Section 1: The fundamentals of

accounting
1.1.1 Bookkeeping and accounting

The importance of measuring business profit and loss

Businesses exist to make a profit and provide a return on the investments made by their owners.

In order to assess performance, an income statement is prepared annually.

The income statement will detail revenues and expenses and conclude with an overall figure for
profit or loss.

The role of accounting in providing information for monitoring progress and for decision
making
Accounting processes result in the production of financial statements.
Financial statements include the income statement (described above) and a statement of financial
position, which sets out details about a business’s resources and how these have been financed at a
particular date.

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These statements can be compared with those from previous years to see what progress, if any, has
been made. They can also be compared with similar businesses to establish whether competitors
are performing better or worse in specific areas of interest.

The financial statements are likely to be studied carefully by business owner(s), managers and
other interested parties (where access is available).
The analysis is likely to focus on profitability and liquidity (the ability to meet financial
obligations when due) because businesses are in danger of failing if either of these key features are
showing signs of weakness.
The analysis of financial statements can provide important evidence to support decisions affecting
the performance of a business. These include
whether or not to:
• expand
• seek ways of increasing sales
• borrow additional finance
• find ways of cutting costs
• hire additional staff.

1.1.2 The accounting equation

Assets = Owner ’s equity + Liabilities
The starting point for all studies of accounting is the accounting equation.
This rule states that business resources are financed by the owner of the business and other
external sources.

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Section 2: Sources and recording of
data
2.1.1 The double-entr y system of bookkeeping – an outline

The system used for recording transactions is based on the following ideas:
1. There should be a separate record (i.e. account) for each aspect of any
transaction.
2. Any transaction will affect two accounts.

3
The idea that transactions always affect two accounts
In every transaction, one account receives, and the other account gives.

How an account works

1. Each account has two sides:
• the left-hand side is called the debit side (abbreviated as Dr)
• the right-hand side is called the credit side (abbreviated as Cr).

2. An entry is required:
• on the debit side when an account receives
• on the credit side when an account gives

3. Each side of an account has space to record:

• the date (month and day)
• a narrative
• the amount.
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examples:

When there is a change in the year, it is important to record details of the year in the date column
on both sides of the account.

4
The basic rule for narratives is to name the other account concerned in the transaction (or the
source of the information, i.e. the book of prime entry).

Posting transactions to the ledger accounts

For any transaction it is important to be able to state precisely which account will be debited and
which account credited. Recording transactions is referred to as ‘posting’.
Here are some typical transactions with a description of the entries to be made:

Preparing ledger accounts

Here are the ledger accounts recording transactions A–J. Dates in January 2019 have been added
by way of example. To make it easier to trace the entries, the accounts are shown in alphabetic
order and the narrative column also includes the relevant letter to help identify the transaction.

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6
2.1.2 Balancing and closing accounts
At the end of a financial period all ledger accounts should be either:
• balanced – where there is an amount left in the account, or
• closed – where there is no balance (often because the amount left in the account has been
transferred elsewhere in the accounting system).

7
Interpreting accounts and their balances
Interpreting an account means explaining what the account shows. It is necessary to look at each
transaction and give a detailed description of what has happened.
Here is the account of a credit customer in a business’s sales ledger:

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2.2.1 Business documents

9
2.2.2 Books of pr ime entr y

Books of prime entry have several advantages:

• They make it possible to summarize information and provide totals for certain types of
transaction, which reduces the number of entries in ledger accounts and therefore saves time.
• As there are seven different books of prime entry is it possible to divide the work of making a
first record of transactions among a small team of accounting staff.
• They provide the information required for control accounts

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11
Petty cash book

General journal

The general journal is often referred to as ‘the journal’. Transactions are recorded which cannot be
recorded in any of the other books of prime entry. These include:
• purchase of non-current assets on credit
• the opening of a new set of books
• corrections of errors (see section 3.2)
• withdrawals of goods for own use
• transfers of information in one account to another account.

