The purpose of accounting

Accounting is the process of recording, classifying, summarising, analysing and communicating financial information about a business so that users can make decisions.

• Record financial transactions accurately so there is a permanent, reliable history of what happened.
• Calculate profit or loss for a period, so the owner knows whether the business is successful.
• Show the financial position — what the business owns (assets), what it owes (liabilities) and the owner’s investment (capital) at a given date.
• Control the business: keep track of amounts owed by customers and to suppliers, monitor cash and inventory, and detect errors or fraud.
• Support decision-making and planning: pricing, expansion, borrowing, cutting costs.
• Meet obligations to outside parties such as tax authorities and lenders.

Book-keeping and accounting

Users of accounting information

Different people look at accounting information for different reasons. Examiners reward answers that link the user to a specific interest.

The role of the accountant and ethics

People who prepare accounts are trusted with confidential and important information. Accountants are expected to act with:

• Integrity — being honest and straightforward; not manipulating figures.
• Objectivity — not letting bias, conflicts of interest or pressure from others affect judgement.
• Professional competence — keeping knowledge and skills up to date.
• Confidentiality — not disclosing business information without proper authority.
• Professional behaviour — complying with laws and regulations and avoiding actions that discredit the profession.

Unethical behaviour, such as overstating profit to obtain a loan, misleads users and can lead to poor decisions, legal penalties and loss of trust.

Key definitions

Classifying assets and liabilities

• Non-current assets: held for use in the business for more than one year, not for resale — land and buildings, machinery, fixtures and fittings, motor vehicles.
• Current assets: expected to be turned into cash within one year — inventory, trade receivables, other receivables, bank, cash.
• Non-current liabilities: due for repayment after more than one year — long-term bank loans.
• Current liabilities: due within one year — trade payables, other payables, bank overdraft.

The accounting equation

Everything a business owns has been financed either by the owner (capital) or by outsiders (liabilities). Because every transaction has two effects, the equation always stays in balance. This is the foundation of double-entry book-keeping and is why the statement of financial position balances.

Finding a missing figure

• A business has assets of $45 000 and liabilities of $12 500. Capital = $45 000 − $12 500 = $32 500.
• Capital is $32 500 and assets are $45 000. Liabilities = $45 000 − $32 500 = $12 500.

Worked example: transactions changing the equation

Lina starts a small gift shop. Follow how each transaction affects the equation. Notice that after every line, total assets equal liabilities plus capital.

1. Lina pays $10 000 of her savings into a business bank account.
2. She buys shop equipment for $3 000, paying by bank transfer.
3. She buys inventory for $2 000 on credit from a supplier.
4. She sells goods that cost $800 for $1 200 on credit.
5. She pays the supplier $1 500 by bank transfer.
6. She withdraws $300 from the business bank account for personal use.

• Transaction 1: assets up, capital up (both sides increase).
• Transaction 2: one asset up, another asset down — totals unchanged.
• Transaction 3: assets up, liabilities up.
• Transaction 4: inventory falls by $800, receivables rise by $1 200: assets rise by $400, and the $400 profit increases capital.
• Transaction 5: assets down, liabilities down.
• Transaction 6: assets down, capital down (drawings reduce capital; they are not an expense).

The four patterns to recognise

Profit, loss and capital

• Profit = revenue − expenses (when revenue is greater than expenses).
• Loss occurs when expenses are greater than revenue.
• Profit increases capital; a loss reduces it. Drawings reduce capital. Extra capital introduced increases it.

The same formula can be rearranged to find a missing figure, e.g. Profit = Closing capital − Opening capital + Drawings − Capital introduced = 23 500 − 20 000 + 4 000 − 1 000 = $6 500.

The accounting cycle

The path that every transaction follows from the moment it happens to the final statements:

The double-entry system

Double-entry book-keeping records every transaction twice: once on the debit side of one account and once on the credit side of another, with equal amounts. This reflects the two-fold effect of each transaction and keeps the accounting equation in balance.

• Debit (Dr) = left-hand side of an account. Credit (Cr) = right-hand side.
• The account that receives value is debited; the account that gives value is credited.
• Total debits must always equal total credits.

DEAD CLIC: drawings, expenses and assets increase on the debit side; liabilities, income and capital increase on the credit side. A decrease goes on the opposite side.

Divisions of the ledger

A ledger is the book (or file) containing all the accounts of a business. It is divided so that work can be shared and errors located more easily.

