Preparing and Using Financial Statements
FoundationThe profit and loss statement deducts cost of goods sold from sales for gross profit, then expenses for net profit; the statement of financial position lists assets, liabilities and capital, with closing capital adjusted for profit and drawings. Financial statements support decisions, yet are limited by historical cost and other principles.
- Profit and loss statement: sales − cost of goods sold = gross profit; gross profit − expenses = net profit
- Cost of goods sold = opening inventory + purchases − closing inventory
- Statement of financial position: assets = liabilities + capital; closing capital = opening capital + profit − drawings
文體小知識：商業知識說明文——示範由試算表編製損益表及財務狀況表的步驟，說明財務報表的用途與限制，並介紹基本會計假設與原則。
§Text Passage
1Financial statements are the output of the accounting cycle, chiefly the profit and loss statement and the statement of financial position. The profit and loss statement reports the results of the period: sales revenue minus cost of goods sold gives gross profit; deducting operating expenses such as rent and wages gives net profit or loss. Cost of goods sold equals opening inventory plus purchases minus closing inventory, so the accuracy of inventory data directly affects the reliability of gross profit.
2The statement of financial position is a financial snapshot of the firm on one day: one side lists assets, split into non-current and current assets; the other side lists liabilities and capital. Closing capital is adjusted from opening capital plus the period's net profit minus the owner's drawings; adding liabilities must equal total assets — returning exactly to the accounting equation: assets equal liabilities plus capital.
3Financial statements are a key basis for decisions. Owners and managers assess profitability and financial strength to expand, scale down or adjust prices; banks check repayment ability before granting loans; investors judge whether to invest; the tax authority assesses profits tax on net profit; suppliers set credit limits by reference to the firm's financial condition.
4However, financial statements have limitations. Under the historical cost concept assets are carried at purchase cost, which may not reflect current market value; accounting involves estimates and judgement, such as depreciation and allowance for bad debts; money measurement cannot capture non-financial factors such as staff quality and brand reputation; and different accounting policies reduce comparability between firms. Readers must understand these limits.
5The statements rest on accounting assumptions and principles: the business entity concept separates the firm from the owner's private finances; the going concern concept assumes the firm will continue operating; the historical cost concept records assets at cost; consistency requires the same methods period after period for comparability; and the accrual concept recognises income and expenses when transactions occur, regardless of when cash is received or paid.
1Summary 重點摘要
The profit and loss statement deducts cost of goods sold from sales for gross profit, then expenses for net profit; the statement of financial position lists assets, liabilities and capital, with closing capital adjusted for profit and drawings. Financial statements support decisions, yet are limited by historical cost and other principles.
2Vocabulary cards Vocabulary
The statement reporting the period's results: sales minus cost of goods sold gives gross profit, then expenses give net profit or loss.
The statement listing assets, liabilities and capital on one day; the two sides must total the same amount.
The cost of goods sold in the period: opening inventory plus purchases minus closing inventory.
Sales revenue minus cost of goods sold, before deducting operating expenses.
Gross profit minus all operating expenses; transferred to increase capital.
Cash or goods the owner takes from the firm for private use; a reduction of capital, not an expense.
The firm is treated as separate from its owner; business and private finances are recorded apart.
The assumption that the firm will continue operating for the foreseeable future.
Assets are recorded at their actual purchase cost and not adjusted for market movements.
Income and expenses are recognised when transactions occur, regardless of cash timing.
3Step by step Steps
- Step 1: From the trial balance to the statementsOnce the trial balance balances, the last stage of the cycle begins: preparing the financial statements. First classify the accounts: sales, purchases and inventory-related items belong in the profit and loss statement; assets, liabilities and capital items belong in the statement of financial position. For example, the bookstore's sales of $100,000 go to the profit and loss statement, while equipment of $40,000 goes to non-current assets — correct classification is the first step.
- Step 2: The profit and loss statement and cost of goods soldThe first part of the statement calculates gross profit: sales revenue minus cost of goods sold. Cost of goods sold equals opening inventory plus purchases minus closing inventory, because goods bought are not all sold within the period. For example, if the bookstore's sales are $100,000, purchases for the year $60,000 and closing inventory $8,000, cost of goods sold is 60,000 − 8,000 = $52,000, and gross profit is 100,000 − 52,000 = $48,000.