Notes:
1. Information about transactions is taken from source documents.
2. There are source documents to cover all forms of cash and credit transactions.
3. Source documents are retained by a business to provide documentary evidence to support every
entry made in the books of account.
4. Books of prime entry are used to make the first record of transactions in the accounting system.
5. There are seven books of prime entry.
6. The cash book acts as both a book of prime entry and as ledger accounts for cash and bank.
7. Transaction details are posted from books of prime entry to ledger accounts, where appropriate
totals are posted (rather than individual amounts).
8. Trade discounts are sometimes offered on large orders to businesses in the same trade. Only the
net amount charged is entered in ledger accounts.
9. Cash discounts are offered to encourage prompt payment. Where an account due is settled
within the speci ed time limit, entries are made to record any cash discount deducted in the
ledger accounts.

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 Chapter 6 The tr ial balance
3.1.1 Uses and limitations of a tr ial balance; pr epar ing a tr ial balance
The trial balance is a list of all the balances in an accounting system on a particular date. It has
separate columns to record the debit balances and the credit balances.

Preparing a trial balance

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3.1.2 Er r or s not r evealed by a tr ial balance

1. There are six types of error which are not revealed by a trial balance.
2. Errors are corrected by means of journal entry.
3. Special care is needed with errors of reversal, as any correction requires the amount of the error
to be doubled.

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 Chapter 7 Cor r ection of er r or s
3.2.1 Types of er r or and their cor r ection
Errors revealed by the trial balance

3.2.2 The suspense account

1. A suspense account is used to make the totals of a trial balance agree.
2. The entry could be on the debit or credit side of the trial balance – whichever is lower.
3. A suspense account is opened in the nominal ledger and the opening balance is recorded on the
same side as the entry in the trial balance.
4. The suspense account will be closed when all the errors affecting the trial balance totals are
found and corrected.

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3.2.3 Cor r ecting financial statements
Correcting an income statement
Errors in the books of account can lead to incorrect information being shown in the draft income
statement. In these circumstances it is necessary to prepare a statement to amend the draft profit or
loss.

Correcting a statement of financial position

Correcting some errors can involve multiple changes to items on a statement of financial position.
Here are some examples:

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 Chapter 8 Bank r econciliation
3.3.1 Bank statements
A bank statement is a copy of the bank’s record of a customer’s account, which is sent to the
customer at regular intervals. Banks use the running balance layout, with three money columns
(debit, credit, balance) and a new balance shown after each transaction.
The statement is prepared from the bank’s point of view, so the balance shown on the account:
• is cr edit , where the customer has a positive balance – indicating the bank owes the customer
this amount (i.e. a liability for the bank)
• is debit , where the customer has a negative (overdrawn) balance – indicating the bank is owed
this amount by the customer (i.e. an asset for the bank).

3.3.2 Updating cash books

When a bank statement is received, it is unlikely that the final balance shown will be the same as
the balance on the cash book on that date.
There are likely to be transactions recorded on the bank statement which have not yet been
recorded in the cash book.

Here is an example of the format for updating a cash book:

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3.3.3 Bank r econciliation statements
The bank statement is also unlikely to be fully up to date. The reasons are as follows:

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 Chapter 9 Contr ol accounts
3.4.1 The role and use of control accounts
Control accounts are used to check the accuracy of the personal accounts of credit suppliers in the
purchases ledger, and credit customers in the sales ledger.

Control accounts help to locate errors where the totals of a trial balance have failed to agree. They
are memorandum accounts – meaning they are not part of the double-entry system.

Sources of information for control accounts

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Contra entries in control accounts occur in the following circumstances.
• The business is both a supplier and a customer of another organization.
• Separate accounts are maintained for acting as a supplier and for acting as a customer.
• By agreement, the balance of one account is ‘set off ’ against the balance of the other account to
find the net balance.
• The net balance could be due to the other organization or owed by the other organization.
• The contra entry is recorded first in the journal and then in each of the personal accounts.

Balance on both sides of control accounts

The account of a trade payable could occasionally have a debit balance.
This is usually because the supplier has been overpaid. Any debit balances on the accounts of
trade payables are shown separately in the purchases ledger control account, both as opening
balances and as closing balances.
Similarly, the accounts of a trade receivable could have a credit balance if the customer has
overpaid. Any credit balances on the accounts of trade receivables are shown separately in the
sales ledger control account, both as opening balances and as closing balances.