• Personal accounts: for people and businesses (customers, suppliers, the owner’s capital).
• Impersonal accounts: real accounts for things owned (premises, vehicles) and nominal accounts for income, expenses, gains and losses.

Business documents

Source documents provide evidence that a transaction took place and give the details needed to record it.

Trade discount and cash discount

• Trade discount: a reduction in list price given to other traders, often for bulk buying. It is shown on the invoice and never recorded in the books — only the net amount is recorded.
• Cash discount: a reduction given for paying within a stated time. It is recorded in the cash book discount columns as discount allowed (an expense for the seller) or discount received (income for the buyer).

Books of prime entry

Transactions are first listed in a book of prime entry before being posted to the ledger. This reduces the number of entries in the ledger (totals can be posted), keeps transactions in date order and gives a reference trail back to the source document.

Example: sales journal

Each customer’s account in the sales ledger is debited with their invoice; the sales account in the nominal ledger is credited with the total of $2 690. Total debits ($2 690) = total credit ($2 690).

Example: general journal

Worked example: writing up ledger accounts

Tom starts trading on 1 March 2026. His transactions for March:

• 1 Mar — paid $8 000 capital into the business bank account
• 3 Mar — bought goods on credit from K Supplies, $1 500
• 8 Mar — sold goods on credit to R Lee, $900
• 12 Mar — paid rent by bank transfer, $400
• 18 Mar — cash sales paid directly into the bank, $650
• 25 Mar — paid K Supplies $1 000 by bank transfer
• 28 Mar — R Lee paid $600 by bank transfer

The other accounts are: Capital (Cr $8 000), Purchases (Dr $1 500, details “K Supplies”) and Rent (Dr $400, details “Bank”). The balances show that Tom has $7 850 in the bank, owes K Supplies $500 (a credit balance — liability) and is owed $300 by R Lee (a debit balance — asset).

Balancing an account

If an account has only one entry, or both sides are already equal, no balancing is needed — simply total both sides if they are equal.

The cash book

• A two-column cash book has a cash column and a bank column on each side. Receipts go on the debit side; payments on the credit side.
• A three-column cash book adds a discount column on each side: discount allowed on the debit side (given to customers who pay promptly) and discount received on the credit side (from suppliers we pay promptly).
• The discount columns are memorandum columns only — they are not balanced. Their totals are posted: Dr Discount allowed account; Cr Discount received account. Individual discounts are posted to each customer’s or supplier’s account.
• A contra entry is a transfer between cash and bank within the cash book, marked “C”. Both sides of the double entry are in the cash book itself.
• A credit balance on the bank column means a bank overdraft (a current liability). The cash column can never have a credit balance.

Worked example: three-column cash book

May 2026: opening balances cash $120, bank $2 400. 4 May A Khan paid $485 by bank in full settlement of $500 owed. 7 May paid P Ross $784 by bank in full settlement of $800. 10 May cash sales $260. 12 May paid wages in cash $150. 15 May paid $200 cash into the bank. 22 May withdrew $90 from the bank for office cash. 26 May owner’s drawings $300 by bank.

• A Khan’s account is credited with both $485 (Bank) and $15 (Discount allowed), clearing the $500 debt.
• P Ross’s account is debited with $784 (Bank) and $16 (Discount received), clearing the $800 owed.
• Discount allowed account: Dr $15. Discount received account: Cr $16.

The petty cash book and the imprest system

Small, frequent expenses (postage, cleaning, travel, refreshments) are paid by a petty cashier from a separate float so the main cashier is not distracted by minor items.

Analysis totals: 30 + 55 + 24 + 42 = $151, matching the total column. After reimbursement, the float is back to $49 + $151 = $200.

Advantages of the imprest system

• The petty cashier can never hold more than the imprest, limiting the risk of theft.
• Cash in hand plus vouchers must always equal the imprest, so checks are easy at any time.
• Analysis columns mean only totals are posted, saving time in the nominal ledger.
• Frees the main cashier from small, routine payments.

Technology and accounting software

Most businesses now record transactions using accounting software, often cloud-based. The double-entry principles are unchanged, but the way they are carried out is different.

