Fundamentals of Financial Accounting: Double Entry, Adjustments and Ratios
Financial accounting produces the external reports - statement of profit or loss, statement of financial position and statement of cash flows - under IFRS. BA1 tests double entry, period-end adjustments, depreciation, inventory measurement and basic ratio interpretation.
Double entry and the accounting equation
- Assets = capital + liabilities, and every transaction has two equal effects.
- Debits increase assets and expenses; credits increase liabilities, income and capital.
- Transactions flow from books of prime entry to the ledgers and then the trial balance. A balanced trial balance proves only that debits equal credits.
Period-end adjustments
- Accruals match income and expense to the period earned or incurred, not to cash. An accrued expense increases the expense and creates a liability; a prepayment reduces the expense and creates an asset.
- Depreciation allocates the depreciable amount (cost less residual value) over useful life: straight line gives an equal annual charge; reducing balance applies a constant percentage to the carrying amount. It is neither a cash flow nor a valuation.
- Inventory is measured at the lower of cost and net realisable value (IAS 2).
Statements and ratios
- The statement of financial position is a snapshot; profit or loss covers a period; cash flows split into operating, investing and financing activities.
- Underlying concepts: going concern, accruals, consistency, prudence, materiality.
- Ratios: gross margin = gross profit ÷ revenue; ROCE = operating profit ÷ capital employed; current ratio = current assets ÷ current liabilities; gearing = debt ÷ (debt + equity).
Worked example
Draft profit is $50,000. Rent of $3,000 is accrued, insurance of $2,000 relates to next year, and depreciation of $8,000 is unrecorded. Adjusted profit = 50,000 − 3,000 + 2,000 − 8,000 = $41,000. The accrual increases the expense, the prepayment reverses an expense already charged, and depreciation is charged to profit with an equal increase in accumulated depreciation.
Traps
Adding a prepayment to profit instead of reversing it; adding depreciation back when calculating profit (it has already been charged); treating capital expenditure as an expense; assuming a balanced trial balance means the records are correct - errors of omission, commission, principle and compensating errors all survive it.