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3.4.2 Control account formats

21
 Chapter 10 Capital and r evenue expenditur e and r eceipts
4.1.1 Capital expenditure and revenue expenditure
Capital expenditur e is money spent on non-current assets.

Capital expenditure does not include repairs and maintenance costs, because it is assumed these
costs do not improve the non-current asset or increase its value.
Capital expenditure is recorded on a statement of financial position.
Depreciation charges are based on the total capital expenditure on a noncurrent asset. Capital
expenditure is assumed to benefit a business for a long period (more than one financial year).

Revenue expenditur e is money spent on the day-to-day expenses of running a business.

Revenue expenditure is charged to the income statement. It is assumed to benefit the business for
a short period (less than one financial year).

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4.1.2 Capital expenditure and revenue receipts
Capital receipts are amounts received from one-off non-trading activities.

Capital receipts are not included in the income statement. In the case of the sale of non-current
assets, only any loss or profit made on a disposal is recorded in the income statement.

Revenue r eceipts are amounts received from normal business activities.

Revenue receipts are recorded in the income statement. In a trading business, revenue is recorded
in the trading section and other income is recorded in the profit and loss section.

4.1.3 The effect of incorrect treatment of revenue and capital items on profit
and asset valuations
When mistakes are made recording revenue and capital items in the financial statements it will
mean that:
• profits and losses will be incorrect
• asset valuations on the statement of financial position will be incorrect
• the analysis of a business’s performance will be affected because ratio calculations will show the
wrong results
• decisions made by owners, managers and other interested parties are likely to be misguided
because they are based on incorrect information.

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24
 Chapter 11 Depr eciation and disposal of non-cur r ent asset
4.2.1 Depreciation: background
Non-current assets lose their value over time for a number of reasons:

Depreciation has a specific meaning: the loss in value of a non-current asset over its useful life.
Almost all non-current assets are subject to depreciation (most forms of land are an exception).

Depreciation is an expense which is charged to the annual income statement. The term ‘net book
value’ is used to describe the value of a non-current asset based on cost less accumulated
depreciation.

Methods of calculating depreciation

There are three main methods used to calculate depreciation:
1. The straight-line method of depreciation is sometimes called the fixed installment method. It is
appropriate to use this method when a noncurrent asset is likely to benefit a business to the same
extent each accounting year. It has the advantage of being easy to calculate. Residual value is a
reference to the estimated value of the asset at the end of its useful life (sometimes called scrap
value).

2. The reducing-balance method of depreciation is sometimes called the diminishing balance

method. It is appropriate to use this method when it is likely that an asset will lose the most value
in its first year and lose less value in each succeeding year. It is less easy to calculate as the
depreciation charge is subject to a different calculation each year of the asset’s life.

3. The revaluation method is useful where a non-current asset consists of many small items each
of which may last a few years but which would be impractical (far too time consuming) to

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depreciate separately using either the straight-line or reducing-balance methods. The method is
relatively easy to use but the figures used will be based on someone’s opinion (i.e. subjective)
rather than hard facts (i.e. objective).

Depreciation and accounting principles

Depreciation is a good example of the matching (accruals) concept, which requires the revenue of
an accounting period to be matched with all the costs incurred in achieving that revenue. The
consistency principle is also applied to depreciation. It requires the same depreciation method to
be used each year. As a result, it is possible to make valid comparisons of a business’s results,
comparing one year with another

Note:
1. Non-current assets lose their value over their useful lives for a variety of reasons, of which wear
and tear is the most common.
2. There are three main methods of calculating depreciation, each of which results in providing an
estimate of the loss in value of the non-current asset during a year.
3. Depreciation is charged to the income statement each year.
4. Depreciation is required in order to comply with the matching (accruals) principle.
5. The same depreciation method should be applied each year in order to comply with the
consistency principle

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4.2.2 Ledger and journal entries to record depreciation

Entries when purchasing a non-current asset

Entries when depreciating a non-current asset

Provision for depreciation account

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Depreciation and the statement of financial position
The statement of financial position should record:
• the original cost of each type of non-current asset
• the accumulated provision for depreciation at the date of the statement
• the net book value of each type of non-current asset.

