Final AccountsThe final step of the accounting process

A business’s financial statements are important documents.

They are its primary way of communicating its financial condition with its shareholders, creditors, potential investors, and even employees.

This is one incentive as to why you want to make your financials as presentable as possible.

While the contents of financial statements are what make them important, it’s all for nothing if their intended audience cannot understand them.

In the accounting of your business’s transactions, you’ll be maintaining different ledgers, some of which are subsidiary ledgers.

Presenting all of them on your business’s financial statement, such as the balance sheet and income statements, will make them cluttered and messy.

Just imagine the format of your initial trial balance.

Present your balance sheet or income statement the same way.

Not good right?

You want to make your financial statement clean and presentable (on top of being accurate of course).

Sure, you can post all of an account’s subsidiary accounts on your balance sheet.

But doing so will make your balance sheet unnecessarily cluttered.

That’s where the concept of final accounts comes in.

Simply put, final accounts are the accounts that you see in a business’s financial statements.

They illustrate a business’s profit or loss, as well as its financial position.

The preparation of final accounts is the final stage of the accounting process.

It is when the business transfer accounts from the trial balance into their appropriate financial statements (e.g. asset accounts to the balance sheet, expense accounts to the income statements, etc.).

In this article, we will be learning about what final accounts are.

We will also learn about their importance and purpose in the preparation of financial statements.

What are Final Accounts?

Final accounts are the accounts that a business prepares at the final stage of the accounting process/cycle.

They present a business’s profit or loss as well as its financial position.

They present the journal entries made by the business in a way that can be understood by shareholders, investors, and creditors.

The primary purpose of running a business is to make a profit.

And while profit can be physically seen or felt as the business grows, it can be best represented with numbers.

Quantifying your business’s profit or loss via financial statements is an effective way of communicating its financial condition.

That’s why it’s essential for a business to properly account for all of its transactions.

Initially, a business records its transactions in its books via journal entries.

The business then reflect these entries in their appropriate ledger accounts.

For example, journal entries about accounts receivable are reflected in the accounts receivable ledger.

Eventually, usually at the end of the period, the business uses these ledger accounts to prepare its trial balance, which ensures that all the accounts have equal credit and debit balances.

Finally, the business uses the trial balance to prepare the final accounts, which it will then use to prepare its financial statements.

There are three general types of final accounts.

The Trading Accounts are accounts that represent the business’s gross profit (or loss).

Essentially, they present the business’s operating profit or income from its main operations.

The Profit and Loss Accounts represent the indirect income and expenses of the business, as well as its net income (or loss) for the concerned period.

This mainly includes operating expense accounts.

Finally, the Balance Sheet Accounts represent the financial position of the business.

These include the asset, liabilities, and equity accounts of the business.

Trading Accounts

Trading accounts are accounts that represent the gross profit of the business or its income from its main operations.

For businesses that sell goods, they represent the results of buying, producing (if applicable), and selling goods.

As for businesses that provide services, they represent the results of providing services.

For a business that sells goods, the following are typically its trading accounts

Debit Accounts

• Cost of Goods Sold
  • Inventory, Beginning
  • Net Purchases made during the concerned period; total purchases less purchase returns, discounts, and allowances
  • Inventory, Ending

To compute the Cost of Goods Sold, we use the following formula:

Cost of Goods Sold = Inventory, Beginning + Net Purchases – Inventory, Ending

Credit Accounts

• Net Sales; total sales less sales returns, discounts, and allowances

We can compute the gross profit of a business that sells goods by using the following formula:

Gross Profit = Net Sales – Cost of Goods Sold

For a business that sells services, the following are typically its trading accounts:

Debit Accounts

• Cost of Service
  • (Debit) Expenses that can be directly traceable to the performance of service; for example, supplies or materials used, cost of labor, etc.

Credit Accounts

• (Credit) Service Revenue

We can compute the gross profit of a business that sells services by using the following formula:

Gross Profit = Service Revenue – Cost of Service

Finally, for a business that manufactures the products that it sells, it will have the following trading accounts:

Debit Accounts

• Cost of Direct Materials Used
  • Raw Materials Inventory, Beginning
  • Purchases of raw materials
  • Raw Materials Inventory, Ending

To compute the Cost of Direct Materials Used, we use the following formula:

Cost of Direct Materials Used = Raw Materials Inventory, Beginning + Purchases of Raw Materials – Raw Materials Inventory, Ending

• Direct Labor Costs
• Manufacturing Overhead Costs
  • include expenses that are directly attributable to the manufacturing function such as utilities and maintenance expense, depreciation of machinery and equipment, etc.
• Cost of Goods Manufactured
  • WIP Inventory, Beginning
  • Cost Direct Materials Used
  • Direct Labor Costs
  • Manufacturing Overhead Costs
  • WIP Inventory, Ending