• Automation: recurring entries (rent, loan repayments), bank reconciliation matching and payment reminders can be automated.
• Data security: protect records with passwords and access levels, regular backups, encryption and up-to-date anti-virus software. Personal data about customers must be kept confidential.
• Limits: software cannot tell whether a transaction was entered in the wrong account with the correct amount (an error of commission or principle still balances). Human judgement and checking are still needed.
• Sustainability: digital invoices and records reduce paper use and storage space.

The trial balance

A trial balance is a list of the balances on all the ledger accounts at a certain date. Debit balances go in one column and credit balances in the other, and the two totals should agree.

Purpose of a trial balance

• It checks the arithmetical accuracy of the double entry: for every debit there should be an equal credit.
• It helps to find errors. If the totals disagree, there must be at least one mistake.
• It gives a summary of all ledger balances in one place, which makes it a starting point for preparing the financial statements.

Limitations of a trial balance

• When the totals agree, that does not prove the books are free of errors. Some errors leave the totals equal.
• It does not show where an error is, only that one exists.
• It is only correct for the date on which it is drawn up.

Errors not revealed by a trial balance

In each of these errors the debit entry still equals the credit entry, so the trial balance totals agree.

Errors that are revealed by a trial balance

• Single entry: only one side of the transaction is recorded.
• Two debits or two credits: both entries are made on the same side.
• Different amounts: the debit and the credit are for different figures, for example because of a transposition such as $540 entered as $450 on one side only.
• Casting errors: a book of prime entry or ledger account is overcast or undercast, i.e. added up wrongly.
• Balance omitted from the trial balance, or entered in the wrong column.

Correction of errors

Errors are corrected through the journal. Each entry gives the date, the account to debit, the account to credit, the amounts and a short narrative explaining the correction.

The suspense account

• When the trial balance totals do not agree, the difference is entered in a suspense account for the time being, so that draft financial statements can still be prepared.
• If the debit total is larger, the suspense account gets a credit balance. If the credit total is larger, it gets a debit balance.
• Only errors that affect the trial balance totals pass through the suspense account. Once all of these are corrected, the suspense account balance falls to zero (the account clears).

Effect of errors on profit and on the statement of financial position

• If a correction changes an income or expense account (including purchases, sales and returns), it changes profit for the year.
• If a correction changes only assets, liabilities or capital accounts, profit stays the same and only the statement of financial position changes.
• When profit changes, the capital figure in the statement of financial position changes by the same amount.

The P Dube correction makes trade receivables $70 lower and does not affect profit. The equipment correction raises non-current assets by $1 200.

Bank reconciliation

A bank reconciliation statement explains why the bank balance in the cash book differs from the balance on the bank statement at the same date.

Reasons for differences

• Items on the bank statement that are not yet in the cash book, so the cash book must be updated:
  • bank charges and interest charged
  • direct debits and standing orders
  • credit transfers (bank transfers) received from customers
  • dishonoured cheques, where a customer’s cheque was returned unpaid
  • interest received
• Timing differences, which appear in the reconciliation statement:
  • unpresented cheques: cheques entered in the cash book but not yet paid by the bank
  • outstanding lodgements (amounts not yet credited): money paid in and entered in the cash book but not yet shown on the bank statement
• Errors, made either in the cash book or by the bank.

Why reconcile regularly?

• It finds errors and omissions in the cash book and on the bank statement.
• It brings the cash book up to date so the bank figure in the statement of financial position is correct.
• It shows up stale (old unpresented) cheques and dishonoured cheques.
• It helps to detect fraud and theft, and it is part of good internal control.

Control accounts

A control account is a summary account that holds the totals of all the entries made in a ledger. Its balance should equal the total of the individual balances in that ledger.

• The sales ledger control account (trade receivables control) summarises all the customer accounts in the sales ledger.
• The purchases ledger control account (trade payables control) summarises all the supplier accounts in the purchases ledger.

Sources of information

• Set-off (contra entry): when a business both sells to and buys from the same person, it can cancel the smaller balance against the larger. This reduces both the amount receivable and the amount payable.
• Credit balances in the sales ledger can arise when a customer overpays or returns goods after paying. Debit balances can also appear in the purchases ledger. These are shown separately on the opposite side of the control account.

Uses of control accounts

• They check the arithmetical accuracy of each ledger separately, which helps to locate errors faster.
• They give a quick total of trade receivables and trade payables for the financial statements.
• They help to prevent fraud, especially when the control account is kept by someone other than the ledger clerk.
• They allow the work to be divided between staff.

