Sample Notes: Financial Statements

A2 Level Accounting – 3.1.1 Financial Statements

1. Purpose and Importance of Financial Statements

• Definition: Financial statements are formal records of the financial activities and position of a business, person, or other entity.
• Purpose:
  • Measure profitability, liquidity, and solvency of an entity.
  • Provide information to internal (management, owners) and external users (investors, tax authorities, banks).
  • Enable informed decision-making and strategic planning.
  • Fulfill legal and regulatory requirements (e.g., Companies Act or IFRS compliance).
• Users of Financial Statements:
  • Owners/Shareholders: For returns and investment decisions
  • Management: For planning, control, and decision-making
  • Creditors: For loan appraisal
  • Government: For taxation and regulatory monitoring
  • Employees: For job security and wage negotiations
  • Public: To understand business impact on society

2. Types of Financial Statements

2.1 Statement of Financial Position (Balance Sheet)

• Purpose: Shows the financial position of the business at a specific date.
• Structure:
  • Assets (Non-current and Current)
  • Liabilities (Non-current and Current)
  • Equity (Capital, Retained Earnings, Reserves)

Example Format:

2.2 Income Statement (Statement of Profit or Loss)

• Purpose: Measures the business performance (profitability) over a specific period.
• Structure:
  • Revenue
  • Less: Cost of Sales (COGS)
  • Gross Profit
  • Less: Operating Expenses
  • Add: Other Income
  • Profit before interest and tax
  • Less: Interest and Tax
  • Net Profit

Example Format:

2.3 Statement of Changes in Equity

• Purpose: Shows changes in ownership interest during the year (capital contributions, drawings, profits).
• Example Entries:
  • Opening Capital
  • Add: Profit for the year
  • Less: Drawings/Dividends
  • Closing Capital

3. Financial Statements for Different Entities

3.1 Sole Trader

• Simplest format.
• No separation between personal and business equity (except for legal purposes).
• Key Statements: Income Statement and Statement of Financial Position.
• Features:
  • No shareholders
  • Capital = Owner’s Investment + Profit – Drawings

3.2 Partnership

• Additional details include:
  • Current Accounts (for ongoing transactions like salary, interest, drawings)
  • Capital Accounts (for long-term investments)
  • Appropriation Account: Divides profit among partners

Format Example – Appropriation Account:

3.3 Limited Companies

• Complex and regulated.
• Follow International Accounting Standards (IAS/IFRS).
• Include:
  • Income Statement
  • Statement of Financial Position
  • Statement of Changes in Equity
  • Statement of Cash Flows (covered in detail in a separate section)
  • Notes to Accounts

Special Features:

• Share capital: Ordinary and preference shares
• Reserves: Share premium, revaluation reserve
• Dividends: Declared and paid

3.4 Manufacturing Accounts

Used by businesses that produce goods.

Structure:

1. Manufacturing Account:
   • Direct Materials (Opening + Purchases – Closing)
   • Direct Labour
   • Direct Expenses
   • Prime Cost
   • Add: Factory Overheads
   • Add/Less: WIP Opening/Closing
   • Cost of Production
2. Transferred to Trading Account for Gross Profit calculation.

3.5 Clubs and Non-Profit Organisations

Key Statements:

• Receipts and Payments Account (like a cash book)
• Income and Expenditure Account (like an income statement)
• Statement of Financial Position

Unique Items:

• Subscriptions (received/owing)
• Entrance fees
• Donations
• Life membership fund
• Surplus/Deficit instead of profit/loss

4. Key Concepts and Principles Applied

4.1 Accruals vs Cash Basis

• Accruals Concept: Revenue and expenses are recorded when earned/incurred, not when received/paid.
• Used in all financial statements except receipts & payments account.

4.2 Matching Concept

• Costs are matched to the revenue of the same period.

4.3 Going Concern

• Assumes business will continue operating unless there’s evidence to the contrary.

4.4 Consistency

• Accounting methods must remain consistent across periods unless changed with explanation.

4.5 Prudence

• Do not overstate income or understate expenses.

5. Example – Adjustments in Financial Statements

1. Depreciation: Deducted from asset value in SOFP, shown as expense in Income Statement.
2. Prepaid Expenses: Deduct from expense in income statement, shown as current asset.
3. Accrued Expenses: Add to expense, shown as current liability.
4. Inventory:
   • Opening: Part of COGS
   • Closing: Deducted in COGS, shown in SOFP

6. Exam Tips and Application

• Practice full-format questions, especially:
  • Partnership changes (admission, retirement)
  • Limited company formats and notes
  • Calculation of depreciation, bad debts, provision for doubtful debts
• Use proper labels and headings:
  • “Statement of Financial Position as at 31 Dec 2025”
  • “Income Statement for the year ended 31 Dec 2025”
• Show workings clearly
• Use 2-column format where applicable
• Clearly state assumptions if made
• Interpret financial information (ratios are covered later)