Financial Accounting: Records, Statements and Interpretation
The accounting equation and double entry
Everything rests on assets = capital + liabilities. Each transaction has equal debit and credit effects, and the trial balance tests arithmetic equality, not accuracy. Know the purpose of the books of prime entry (sales day book, purchase day book, cash book, journal) and the role of control accounts and the bank reconciliation in detecting errors.
Preparing the statements
Candidates must understand the income statement (revenue less cost of sales = gross profit; less expenses = operating profit; less finance costs and tax = profit for the year) and the statement of financial position (non-current assets, current assets, current liabilities, non-current liabilities, capital). Be confident with accruals and prepayments, depreciation (straight-line and reducing balance), irrecoverable debts and closing inventory adjustments - these are the classic exam adjustments.
Worked example
A business has revenue 200,000, opening inventory 20,000, purchases 120,000, closing inventory 25,000. Cost of sales = 20,000 + 120,000 − 25,000 = 115,000. Gross profit = 200,000 − 115,000 = 85,000. If expenses are 50,000 and depreciation 10,000, operating profit = 25,000.
Interpretation
Use ratios: gross margin, operating margin, current ratio, quick ratio, gearing, receivables and payables days, inventory turnover. State the formula, compute, then interpret in context - a high current ratio may signal poor inventory control, not strength.
Common traps
Adding closing inventory instead of deducting it; treating capital expenditure as an expense; forgetting that drawings reduce capital; and calculating a ratio correctly but giving no interpretation.