ACCA FA2

Maintaining Financial Records

COMPLETE SUBJECT NOTES

BY VERTEX LEARNING SOLUTIONS
VALID UNTIL JUNE 2024
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 TABLE OF CONTENTS

CHAPTER TOPIC PAGE NO.

1 Asset, Liabilities and Accounting Equation 3

2 Statement of Financial Position and Profit and Loss 9

3 Recording and Summarizing Transaction 15

4 Posting Transactions, Balancing Accounts and Trial Balance 22

5 Accounting Principles and Characteristics 42

6 Control Account and Correction of Errors 46

7 Accruals and Prepayments, Receivables and Irrecoverable Debts 65

8 Cost of Goods Sold and Inventories 71

9 Non-Current Assets and Depreciation 81

10 The Accounts of Sole Traders 89

11 Extended Trial Balance 93

12 Incomplete Records 95

13 Partnerships 108

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Chapter 1
Asset, Liabilities and Accounting Equation
Business
A business can be defined in various ways:
▪ A business is a commercial or industrial concern which exists to deal in the manufacture,
resale or supply of goods and services.
▪ A business is an organization which uses economic resources to create goods or services
which customers will buy.
▪ A business is an organization providing jobs for people to work in.
▪ A business invests money in resources (e.g., it buys buildings, machinery etc.; it pays
employees) in order to make even more money for its owners.
▪ Business is investing money to make more money i.e., profit.
As an accountant, we measure income, expenditure, profit and the resources we have in a
business.

Accounting Elements
Assets:
a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity'. The access to a resource (an economic resource)
arises as a result of a transaction that has already been completed.
The assets that give benefit for more than one year are known as Non-Current Assets whereas
the assets that benefit the user for less than a year are current asset.
Liability:
a present economic obligation for which the entity is the obligor'. In simple words, liability is a
debt. Examples are bank loan, bank overdraft, trade payables, tax payables, etc.
However, the loans taken for more than one year are known as Non-Current Liabilities whereas
the loans taken for less than a year are current liability.
Equity/Capital:
Capital is the amount invested in a business by its owner (the sole trader/shareholders)

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Drawings:
Drawings are a reduction in the liability of business to the owner. If the owner takes out cash or
goods from business for personal use, it reduces the liability of the business towards owner.
Expenses:
Expenses are a decrease in economic benefits during the accounting period in the form of
outflows or depletion (decrease in value) of assets or occurrence of liabilities. Expenses are cost
of supply of goods or services i.e., cost of operating a business.
Income:
Income means inflow of economic benefits (whether by sale for cash or on credit). The definition
of income covers both revenue and gains.

Business Entity Concept

A business is always treated as a separate entity from its owners for accounting purposes. For
accounting purposes, it is important to keep business assets and liabilities separate from the
personal assets and liabilities of the proprietor(s).

Accounting Equation
Asset = Liabilities + Capital

(Resources = Sources)
This is the basis of a fundamental rule of accounting, which is that the assets and the aggregate
of the capital and the liabilities of a business must always be equal (the accounting equation)
To find out the amount of Capital invested this equation could be arranged as
Capital = Asset – Liabilities
(Net Assets = Total Assets – Total Liabilities)

For e.g.,
When opening a new business, one needs to invest some money in the business. That is called
capital.
Let’s assume that with the money invested a machine was bought. Thus, capital and assets both
increased by an equal amount (Proving the equation i.e., left hand side is equal to right hand
side).
However, the capital invested into a business from its owners is distinct from other funding to
the business from third parties. Funds coming into the business from third parties are treated as
loans rather than investments of capital and as such are the liabilities of the business.

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Profit and Drawings:
Profit is excess of income over expenditure. All businesses operate to earn profit.

For e.g., a fruit seller bought fruits for $340. He sold all those fruits for $450. In this case, the cost
is $340, and the income is $450. Since Income is greater than expense, there is a profit of $110.
Considering another scenario, the fruit seller bought the fruits for $340 but was not able to sell
them all before they deteriorated. Hence his income was $250. In this case the expense is greater
than income hence a loss of $90.
Considering the above equation, we could expand it like
Asset = Liabilities + (Capital Introduced + Retained Profit)

Drawings are a part of capital taken out by the owner from the business for his/her personal use.
Hence it should be deducted from capital. Hence
Asset = Liabilities + (Capital Introduced + Retained Profit - Drawings)
Further Expansion of Accounting Equation:
Asset = Liabilities + (Capital Introduced + Retained Profit - Drawings)
This equation contained the previous profit earned and saved for future. The current period’s
profit will also be added in capital. Moreover, in the case of any capital introduced during the
year, it will also be added in capital. Considering the above transactions our equation would be:
Asset = Liabilities + (Capital Introduced + Retained Profit + Current Period Profit + Additional
Investment - Drawings)

