Financial statements and company equity
What the domain tests
You must prepare a trading account, profit and loss account and balance sheet from a trial balance, adjusting for accruals, prepayments, depreciation, bad debts, provisions and inventory. The exam rewards correct structure and correct treatment of adjustments.
Structure and rules
Trading account: sales less returns inwards gives net sales. Cost of sales is opening inventory + purchases + carriage inwards − returns outwards − closing inventory. Gross profit is net sales less cost of sales.
Profit and loss account: gross profit plus other income less expenses. Depreciation, bad debts, increase in the provision for doubtful debts, discount allowed and accruals are expenses. Carriage outwards, administration and selling costs are expenses. Drawings are not an expense.
Balance sheet: non-current assets at net book value; current assets include inventory, receivables net of provision, prepayments and bank/cash; current liabilities include payables, accruals and bank overdraft; long-term liabilities; capital is opening capital + additional capital introduced + net profit − drawings.
Worked example
Sales 2,000,000; returns inwards 100,000; opening inventory 200,000; purchases 1,300,000; returns outwards 50,000; carriage inwards 30,000; closing inventory 250,000. Expenses are 300,000, depreciation 80,000 and bad debts 20,000.
- Net sales = 1,900,000.
- Cost of sales = 200,000 + 1,300,000 + 30,000 − 50,000 − 250,000 = 1,230,000.
- Gross profit = 670,000.
- Net profit = 670,000 − 300,000 − 80,000 − 20,000 = 270,000. Closing inventory appears in the trading account and as a current asset, never twice in the same account.
Traps
Carriage inwards is part of cost of sales; carriage outwards is a distribution expense. In the specified periodic-purchases model, goods taken by the owner are Dr Drawings; Cr Purchases at cost. A perpetual-inventory model instead credits inventory. An increase in the provision for doubtful debts is an expense, but a decrease is income. Accrued expenses are current liabilities and prepaid expenses are current assets. Do not deduct drawings before calculating net profit.
What the domain tests
You must record share issues, distinguish types of capital and reserves, account for debentures and dividends, and present a company income statement and statement of financial position. Questions often involve share premium, debenture interest and tax.
Core rules
- Where the legal system uses authorized capital, it denotes an issue limit rather than the actual issued capital balance. Its existence and required disclosures must be checked locally.
- Issued capital is the nominal value of shares actually issued. Called-up capital is the amount demanded; paid-up capital is the amount received.
- Share premium arises when shares are issued above nominal value and is a capital reserve, not profit.
- Debentures are long-term borrowings. Debenture interest is a finance cost charged before tax, not an appropriation of profit.
- In this simple equity-share model, ordinary dividends are distributions to owners rather than expenses. Instruments called preference shares may have different liability/equity classification, so their accounting is not settled by the label alone.
- Reserves include share premium, revaluation surplus and retained earnings.
Worked example
A company issues 100,000 ordinary shares of 1,000 FCFA each at 1,250 FCFA, fully paid. Profit before interest and tax is 40,000,000; 10% debentures are 50,000,000; the hypothetical tax rate is 30%, taxable profit is assumed equal to profit before tax; an ordinary dividend of 8% is declared; 5,000,000 is transferred to a general reserve.
- Share issue: Dr Bank 125,000,000; Cr Ordinary share capital 100,000,000; Cr Share premium 25,000,000.
- Debenture interest = 5,000,000. Profit before tax = 35,000,000. Tax = 10,500,000. Profit after tax = 24,500,000.
- Dividend = 8% × 100,000,000 = 8,000,000. Transfer = 5,000,000. Retained profit for the year = 11,500,000.
Traps
Debenture interest is never an appropriation; dividends are never an expense. Legal restrictions on share premium and distributions depend on the actual jurisdiction; do not infer them from the generic ledger example. Authorised capital is not the figure in the statement of financial position. Do not ignore tax when calculating distributable profit. Calls in arrears reduce paid-up capital, and a bonus issue converts reserves into share capital without raising cash.