A Level Accounting: The Role of the Accountant and Financial Statements — Revision Notes

Condensed for the final weeks. For the full explanation, use the Role of the Accountant study guide.

The accounting equation and double entry

ASSETS = CAPITAL + LIABILITIES

DEAD CLIC — Debit Expenses, Assets, Drawings; Credit Liabilities, Income, Capital.

Capital appears with liabilities because, from the business’s perspective, it is owed back to the owner. The business and the owner are separate entities — which is the business entity concept.

Accounting concepts

Concept	Meaning
Business entity	Owner and business are separate
Going concern	The business will continue for the foreseeable future
Accruals / matching	Record income and expenses when incurred, not when cash moves
Consistency	Same treatment each period, so figures are comparable
Prudence	Do not overstate profit or assets; provide for foreseeable losses
Materiality	Insignificant items need not be treated strictly
Realisation	Revenue recognised when the goods or service pass, not when paid
Money measurement	Only what can be measured in money is recorded

Accruals is the concept that drives all the year-end adjustments, and prudence is the one that resolves most judgement questions — where two treatments are defensible, choose the one that does not overstate profit.

Money measurement has a consequence worth stating: staff quality, brand reputation and management skill do not appear in the accounts, which is a real limitation of financial statements as a picture of a business.

Year-end adjustments

Adjustment	Effect on profit	Statement of financial position
Accrued expense	Reduces	Current liability
Prepaid expense	Increases	Current asset
Accrued income	Increases	Current asset
Prepaid income	Reduces	Current liability
Depreciation	Reduces	Reduces carrying amount
Irrecoverable debt	Reduces	Reduces receivables
Increase in allowance for doubtful debts	Reduces	Reduces receivables

Every adjustment has two effects — one on profit and one on the statement of financial position. Questions asking for “the effect” want both; giving one is worth half.

Depreciation allocates the cost of a non-current asset over its useful life, matching cost to the revenue it helps generate. It is not a way of saving up to replace the asset and not a fall in market value.

• Straight line: (cost − residual value) / useful life. Equal charge each year; suits assets used evenly.
• Reducing balance: a fixed percentage of the carrying amount. Higher charge early; suits assets that lose value fastest at first, such as vehicles.

Capital and revenue

• Capital expenditure — acquiring or improving a non-current asset. Includes delivery, installation and legal fees.
• Revenue expenditure — running costs, including repairs and maintenance.

Treating capital expenditure as revenue understates profit and understates non-current assets; the reverse overstates both. Being able to state the effect on both statements is what earns full marks.

Ratio analysis

Profitability

gross profit margin  = gross profit / revenue x 100
profit margin        = profit for the year / revenue x 100
ROCE                 = profit before interest / capital employed x 100

Liquidity

current ratio  = current assets / current liabilities          (~2:1)
acid test      = (current assets - inventory) / current liabilities   (~1:1)

Efficiency

inventory turnover  = cost of sales / average inventory   (times per year)
receivables days    = receivables / credit sales x 365
payables days       = payables / credit purchases x 365

A ratio on its own means nothing. Every analysis answer needs a comparison — against the previous year, against a competitor, or against the industry norm — and then a reason for the change.

The most-missed point: a high current ratio is not automatically good. It can indicate excess inventory, slow-collecting receivables, or idle cash that should be invested. Similarly, a rising gross margin with falling volume may signal overpricing.

Limitations of ratio analysis: it uses historic data, ignores non-financial factors, is distorted by different accounting policies between firms, is affected by inflation and seasonality, and a single figure can be manipulated by year-end timing.

Exam traps

• Giving only one effect of an adjustment.
• Saying depreciation is a cash fund for replacement.
• Treating installation or delivery costs as revenue expenditure.
• Quoting a ratio without comparison or interpretation.
• Assuming a higher current ratio is always better.
• Treating drawings as an expense — they reduce capital, not profit.
• Omitting the limitations when a question says “evaluate”.

Self-test

1. State the accounting equation and explain why capital sits with liabilities.
2. What is the accruals concept, and which adjustments does it drive?
3. Give both effects of an accrued expense.
4. What does depreciation actually do, and what are the two common misconceptions?
5. Why might a high current ratio be a bad sign?

Answers: 1. Assets = Capital + Liabilities; under the business entity concept the business is separate from its owner, so capital is treated as owed back to the owner. 2. Income and expenses are recorded when incurred rather than when cash moves; it drives accruals, prepayments, depreciation and provisions. 3. It reduces profit for the year and appears as a current liability in the statement of financial position. 4. It allocates the cost of a non-current asset across its useful life to match cost with the revenue it generates; it is not a fund for replacement and not a measure of the fall in market value. 5. It may indicate excess inventory, slow-collecting receivables, or cash sitting idle instead of being invested productively.