Business Equation
Consider the following equation:
P=I+D–C
P = Profit earned in current period
I = Increase / Decrease in Net Assets (Assets – Liabilities)

D = Drawings in the current period

C = Capital Introduced in current period
Using the Basic Accounting Equation
Asset = Liabilities + (Capital Introduced + Retained Profit + Current Period Profit + Additional
Investment - Drawings)

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 Asset at the start of = Liabilities at the start of + Capital Introduced
the period the period Profit Earned in current period
Drawings
Increase / Decrease = Increase / Decrease in + Capital Introduced (C)
in Assets (I) Liabilities (I) Profit Earned in current period
(P)
Drawings (D)

Accounts Payable and Accounts Receivables

Sale and Purchase
Sale and Purchase are the core activities in an organization. These transactions are done on cash
as well as credit.
A sale takes place at one of two points in time.
(i) Cash Sales: If the sale is for cash, the sale occurs when goods or services are given in
exchange for immediate payment, in notes and coins, or by cheque or plastic card.
(ii) Credit Sales (goods are ordered and delivered before payment is received): If it is on
credit, the sale occurs when the business sends out an invoice for the goods or
services supplied; cash is received later.
A purchase also takes place at one of two points in time.
(i) Purchases for Cash: If the goods are paid for in cash, then the purchase occurs when
the goods and cash exchange hands.
(ii) Purchases on Credit: If the goods are bought on credit, the purchase normally occurs
when the business receives the goods, accompanied by an invoice from the supplier.
Cash is paid later.
Accounts Payable
An account payable results from the purchase by a business of items for later payment.
An account payable is a liability of the business.
A trade account payable is a balance owing for debts incurred during trading operations. The
term might refer to debts still outstanding which arise from the purchase from suppliers of goods
for resale.
It is a common business practice to make purchases on credit terms, with a promise to pay within
30 days, or two months or three months of the date of the purchase.

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Accounts Receivable
An account receivable results from the sale by a business of items for later payment.

An account receivable is an asset of a business (the right to receive payment is owned by the
business).
A trade account receivable is a balance owing to the business for debts incurred in the course of
trading operations i.e., because the business has sold its goods or services.
Just as a business might buy goods on credit, so too might it sell goods to customers on credit.

Double Entry Bookkeeping

Double entry bookkeeping is the system of accounting which reflects the fact that: Every financial
transaction affects the entity in two ways and gives rise to two accounting entries, one a debit
and the other a credit The total value of debit entries is therefore always equal at any time to the
total value of credit entries.

As explained in the above examples, we can conclude that each transaction will have a dual
effect. For example, when investing capital in the business in form of a machine, we will increase
capital and increase asset.

If we purchase an asset from cash, at one end our asset (Cash) will decrease and at the other end
our asset (Machine) will increase. Hence the net effect of assets will be zero ensuring left hand
side is equal to right hand side.

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For e.g. A business receives a loan from the bank. This means that cash is increased due to money
received from loan (Increase in Asset – Debit)
Since a loan was taken, the liability is increased (Increase in Liability – Credit)
Dr. Cash XX
Cr. Bank Loan XX

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Chapter 2
Statement of Financial Position and Profit and Loss
Statement of Financial Position
A statement of financial position is a statement of the assets, liabilities and capital of a business
at a given moment in time. It is drawn up 'as at' a particular date. A distinction is made between
non-current liabilities and current liabilities, and between non-current assets and current assets
A statement of financial position is therefore very similar to the accounting equation.
Assets = Capital introduced + Retained profit + Liabilities
In fact, there are only two differences between a statement of financial position and the
accounting equation, which are as follows:
▪ The manner or format in which the assets and liabilities are presented.
▪ The extra detail which is usually contained in a statement of financial position.
The total value in one half of the statement will equal the total value in the other half. You should
readily understand this from the accounting equation.

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Assets
Non-Current Assets
A non-current asset is an asset acquired for use within the business (rather than for selling to a
customer), with a view to earning income or making profits from its use, either directly or
indirectly, over more than one accounting period.
To be classed as a non-current asset in the statement of financial position of a business, an item
must satisfy two further conditions:

1. It must be used by the business. For example, the proprietor's own house would not
normally appear on the business statement of financial position.
2. The asset must have a 'life' in use of more than one year (strictly, more than one
'accounting period', which might be more or less than one year).

Current Assets
Current assets are:
▪ Items owned by the business with the intention of turning them into cash within one year
(inventories of goods, and receivables).
▪ Cash, including money in the bank, owned by the business.
▪ Assets are 'current' in the sense that they are continually flowing through the business.
Question
Which of the following falls into the 'non-current' category and which should be treated as
'current'?