4.2.3 The disposal of a non-current asset

The example below looks at the disposal of some equipment which cost
$10000 and on which there was accumulated depreciation of $7,500.

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1. Where a profit is made on disposal (the equipment is sold for $3,800):

2. Where a loss is made on disposal (the equipment is sold for $1,900):

1. The details of the disposal of a non-current asset are recorded in a separate ledger account.
2. On the date of the disposal the account should record the original cost of the asset,
accumulated depreciation and the sale proceeds.
3. At the year end the balance of the account should be transferred to the income statement. The
balance will represent either a profit or a loss on the disposal.

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 Chapter 12 Other r eceivables and payables
4.3.1 Expense adjustments
Recording accrued expenses
Where an expense remains unpaid for part of an accounting period, the amount due is referred to
as an accrual and reference is made to an accrued expense
The amount unpaid has to be included in the amount recorded for that expense in the income
statement for that accounting period.
The accrued expense is also shown on the organization’s statement of financial position as a
current liability and is labelled ‘other payable’.

Recording prepaid expenses

Where payment for an expense covers part of the next accounting period it is referred to as a
prepayment and reference is made to an expense prepaid
The amount prepaid must be excluded from that accounting period’s income statement. The
amount is shown on the organization’s statement of financial position as a current asset and
labelled ‘other receivable’

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Working out time spans

When using a timescale chart, double-check whether the beginning date is for the first of the
month or the end of the month, and check whether the end date is for the beginning or end of a
month.

Expense accounts with opening balances

Expense accounts may start with opening balances for an accrual or prepayment brought down
from the previous year.

The example below shows an accrued expense as an opening and closing balance:

The expense account starts with an opening credit balance of $720, which represents the amount
owed or the previous year (2017). The amount transferred to the income statement represents the
business’s expense for 2018. Therefore it excludes the amount owed for 2017, but includes the
amount due at the end of 2018.

The example below shows a prepaid expense as an opening and closing balance:

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The expense account starts with an opening debit balance of $360, which represents the amount
prepaid in the previous year (2017).
The amount transferred to the income statement represents the business’s expense for 2018.
Therefore it includes the opening prepayment, but excludes the amount prepaid for 2019.

Accounts combining two expenses

In some cases it may be convenient for a business to use one ledger account for a combination of
expenses. The account could show:
• two opening balances – a prepayment for one of the expenses and an accrual for the other
expense
• payments made for each type of expense
• a single figure for the transfer to the income statement combining the annual costs for each
expense
• two closing balance to carry down – a prepayment for one of the expenses and an accrual for the
other expense.

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The single figure transfer to the income statement has been entered as the balancing figure in the
account after all the other entries have been made.
The income statement transfer can also be calculated as follows:
• stationery $1,480 ($360 opening prepayment + $1,290 bank − $170 closing prepayment)
• computer supplies $2,780 ($2,820 bank − opening accrual $330 + closing accrual $290)
• total: stationery $1,480 + computer supplies $2,780 = $4,260.

4.3.2 Income adjustments

When the matching principle is applied to income items the entries shown below are required.
Accrued income at the year end
Here is an income account before recording the accrued income:

The account after recording the accrued income and transfer to the income statement would look
like this:

Although $11 300 has actually been received during the year, the amount transferred to the
income statement is $11 800, in order to take account of the accrued income.
Accrued income appears as a debit balance in the income account as it is an asset.
Accrued income is shown as a current asset (other receivables) on a statement of financial
position.
The transfer to the income statement should first be recorded in the general journal:

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Prepaid income at the year end
Here is an income account before recording the prepaid income:

The account after recording the accrued income and transfer to the income statement would look
like this:

Although $7,800 has actually been received during the year, the amount transferred to the income
statement is $7,400, which ensures the income prepaid is excluded.
Prepaid income appears as a credit balance in the income account as it is
a liability. Prepaid income is shown as a current liability on a statement of financial position.
The transfer to the income statement should first be recorded in the general journal.