- Step 3: Operating expenses and net profitAfter gross profit, deduct the period's operating expenses — rent, wages, utilities, depreciation and so on — to arrive at net profit or loss. Net profit is the overall measure of performance and is carried to the statement of financial position to increase capital. For example, with gross profit of $48,000 and yearly rent $10,000, wages $15,000 and other expenses $5,000, total expenses are $30,000 and net profit is 48,000 − 30,000 = $18,000.
- Step 4: Preparing the statement of financial positionThe statement balances on two sides: one side lists non-current assets such as equipment and current assets such as inventory, receivables and cash; the other side lists capital and liabilities. Closing capital = opening capital + net profit − drawings. For example, the bookstore's opening capital of $40,000 plus net profit of $18,000 gives $58,000; adding accounts payable of $10,000 gives $68,000, equal to total assets of $68,000 — the statement balances.
- Step 5: Using the financial statementsDifferent stakeholders read the statements differently: owners look at profit and capital movements to decide on expansion; managers compare periods to control costs; banks check repayment ability and security; investors assess returns; the tax authority charges profits tax on net profit; suppliers set credit limits. For example, seeing the bookstore's steadily rising profit and ample cash, a bank is more willing to approve a loan for a new branch — statements directly affect financing.
- Step 6: Limitations of the financial statementsThe statements are not perfect: historical cost means book values may not reflect market prices; depreciation and bad debts involve estimates; money measurement ignores non-financial factors such as staff quality and brand reputation; and different accounting policies distort direct comparisons. For example, two cafes may report the same profit, yet one depreciates by the straight-line method and the other by the reducing-balance method — their true performance may differ, so note the policies used.
- Step 7: Accounting assumptions and principlesThe statements rest on basic assumptions and principles: the business entity concept separates business transactions from the owner's private finances; the going concern concept assumes continued operation; the historical cost concept records assets at cost; consistency requires the same methods each period; and the accrual concept recognises income and expenses when transactions occur, whatever the cash timing. For example, paying the owner's children's school fees by company cheque violates the business entity concept — it is drawings, not an expense.
5Worked example Example
Wing Wah Stationery's trial balance at 31 March 2026 shows: sales $100,000 (credit), purchases $60,000 (debit), rent $10,000 (debit), wages $15,000 (debit), other expenses $5,000 (debit), equipment $40,000 (debit), accounts receivable $12,000 (debit), cash $8,000 (debit), accounts payable $10,000 (credit), capital $40,000 (credit). Closing inventory is $8,000 and there was no opening inventory. Prepare the profit and loss statement for the year ended 31 March 2026 and the statement of financial position as at that date.
- Cost of goods sold: purchases 60,000 − closing inventory 8,000 (no opening inventory) = $52,000.
- Profit and loss statement: sales 100,000 − cost of goods sold 52,000 = gross profit $48,000; expenses 10,000 + 15,000 + 5,000 = $30,000; net profit = 48,000 − 30,000 = $18,000.
- Statement of financial position, assets: non-current asset equipment $40,000; current assets inventory 8,000 + receivables 12,000 + cash 8,000 = $28,000; total assets $68,000.
- Capital and liabilities: capital 40,000 + net profit 18,000 = $58,000; plus current liability accounts payable 10,000 = $68,000.
- Check: total assets $68,000 = capital and liabilities $68,000 — both sides balance and the statements are complete.
- Answer: Profit and loss statement: gross profit $48,000 (sales 100,000 − cost of goods sold 52,000); net profit $18,000 (gross profit 48,000 − expenses 30,000). Statement of financial position: total assets $68,000 (equipment 40,000 + inventory 8,000 + receivables 12,000 + cash 8,000); capital 40,000 + net profit 18,000 = $58,000, plus accounts payable 10,000, totalling $68,000 — both sides balance.
6Common mistakes Mistakes
7Quick check Quick check
Q1How is gross profit calculated?
Q2Sales $100,000, purchases $60,000, closing inventory $8,000 — what is the gross profit?
Q3How is closing capital calculated?
Q4Paying the owner's children's school fees by business cheque violates which concept?
Q5What are the main limitations of financial statements?
8Recap Recap
- Profit and loss statement: sales − cost of goods sold = gross profit; gross profit − expenses = net profit
- Cost of goods sold = opening inventory + purchases − closing inventory
- Statement of financial position: assets = liabilities + capital; closing capital = opening capital + profit − drawings
- Uses: owners' decisions, bank lending, tax assessment, investment judgement, supplier credit
- Five principles: business entity, going concern, historical cost, consistency, accrual