Financial Accounting

Income statement of a trading firm

$\text{Net sales} = \text{Sales} - \text{Returns inwards}$ $\text{Cost of goods sold} = \text{Opening inventory} + \text{Net purchases} - \text{Closing inventory}$ $\text{Net purchases} = \text{Purchases} - \text{Returns outwards} + \text{Carriage inwards}$ $\text{Gross profit} = \text{Net sales} - \text{Cost of goods sold}$ $\text{Profit for the year} = \text{Gross profit} + \text{Other revenue} - \text{Expenses}$

Carriage inwards is part of the cost of goods sold; carriage outwards is a selling expense.

Statement of financial position

Section	Examples
Non-current assets	Premises, equipment, motor vehicles (cost less accumulated depreciation)
Current assets	Inventory, trade receivables (less allowance for doubtful accounts), prepaid expenses, bank, cash
Current liabilities	Trade payables, accrued expenses, bank overdraft
Non-current liabilities	Long-term loans
Capital	Opening capital + profit for the year − drawings

Period-end adjustments

Accruals and prepayments (accrual principle):

• Accrued expense (owing at the year end): add to the expense; show under current liabilities.
• Prepaid expense (paid in advance for next year): deduct from the expense; show under current assets.

Bad debts and allowance for doubtful accounts (prudence): write off debts that cannot be collected; make an allowance for trade receivables that may not be collected. Only the change in the allowance is charged to the income statement.

Depreciation: capital expenditure on non-current assets is spread over their useful lives.

$\text{Straight-line method: annual depreciation} = \frac{\text{Cost} - \text{Residual value}}{\text{Useful life}}$

• Reducing-balance method: a fixed percentage of the net book value each year.
• Usage-based method: based on actual usage, e.g. machine hours.

Inventory valuation: inventory is valued at the lower of cost and net realisable value (prudence). Cost may be found by FIFO or the weighted average cost method.

Ratio analysis

Ratio	Formula	Measures
Gross profit ratio	$\dfrac{\text{Gross profit}}{\text{Net sales}} \times 100\%$	Profitability
Mark-up	$\dfrac{\text{Gross profit}}{\text{Cost of goods sold}} \times 100\%$	Pricing
Net profit ratio	$\dfrac{\text{Profit for the year}}{\text{Net sales}} \times 100\%$	Profitability
Return on capital employed	$\dfrac{\text{Profit for the year}}{\text{Capital employed}} \times 100\%$	Profitability
Current ratio	$\dfrac{\text{Current assets}}{\text{Current liabilities}}$	Liquidity
Quick ratio	$\dfrac{\text{Current assets} - \text{Inventory} - \text{Prepayments}}{\text{Current liabilities}}$	Liquidity
Inventory turnover	$\dfrac{\text{Cost of goods sold}}{\text{Average inventory}}$	Management efficiency

Common mistake: drawings are not an expense. They reduce capital in the statement of financial position, not profit.