Income accounts with opening balances

If income accounts show closing balances for accrued and/or prepaid income, it follows that the
following year will begin with those items as opening balances.
This income account shows accrued income as an opening and closing balance:

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The income account starts with an opening balance of $300, which represents the amount due for
the previous year (2017).
The amount transferred to the income statement represents the business’s income for 2018.
Therefore it excludes the amount due for 2017, but includes the closing accrued income.

This income account shows prepaid income as an opening and closing balance:

The income account starts with an opening balance of $350, which represents income prepaid in
the previous year (2017).
The amount transferred to the income statement represents the business’s income for 2018.
Therefore it includes the opening prepaid income, but excludes the closing prepaid income.

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 Chapter 13 Ir r ecover able debts and pr ovision for doubtful debt
4.4.1 Irrecoverable debts and recovery of debts written off

Avoiding irrecoverable debts and credit control

When a new customer asks for credit terms, check with the customer’s bank and that customer’s
suppliers to establish whether the person or organization is creditworthy.
Set a credit limit for each customer – this will be low in the case of new customers and higher in
the case of those customers who have proved to be reliable.
Maintain detailed records of how much each customer owes and for how long the debt has been
outstanding (sometimes referred to as an aging schedule of trade receivables).

4.4.2 Recording irrecoverable debts

Irrecoverable debts should be written off promptly. This requires an entry in the general journal
and the closure of the credit customer’s account.

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4.4.3 Recording recovery of debts written off

4.4.4 Provision for doubtful debts

A pr ovision for doubtful debts is the amount of profit set aside to cover any outstanding debts
which are not likely to be paid and so will become irrecoverable.

37
4.4.5 Recording provision for doubtful debts
Creating a provision for doubtful debts

Adjusting a provision for doubtful debts

Once a provision has been created, it has to be adjusted at the end of each financial year to keep
it in step with the total of trade receivables.

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Format for a provision for doubtful debts account

The example above shows the provision account over a four-year period:
• Year 1: the provision is created.
• Year 2: the provision is increased and the account is balanced.
• Year 3: the provision is decreased and the account is balanced.
• Year 4: the account balance is brought down to start the year.

Notes:
1. Provisions for doubtful debts are rst recorded in the general journal.
2. A provision account always has a credit balance.
3. Increases in a provision are credited to the account.
4. Decreases in a provision are debited to the account

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 Chapter 14 valuation of inventor y
4.5.1 The rule for the valuation of inventory
Net realizable value means the resale value less any costs incurred in putting inventory in a
saleable condition (perhaps repairing an item which has been damaged).

Applying the rule for the valuation of inventory

Preparing an inventory valuation statement

Details of inventory items can be set out in the form of a table:

For each item the valuation has been based on cost or NRV – whichever is
the lower:
• XB2 items have been valued at NRV.
• YH4 items have been valued at cost.
• ZT3 items have been valued at NRV.

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4.5.2 The effects of an incorrect valuation of inventory

Note:
1. Any error in the valuation of inventory will have many consequences for figures in the financial
statements.
2. An incorrect valuation will mean that cost of sales, gross profit and profit for the year will be
incorrectly recorded in the income statement.
3. An incorrect valuation will mean that current assets and capital will be incorrectly recorded in
the income statement.

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 Chapter 15 Sole tr ader
5.1.1 Sole trader background
Advantages and disadvantages of operating as a sole trader

The importance of the financial statements

A sole trader’s financial statements provide the most important source of information for the
owner when assessing the performance of the business.
• The income statement provides details about the business’s gross profit (if it is a trading business)
and profit or loss for the year.
• The statement of financial position provides details of the business’s resources.
The owner’s assessment will lead to key decisions about the business’s future, for example:
• how to improve profits
• whether to invest in additional resources
• how to raise finance to make improvements.

