Financial Accounting
Financial Accounting in Module II tests double-entry bookkeeping, year-end adjustments and the preparation of financial statements for a sole trader or partnership. The exam favours adjustments that change profit and net assets, so you must see the link between the statement of profit or loss and the statement of financial position.
Core rules
- The accounting equation is assets = liabilities + capital; every transaction keeps it balanced.
- Accrual accounting records income when earned and expenses when incurred, not when cash moves.
- A prepayment is an asset until consumed; an accrual is a liability until paid.
- Closing inventory reduces cost of sales and appears as a current asset.
- Straight-line depreciation = (cost - residual value) / useful life.
Worked example
On 1 October a business pays 1,200 for 12 months of insurance. Its year end is 31 December. It also owns equipment costing 10,000 with a residual value of 1,000 and a five-year life. Insurance expense for the year is 1,200 x 3/12 = 300; the remaining 900 is a prepayment. Depreciation is (10,000 - 1,000) / 5 = 1,800. The adjusting entries are Dr Insurance expense 300, Dr Prepaid insurance 900, Cr Cash 1,200 (or Cr Prepaid insurance if initially capitalised); and Dr Depreciation expense 1,800, Cr Accumulated depreciation 1,800. Profit falls by 2,100, while the statement of financial position shows prepaid insurance 900 and equipment at carrying amount 8,200.
Traps
- Charging the full 1,200 to this year's profit.
- Forgetting that accumulated depreciation is a credit balance and does not reduce the asset account directly.
- Treating drawings as an expense instead of a reduction in capital.
- Assuming a balanced trial balance proves there are no errors: it misses errors of omission, principle and compensating errors.