | 5,000,000        |
| Rent Revenue               | 100,000          |
| **Total Revenue**          | **5,100,000**    |
| **Expenses**               |                  |
| Salaries Expense           | 1,400,000        |
| Rent Expense               | 300,000          |
| Depreciation Expense       | 400,000          |
| **Total Expenses**         | **2,100,000**    |
| **Net Profit**             | **3,000,000**    |

B. Balance Sheet (Statement of Financial Position)

Shows assets = liabilities + equity at a point in time. Example for Kathmandu Book Shop (31 Dec 2023)

| **Assets**                | **NPR**          | **Liabilities + Equity** | **NPR**          |
|---------------------------|------------------|--------------------------|------------------|
| **Current Assets**        |                  | **Current Liabilities**  |                  |
| Cash at Bank              | 1,200,000        | Accounts Payable         | 600,000          |
| Accounts Receivable       | 800,000          | Salaries Payable         | 200,000          |
| Inventory                 | 1,500,000        | **Total Current Liab.**  | **800,000**      |
| **Total Current Assets**  | **3,500,000**    | **Equity**               |                  |
| **Non-Current Assets**    |                  | Capital                 | 3,000,000        |
| Furniture & Fixtures      | 2,000,000        | Retained Earnings        | 2,700,000*       |
| Less: Accumulated Depreciation | 900,000    | **Total Equity**        | **5,700,000**    |
| **Net Non-Current Assets**| **1,100,000**    | **Total Liab. + Equity**| **6,500,000**    |
| **Total Assets**          | **4,600,000**    |                          |                  |

*Retained Earnings = Previous Retained Earnings + Net Profit (assuming no dividends).

C. Cash Flow Statement

Shows cash inflows and outflows from operating, investing, and financing activities. Simplified Example

| **Activity**       | **Cash Inflow (NPR)** | **Cash Outflow (NPR)** |
|--------------------|-----------------------|------------------------|
| **Operating**      |                       |                        |
| Cash Sales         | 2,000,000             |                        |
| Rent Collected     | 100,000               |                        |
| Salaries Paid      |                       | 1,200,000              |
| Rent Paid          |                       | 300,000                |
| **Net Cash Flow**  | **2,100,000**         | **1,500,000**          |
| **Net Operating CF**| **600,000**           |                        |
| **Investing**      |                       |                        |
| Furniture Purchase  |                       | 500,000                |
| **Financing**      |                       |                        |
| Capital Injection   | 1,000,000             |                        |
| **Net Change in Cash**| **1,100,000**        |                        |

4. Closing Entries: Resetting the Books

Temporary accounts (revenues, expenses, drawings) are closed to retained earnings at year-end. Permanent accounts (assets, liabilities, capital) remain open.

Steps for Closing Entries

1. Close Revenue Accounts (Credit Balance → Debit to Retained Earnings).
2. Close Expense Accounts (Debit Balance → Credit to Retained Earnings).
3. Close Income Summary (if used as an intermediary).
4. Close Dividends/Drawings (if applicable).

Example for Kathmandu Book Shop

| **Date**       | **Account**               | **Debit (NPR)** | **Credit (NPR)** | **Description**                     |
|----------------|---------------------------|-----------------|------------------|-------------------------------------|
| 31-Dec-2023    | Sales Revenue             | 5,000,000       |                  | Close revenue                       |
| 31-Dec-2023    | Rent Revenue              | 100,000         |                  |                                     |
| 31-Dec-2023    | Income Summary            |                 | 5,100,000        |                                     |
| 31-Dec-2023    | Income Summary            | 2,100,000       |                  | Close expenses                      |
| 31-Dec-2023    | Salaries Expense          |                 | 1,400,000        |                                     |
| 31-Dec-2023    | Rent Expense              |                 | 300,000          |                                     |
| 31-Dec-2023    | Depreciation Expense      |                 | 400,000          |                                     |
| 31-Dec-2023    | Income Summary            | 3,000,000       |                  | Transfer net profit to retained earnings |
| 31-Dec-2023    | Retained Earnings         |                 | 3,000,000        |                                     |

Mermaid Diagram: Accounting Cycle

In the Real World

1. eSewa (Nepal)

   • Idea Used: Cash Flow Statement
   • How: eSewa tracks cash inflows (transaction fees, commissions) and outflows (payment processing, refunds) to ensure liquidity. Their operating cash flow must cover expenses like server costs and customer support.