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The format for income statements

It is important to remember that income statements are formal documents,

so they require high standards of presentation. For example:
• always include the name of the business (if known)
• the title should be written in full without abbreviations
• place negative figures in brackets
• if the business makes a loss, the final result will be labelled ‘loss for the year’, and the amount
will be shown in brackets

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5.1.2 Statements of financial position
Format of a statement of financial position

44
5.1.3 Adjustments and the income statement
Example with adjustments shown in italics

45
 Chapter 16 Par tner ship
5.2.1 Advantages and disadvantages of for ming a par tner ship

5.2.2 Par tner ship agr eements

Partners are advised to make an agreement to avoid disputes which can lead to the
closure of the business. If a formal written document is prepared this is referred to as
a deed of partnership Partners can include the following in an agreement:
• capital contributions (often fixed)
• how profits and losses will be divided (this could be as simple as equal shares, or
could be in the form of a ratio)
• limits on drawings per annum
• the responsibilities of each partner for the management of the business
• the rate of interest to be provided on any loan made by a partner
• whether partners are to be penalized by charging interest on drawings when
sharing profits
• whether partners are to be rewarded before sharing profits by providing interest on
capital contributions or a partnership salary for undertaking some particular role in
managing the partnership.

46
5.2.3 Financial statements
An appropriation account shows in detail how profits or losses for the year are to be shared
between each partner. Interest on drawings is added to the profit for the year, whereas interest on
capital and partnership salaries is deducted.
A statement of financial position resembles that of a sole trader for the following sections:
• non-current assets
• current assets
• current liabilities.
Non-current liabilities could include loans from partners. The capital section is set out to show
details of each partner’s capital contributions and separate information from each partner’s current
account

5.2.4 For mat for par tner s’ ledger accounts and financial statements
Appropriation account

The profit (or loss) for the year is transferred from the income statement. It is recommended that
interest on drawings is recorded next and added to the profit for the year; then each share of profit

47
(salary, interest on capital, etc.). It is recommended that subtotals are shown after each
appropriation.

Fixed capital accounts

A fixed capital account records the agreed and unchanging capital contribution of a partner.

Only if all the partners agree should additional entries be made in the capital account for any
withdrawal of capital (debit entry) or any addition to capital (credit entry).

Current accounts

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Statement of financial position
Summarized version

Detailed version

49
 Chapter 17 Limited company
5.3.1 The background to limited companies
Advantages and disadvantages of operating as a limited company

Features of limited companies

50
5.3.2 The financial statements of a limited company
Income statement format

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Statement of changes in equity format
This statement details the changes during a financial year in each element in a company’s equity.

Statement of financial position

A limited company’s statement of financial position closely resembles that of a sole trader and
partnership. The main differences occur in recording the equity and non-current liabilities
sections:

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53
 Chapter 18 Club and societies
5.4.1 Receipts and payments accounts and income and expenditure accounts

Preparing a receipts and payments account

Notes:
1. A receipts and payments account is a summary of the cash book maintained by the treasurer of
a club.
2. An income and expenditure account is similar to a business’s income statement.

54
3. Both statements are designed to help the club’s membership understand the financial position of
the club.

5.4.2 Revenue-generating activities

Members’ subscriptions

55
Account format for subscriptions

56
5.4.3 Income and expenditure account format

If the club’s expenditure is more than its income, the result will be recorded as ‘Deficit for year’
rather than ‘Surplus for year’, and the figure will appear in brackets.
All revenues and expenses must be adjusted in accordance with the matching (accruals) principle.

Statement of financial position; the accumulated fund

The format will closely resemble that of a business, with subheadings for non-current assets,
current assets and current liabilities.
The accumulated fund replaces the capital section. It should consist of an opening balance (the
value of the club at the beginning of the year) plus the surplus for the year (or less the deficit for
the year). It should end with a subtotal representing the value of the club at the end of the year.

57
 Chapter 19 Manufactur ing accounts
5.5.1 Dir ect and indir ect costs, factor y over heads and pr ime cost

5.5.2 Wor k in pr ogr ess; calculating cost of pr oduction

Cost of production is calculated as follows:
Direct cost + Indirect cost + Opening inventory of work in progress-closing inventory of work in
progress

58
5.5.3 Pr epar ing the annual financial statements of a manufactur ing
or ganization
Format: manufacturing account

59
Format: income statement

Format: statement of financial position

60
5.5.4 Adjustments to financial statements
A manufacturer’s financial statements may require all the adjustments which affect the financial
statements of retail, wholesale and service businesses in line with the matching (accruals) and
prudence concepts. These include:
• expense accruals and prepayments
• income due and received in advance
• depreciation of non-current assets
• provisions for doubtful debts.