Answer
Van for a delivery firm is an asset with which it can perform its operations hence a Non-Current
Asset.

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Cement Mixer is a machine for a builder hence a Non-Current Asset.
Car for a car trader is inventory hence a Current Asset.

Liabilities
Non-Current Liabilities
Non-current liabilities are debts which are not payable within the 'short term' and so any liability
which is not current must be non-current. Just as 'current' by convention means one year or less,
'non-current' means more than one year.
Examples of non-current liabilities are bank or venture capital fund loans repayable after more
than one year. Where a loan is being repaid over a period longer than one year, the amount
outstanding will be split. The amount due within one year will be shown under 'current liabilities'
and the balance will be shown under 'non-current liabilities'.

Current Liabilities
Current liabilities are accounts payable of the business that must be paid within a fairly short
period of time (by convention, within one year). Examples of current liabilities include loans
repayable in one year, bank overdrafts, trade payables and income tax due.

Capital
The make-up of the 'capital' section of the statement of financial position will vary, depending on
the legal nature of the business. It will include amounts invested by the owner(s) in the business,
plus profits earned and retained by the business. This is the business's capital account

Statement of Profit and Loss

The statement of profit or loss matches the revenue earned in a period with the costs incurred
in earning it. It is usual to distinguish between a gross profit (sales revenue less the cost of goods
sold) and a net profit (being the gross profit less the expenses of selling, distribution,
administration etc.). If costs exceed revenue the business has made a loss.
The statement of profit or loss normally covers a one-year accounting period, but this is not
always the case; other accounting periods are permissible in certain circumstances.

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From your study of management accounting, you may already be familiar with the term
'overheads', which is often used in financial accounting to describe the expenses which are
deducted from gross profit. The most common categories are selling costs, distribution costs and
administration expenses, which typically include the following:

Capital and Revenue Expenditure

Capital Expenditure
Capital expenditure is expenditure which results in the acquisition of non-current assets, or an
improvement in their earning capacity.
▪ Capital expenditure on non-current assets results in the appearance of a non-current
asset in the statement of financial position of the business.
▪ Capital expenditure is not charged as an expense in the statement of profit or loss.
The cost of a non-current asset includes its purchase price as well as what are called directly
attributable costs such as initial delivery costs, installation costs and professional fees e.g., for
architects and engineers.

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Revenue Expenditure
Revenue expenditure is expenditure which is incurred:

▪ For the purpose of the trade of the business, expenditure is classified as selling and
distribution expenses, administration expenses and finance charges.
▪ To maintain the existing earning capacity of non-current assets, e.g., repairs to non-
current assets.
Revenue expenditure is shown in the statement of profit or loss of a period, if it relates to the
trading activity and sales of that period. If it carries over into the next period, revenue
expenditure would appear as a current asset in the statement of financial position.

Capital Income and Revenue Income

Capital income is the proceeds from the sale of non-trading assets (i.e., proceeds from the sale
of non-current assets). The profits (or losses) from the sale of non-current assets are included in
the statement of profit or loss of a business, for the accounting period in which the sale takes
place.
Revenue income is income derived from:

▪ The sale of trading assets, such as goods bought or made for resale
▪ Rent, interest and dividends received from non-current assets held by the business.
Revenue income appears in the statement of profit or loss.
Note:
The categorization of capital and revenue items given above does not mention raising additional
capital from the owner of the business or raising and repaying loans.
These are transactions which:

▪ Add to the cash assets of the business, thereby creating a corresponding capital or a
liability
▪ Reduce the liabilities (loan) and the assets (cash) of the business when a loan is repaid.

From your understanding of the accounting equation, you should see that these transactions
would be reported through the statement of financial position, not the statement of profit or
loss.
Why is the distinction between capital and revenue items important?
Since revenue expenditure and capital expenditure are accounted for in different ways (in the
statement of profit or loss and statement of financial position respectively), the correct and

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consistent calculation of profit for any accounting period depends on the correct and consistent
classification of items as revenue or capital. Failure to classify items correctly will lead to the
production of misleading profit figures.
Question
In the year to 31 October 20X6, Nadine recorded some revenue expenditure as capital
expenditure. What is the effect on her profit for the year to 31 October 20X6 and her net assets
at that date?
Profit Net assets
A Overstated Overstated
B Overstated Understated

C Understated Overstated
D Understated Understated
Answer
For Revenue Expenditure, a basic accounting entry should be:
Dr. Expense XX
Cr. Cash XX

For Capital Expenditure, a basic accounting entry should be:

Dr. NCA XX
Cr. Cash XX
Considering capital expenditure is recorded instead of revenue expenditure, NCA is increased
(overstated) and Expense is decreased (Understated).
Understated expense means profit is overstated whereas overstated assets mean net assets are
overstated hence the answer is A.

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