To compute the Cost of Goods Manufactured, we use the following formula:

Cost of Goods Manufactured = WIP Inventory, Beginning + Cost of Direct Materials Used + Direct Labor Costs + Manufacturing Overhead – WIP Inventory, Ending

• Cost of Goods Sold
  • Finished Goods Inventory, Beginning
  • Cost of Goods Manufactured
  • Finished Goods Inventory, Ending

To compute the Cost of Goods Sold, we use the following formula:

Cost of Goods Sold = Finished Goods Inventory, Beginning + Cost of Goods Manufactured – Finished Goods Inventory, Ending

Credit Accounts

• Net Sales; total sales less sales discounts, returns, and allowances

We can compute the gross profit of a business that manufactures and sells its own products by using the following formula:

Gross Profit = Net Sales – Cost of Goods Sold

Profit and Loss Accounts

Profit and loss accounts determine the net income of a business for a certain period.

Unlike trading accounts, profit and loss accounts include income and expenses that are not directly traceable to the sale of goods or services.

Mainly, they are operating expenses such as the following:

• Salaries and wages of administrative staff
• Salaries and wages of sales staff
• Cost of sales commission
• Office supplies expense
• Rent for the building that houses that administrative function
• Rent for the building that house the sales function

Also included are non-operating income and expenses such as:

• Gain or loss on investment
• Dividend income
• Interest income or expenses

To compute a business’s net income or loss (before taxes), we use the following formula:

Net Income = Gross Profit (Loss) – Operating Expenses + Other Income – Other Expenses

The profit and loss accounts, along with the gross profit/loss that we get from trading accounts, make up a business’s income statement.

Balance Sheet Accounts

The balance sheet is a listing of the business’s assets, liabilities, and equity.

As such, balance sheet accounts include asset accounts, liability accounts, and equity accounts.

They present the financial position/condition of the business at a specific point in time (usually the end of a given period).

Asset accounts represent the assets of the business.

They are properties that the business benefits from.

For example, a business benefits from the sale of its inventory or the collection of its accounts receivable.

Liability accounts represent the financial debts and obligations of the business.

Liabilities arise when the business borrows money from a creditor, or when it purchases goods on credit.

They can also accumulate through the accrual of expenses.

Equity accounts represent the residual amount between the assets and liabilities.

They also represent the amount of capital invested by the business’s owners or shareholders, as well as its retained earnings.

Here are some examples of balance sheet accounts:

Asset Accounts

• Cash and Cash Equivalents
• Marketable Securities
• Accounts Receivable
• Notes Receivable
• Inventory
• Prepaid Expenses
• Buildings
• Building Improvement
• Land
• Machinery
• Equipment
• Furniture and Fixtures
• Patents
• Software Licenses
• Trademarks

Liability Accounts

• Accounts Payable
• Notes Payable
• Accrued Expenses
• Unearned Revenue
• Interest Payable
• Dividends Payable
• Loans Payable

Equity Accounts

• Shareholder’s Equity
• Retained Earnings
• Capital Surplus
• Revaluation Surplus

In addition, there are also contra accounts such as:

Contra Assets

• Accumulated Depreciation
• Allowance for Doubtful Accounts

The balance sheet is usually presented in a way where the asset accounts represent the debit side while the liabilities and equity accounts represent the credit side.

For asset accounts, they are usually arranged in order of liquidity. As for liability accounts, they are usually arranged according to which is the most current.

Objectives of Final Accounts Preparation

A business prepares final accounts with the following objectives in mind:

• To determine the gross and net profit of the business for a specified period
• To determine the financial position of the business at a specified point in time
• Become a source of information that conveys to the users of financial statements (shareholders, investors, creditors) regarding the solvency of the business

Importance of Final Accounts

Businesses prepare final accounts for the purpose of constructing financial statements.

Both trading accounts and profit and loss accounts make up a business’s income statement.

They present a business’s gross profit as well as its net profit. Balance sheet accounts make up a business’s balance sheet.

Another name for the balance is the statement of financial position.

This means that the balance sheet represents the financial position/condition of a business at a specific point in time.

Final accounts determine which accounts to present on a business’s financial statement.

It helps in making them clean and presentable, on top of being relevant and accurate.

They also ensure that the debit and credit accounts are balanced.

While the books of a business are accessible for its shareholder, not anyone has the time to look at individual journal entries and ledger accounts.

Besides, that’s the job of the accounting and auditing team.

To make the data digestible for shareholders, investors, and creditors, a business uses final accounts for the preparation of financial statements.

Besides, most businesses are required to prepare financial statements nowadays for auditing and tax purposes.

The SEC requires publicly traded companies to submit a copy of their financial statements.

The IRS may also require certain businesses to provide a copy of their financial statements.