Step 1: Journal Entries Explanation
Transaction 1: Capital Contribution
Journal Entry:
o Debit: Cash (100,000)
o Credit: Common Stock (100,000)
The company received cash from the owner as a capital contribution.
Cash increases by $100,000.
Common Stock (equity) increases by $100,000.
Transaction 2: Credit Sales
Journal Entry:
o Debit: Accounts Receivable (200,000)
o Credit: Sales Revenue (200,000)
ABC Ltd. made $200,000 in sales on credit.
Accounts Receivable increases by $200,000 (because customers owe the company
money).
Sales Revenue increases by $200,000 (this is the amount of money ABC Ltd. earned).
Transaction 3: Purchase of Inventory on Credit
Journal Entry:
o Debit: Inventory (80,000)
o Credit: Accounts Payable (80,000)
ABC Ltd. purchased goods for $80,000 on credit.
Inventory increases by $80,000 (since they now have more inventory).
Accounts Payable (liabilities) increases by $80,000 (since they owe money to the
supplier).
Transaction 4: Salaries Paid
Journal Entry:
o Debit: Salaries Expense (50,000)
o Credit: Cash (50,000)
ABC Ltd. paid $50,000 in salaries.
Salaries Expense (Income Statement) increases by $50,000.
Cash decreases by $50,000 because it was paid out.
Transaction 5: Rent Paid
Journal Entry:
o Debit: Rent Expense (12,000)
o Credit: Cash (12,000)
ABC Ltd. paid $12,000 in rent.
Rent Expense increases by $12,000 (Income Statement).
Cash decreases by $12,000.
Transaction 6: Depreciation Expense
Journal Entry:
o Debit: Depreciation Expense (20,000)
o Credit: Accumulated Depreciation (20,000)
The company records $20,000 in depreciation on their fixed assets.
Depreciation Expense increases by $20,000 (Income Statement).
Accumulated Depreciation increases by $20,000 (Balance Sheet).
Transaction 7: Loan Taken
Journal Entry:
o Debit: Cash (100,000)
o Credit: Loan Payable (100,000)
ABC Ltd. took out a $100,000 loan.
Cash increases by $100,000.
Loan Payable (liabilities) increases by $100,000.
Transaction 8: Interest Expense
Journal Entry:
o Debit: Interest Expense (5,000)
o Credit: Cash (5,000)
ABC Ltd. paid $5,000 in interest on their loan.
Interest Expense increases by $5,000 (Income Statement).
Cash decreases by $5,000.
Transaction 9: Income Tax Expense
Journal Entry:
o Debit: Income Tax Expense (40,000)
o Credit: Income Tax Payable (40,000)
ABC Ltd. accrues $40,000 in income tax.
Income Tax Expense increases by $40,000 (Income Statement).
Income Tax Payable increases by $40,000 (Balance Sheet).
Step 2: Trial Balance Breakdown
Once the journal entries are recorded, the next step is to prepare the Trial Balance. Each
account balance is extracted from the journal and added to the trial balance.
Trial Balance for ABC Ltd.
Account Debit ($) Credit ($)
Cash 100,000
Accounts Receivable 200,000
Inventory 80,000
Accounts Payable 80,000
Salaries Expense 50,000
Rent Expense 12,000
Depreciation Expense 20,000
Loan Payable 100,000
Interest Expense 5,000
Sales Revenue 200,000
Income Tax Expense 40,000
Retained Earnings 238,000
Each balance is from the journal entries.
The debits and credits should always match, ensuring no errors were made.
Step 3: Adjusted Trial Balance
Adjustments are made to reflect things like depreciation, inventory adjustments, and income tax
accruals. Let's go over these adjustments.
1. Inventory Adjustment:
oAfter the year-end inventory count, it was determined that the inventory on hand
was $60,000, not $80,000.
o The adjustment is a decrease in inventory by $20,000.
2. Depreciation Adjustment:
o The adjusted depreciation for the year was actually $25,000 (from the original
$20,000).
o The adjustment is an increase of $5,000.
3. Accrued Interest:
o The company accrued $5,000 interest that was not previously recorded.
4. Prepaid Rent:
o The company had $2,000 in prepaid rent that needs to be adjusted for the part
used during the year.
Step 4: Preparing the Financial Statements
Now, using the Adjusted Trial Balance, we prepare the final financial statements.
Income Statement
We start by taking the revenues and expenses from the adjusted trial balance.
Revenue (Sales): The sales revenue was recognized as $200,000.
Cost of Goods Sold (COGS): This is derived from the change in inventory (i.e.,
beginning inventory + purchases - ending inventory). Assuming beginning inventory
was $80,000, and purchases were $80,000, the ending inventory adjustment reduces the
COGS by $20,000.
Operating Expenses: These are salaries, rent, and depreciation.
Net Profit: We subtract total expenses (including interest and tax) from total revenue.
Balance Sheet
The Balance Sheet is derived from the assets and liabilities of the company, which includes:
Assets (Current + Non-Current): Cash, Accounts Receivable, Inventory, Property,
Equipment.
Liabilities: Accounts Payable, Loans, Taxes Payable.
Equity: Common Stock and Retained Earnings.
The Retained Earnings account will include the net income (from the Income Statement) and
any dividends paid.
Cash Flow Statement
The Cash Flow Statement is derived from changes in Cash during the year, as reflected in the
journal entries:
Operating Activities: Start with net profit, add back depreciation (non-cash), adjust for
working capital changes (inventory, receivables, payables).
Investing Activities: Cash spent on purchases of assets.
Financing Activities: Cash from loans and cash paid out for dividends.
Final Example:
After these steps, we end up with the following final numbers:
Net Profit: $255,500
Total Assets: $860,000
Total Liabilities: $450,000
Equity: $710,000
Net Increase in Cash: $190,500
Summary
1. Start by recording journal entries for all transactions.
2. Use the journal entries to prepare the Trial Balance.
3. Make necessary adjustments for things like depreciation and inventory changes.
4. Finally, use the Adjusted Trial Balance to prepare the Income Statement, Balance
Sheet, and Cash Flow Statement.
