Preparation of financial statements: adjustments and linkages
Preparation of financial statements in CIMA F1 tests how a trial balance and adjustments become a statement of profit or loss, statement of financial position, statement of changes in equity and simple statement of cash flows. Exam questions often give draft profit and a list of omitted items, or ask you to classify cash flows.
Core statements
The statement of profit or loss presents revenue, cost of sales, gross profit, operating expenses, finance costs and tax. Expenses may be analysed by function or by nature. The statement of financial position classifies assets and liabilities as current or non-current and links to equity: share capital, share premium, revaluation surplus and retained earnings. The statement of changes in equity reconciles opening and closing equity, showing total comprehensive income, share issues, dividends and transfers. IAS 7 cash flows are classified as operating, investing or financing; the indirect method starts with profit before tax and adjusts for non-cash items and working-capital movements.
Common adjustments
- Accrual: expense incurred but not invoiced-increase the expense and a liability.
- Prepayment: amount paid in advance-reduce the expense and recognise an asset.
- Closing inventory: reduce cost of sales and recognise a current asset.
- Depreciation: increase expense and accumulated depreciation.
- Tax: recognise tax expense and a liability; tax paid is an operating cash flow.
- Dividends: paid reduce retained earnings and are financing cash flows, not expenses.
- Prior period errors: adjust opening retained earnings retrospectively.
Worked example
Draft profit is £80,000. Rent paid £24,000 covers 15 months to 31 March; the year end is 31 December, so three months are prepaid: £24,000 × 3/15 = £4,800, which is added back to profit. Depreciation of £9,000 was omitted, so deduct it. Closing inventory of £6,000 was omitted, so add it because cost of sales is overstated. Final profit = £80,000 + £4,800 − £9,000 + £6,000 = £81,800. In the statement of financial position, prepayments rise by £4,800, PPE falls by £9,000 and inventory rises by £6,000; net assets and retained earnings rise by £1,800.
Traps
Dividends are not expenses. Do not deduct tax paid again if it is already reflected in profit before tax-check the wording. Accruals and prepayments move profit in opposite directions. In cash flows, depreciation is added back but is not a cash flow; interest paid may be operating or financing under IAS 7 policy, but must be consistent. Prior period errors are not put through current profit.