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 Chapter 20 Incomplete r ecor ds
5.6.1 Disadvantages of not keeping a full set of accounting r ecor ds
Where details records of transactions are not maintained the following problems can arise.
• There is limited or no access detailed information about aspects of the business.
• Financial statements are difficult to prepare.
• The performance of the business cannot be assessed.
• Decision making to improve performance will be hampered because analysis of current
weaknesses is limited or non-existent.
• Information is not available to support loan applications.
• Reliable information for tax assessments may not be available.

Calculating profits from changes in capital over time

Calculating profit or loss in the form of a statement

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Calculating profit or loss in the form of a statement

5.6.2 Pr epar ing income statements and statements of financial position

fr om incomplete infor mation
Credit sales
Credit sales are calculated by reconstructing a total trade receivables account. In its simplest form
this means including the:
• total of opening balances of trade receivables
• total of receipts from trade receivables
• total of closing balances of trade receivables.
But all transactions affecting trade receivables should be included, so additional entries should be
made for discounts allowed.

Credit purchases
A similar process is used to find credit purchases requiring the preparation
of a total payables account which will include the:
• total of opening balances of trade payables
• total of payments to trade payables
• total of closing balances of trade payables.
The total payables account could also include discounts received.

Total sales and total purchases

Total sales = credit sales + cash sales
Total purchases = credit purchases + cash purchases

Expenses and income

Expenses for inclusion in the income statement
= Payments made during the year
+ Amounts due but unpaid at the year end
– Amounts prepaid at the year end

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Income or inclusion in income statement
= Receipts during the year
+ Amounts due but not yet received
– Amounts received in advance

Closing bank and cash balances

When preparing a cash account and/or bank account:
Opening balance + receipts – payments = closing balance

5.6.3 Using r atios to find missing infor mation

The following ratios can be used to find missing information in the trading section of an income
statement, such as a closing inventory, purchases or revenue.

It can be useful to be able to convert mark-up to gross margin and vice versa. in certain situations.

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 Chapter 21 Calculating r atios
6.1.1 Importance of ratios and profitability ratios
Importance of ratios
Ratios are a means of analysing and comparing the performance of a business. They:
• are used to compare the results of a business overs several years
• are used to compare the results of similar businesses
• enable significant factors of performance to be highlighted.

Profitability ratios (These ratios are all expressed as percentages.)

6.1.2 Liquidity ratios

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 Chapter 22 - 25 Interpretation of accounting ratios
6.2.1 Comparing results for different years
Investigating profitability ratios

Investigating liquidity ratios which are weaker than they should be

Gross profit = sales revenue – cost of sales. Therefore, the gross margin percentage can only be
affected by changes to cost of sales or sales revenue.
Profit = gross profit + income – expenses. Therefore, the profit margin can only be affected by
changes to gross profit, income and expenses.
The valuation of inventory will have an effect on the cost of sales. Therefore, changes in the
valuation of inventory will have an impact on gross margin.
A change in revenue will have an impact on gross profit assuming that cost of sales does not
change to the same degree. This will have an impact on gross margin.

n of accounting ratios 6.

2
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Where liquidity ratios are stronger than they need to be
It is possible for some liquidity ratios to be stronger compared to what is regarded as normal for
the type of business under review.

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6.2.2 Users of accounting information; limitations of inter-firm comparisons
and financial statements
Users of accounting information
The main function of accounting statements is to provide useful information for those who are
affected by a business’s performance. These groups are referred to as ‘interested parties’ or
‘stakeholders’.

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Limitations of inter-firm comparisons and accounting statements
As well comparing the results of a business over several years, it can be useful to compare the
results of a business with those of a similar business.
It is important that comparisons are only made with a business which is in the same industry.
However, this process may not be straightforward, for the reasons explored in the table below.

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Section 7:Accounting pr inciples, policies and
standar d

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How accounting information can be judged for quality

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