2. Ncell (Nepal)

   • Idea Used: Balance Sheet & Liabilities
   • How: Ncell’s balance sheet shows current liabilities (unpaid customer bills, salaries) and non-current liabilities (long-term loans for network expansion). Investors and regulators use this to assess solvency.

3. Daraz (Nepal)

   • Idea Used: Income Statement & Inventory Management
   • How: Daraz’s cost of goods sold (COGS) is a major expense. Their gross profit margin (Sales Revenue – COGS) is closely watched by investors. Adjusting entries for inventory obsolescence (unsold stock) directly impact net profit.

4. Nepal Rastra Bank (NRB)

   • Idea Used: Financial Statements for Regulation
   • How: Banks like NMB or Global IME must submit audited financial statements (income statement, balance sheet) to NRB. The capital adequacy ratio (a balance sheet metric) determines if they can lend safely.

Worked Example Tie-In:

• Khalti’s Loan Interest Calculation Khalti offers personal loans at 12% annual interest. If a customer borrows NPR 100,000 for 1 year, the interest expense (NPR 12,000) is recorded as an adjusting entry at year-end. This affects:
  • Income Statement: Adds to finance expense.
  • Balance Sheet: Increases interest payable (liability).

Exam Tip

1. Trial Balance Errors:

   • If debits ≠ credits, check for transpositions, omissions, or compensating errors.
   • Example Question: "The trial balance of XYZ Ltd. shows total debits of NPR 5,000,000 and credits of NPR 5,200,000. Identify the possible error."
   • Answer: Likely a NPR 200,000 omission (e.g., an asset or liability not recorded).

2. Adjusting Entries:

   • Always ask: "Is this an accrual, deferral, or estimate?"
   • Example Question: "On 1 Jan 2023, ABC Shop paid NPR 600,000 for 2 years’ rent. Show the adjusting entry for 31 Dec 2023."
   • Answer:

     | **Account**               | **Debit (NPR)** | **Credit (NPR)** |
     |---------------------------|-----------------|------------------|
     | Rent Expense              | 300,000         |                  |
     | Prepaid Rent              |                 | 300,000          |
     

3. Financial Statements:

   • Income Statement: Revenue – Expenses = Net Profit.
   • Balance Sheet: Assets = Liabilities + Equity (always verify this equation).
   • Example Question: "From the adjusted trial balance, prepare the income statement for XYZ Ltd."
   • Tip: Start with sales revenue, subtract COGS, then operating expenses, then non-operating items.

4. Closing Entries:

   • Revenues have credit balances → debit to close.
   • Expenses have debit balances → credit to close.
   • Example Question: "Close the following accounts: Sales Revenue (NPR 5,000,000 Cr.), Salaries Expense (NPR 1,200,000 Dr.)."
   • Answer:

     | **Account**               | **Debit (NPR)** | **Credit (NPR)** |
     |---------------------------|-----------------|------------------|
     | Sales Revenue             | 5,000,000       |                  |
     | Income Summary            |                 | 5,000,000        |
     | Income Summary            | 1,200,000       |                  |
     | Salaries Expense          |                 | 1,200,000        |
     

5. Common Pitfalls:

   • Ignoring adjusting entries: Financial statements prepared from an unadjusted trial balance will be incorrect.
   • Miscounting totals: Always double-check that debits = credits in trial balances and financial statements.
   • Mixing permanent/temporary accounts: Only temporary accounts (revenues, expenses) are closed; permanent accounts (assets, liabilities) remain open.

Final Note:

• Practice is key: Use real-world examples (e.g., a small Kathmandu tea shop’s transactions) to prepare trial balances and statements.
• Memorize the flow: Journal → Ledger → Trial Balance → Adjustments → Financial Statements → Closing Entries.
• Exam Strategy: If stuck on a numerical problem, start with the trial balance and work forward.