Limitations of control accounts

• They do not reveal errors that cancel out, such as omissions, original entry errors, or a posting to the wrong customer (commission).
• They can themselves contain errors.
• They take extra time to prepare, although accounting software usually produces them automatically.

Capital and revenue expenditure and receipts

• Capital expenditure is money spent on buying, adding to or improving non-current assets. It includes delivery, legal fees, installation and testing. It is shown in the statement of financial position.
• Revenue expenditure is money spent on running the business day to day, or on keeping non-current assets in working order. It is charged to the income statement.
• An improvement, such as an extension to a building, is capital expenditure. A repair, such as replacing broken windows, is revenue expenditure.

Effect of incorrect classification

Depreciation

Depreciation is the estimated loss in value of a non-current asset over its useful life. It is an application of the matching (accruals) principle: the cost of the asset is spread over the years that benefit from using it.

Causes of depreciation

• Wear and tear from use
• Obsolescence: the asset is replaced by newer technology
• Passage of time: for example, a lease runs out
• Depletion: natural resources such as a mine are used up

Depreciation is a non-cash expense. It reduces profit, but no money leaves the business.

Straight-line method

The same amount is charged every year.

Reducing balance method

A fixed percentage is applied each year to the net book value (cost less accumulated depreciation), so the charge gets smaller each year.

• Straight-line suits assets that give equal benefit each year, such as fixtures or a lease.
• Reducing balance suits assets that lose more value early in their lives or that need more repairs as they age, such as vehicles and computers.

Recording depreciation

• The asset account stays at cost.
• Each year: Debit income statement (depreciation expense), Credit provision for depreciation account.
• The provision for depreciation account builds up the accumulated depreciation. In the statement of financial position: cost − accumulated depreciation = net book value.

Disposal of a non-current asset

Other payables and other receivables

Under the accruals (matching) principle, income and expenses are recorded in the period they relate to, not when the cash is received or paid.

Expense for the year = amount paid − opening accrual + closing accrual + opening prepayment − closing prepayment.

Irrecoverable debts and provision for doubtful debts

• An irrecoverable debt is an amount owed by a credit customer that will never be received, for example because the customer has become bankrupt. Entries: Debit irrecoverable debts, Credit customer’s account (trade receivables). At the year end, irrecoverable debts are transferred to the income statement as an expense.
• Recovery of a debt written off: first reinstate the debt (Debit customer, Credit irrecoverable debts recovered), then record the receipt (Debit bank, Credit customer). For example, if J Lee pays $300 that was written off last year, both entries are $300 and the recovered amount is shown as income. Reinstating the debt keeps a full record of the customer’s history.
• A provision for doubtful debts is an estimate of the trade receivables that may not be paid. It follows the prudence concept and the matching principle: the possible loss is charged in the same year as the sales that gave rise to it.

Valuation of inventory

• Inventory is valued at the lower of cost and net realisable value. This applies the prudence concept: profit is not overstated, and losses are recognised as soon as they are expected.
• Cost is the purchase price plus any costs of bringing the goods to their present location and condition, such as carriage inwards.
• Net realisable value (NRV) is the expected selling price minus any costs still to be paid to complete and sell the goods, such as repairs or selling costs.
• The rule is applied to each item or group of items separately, not to the inventory as a whole.

Effect of errors in inventory valuation

The two main financial statements

• Income statement — a summary of revenue and expenses for a period (usually one year), showing gross profit and profit for the year (or loss). It is headed “for the year ended …”.
• Statement of financial position — a list of assets, liabilities and capital (equity) at one point in time. It is headed “at …” (a single date), never “for the year ended”.
• Gross profit = revenue − cost of sales. Profit for the year = gross profit + other income − expenses.
• Cost of sales = opening inventory + net purchases (purchases − purchases returns + carriage inwards) − closing inventory.

1. Sole traders: from trial balance to statements

Year-end adjustments are applied so that the statements follow the accruals (matching) concept and prudence. Each adjustment usually affects two places: once in the income statement and once in the statement of financial position.

Worked example: Maya Reyes

Additional information at 31 December 2026:

1. Inventory was valued at $7 200.
2. Fixtures are depreciated at 10% per annum on cost (straight-line); the motor vehicle at 25% per annum reducing balance.
3. Rent of $500 has been paid in advance; electricity of $250 is owing.
4. A further debt of $200 is irrecoverable and must be written off.
5. The provision for doubtful debts is to be 5% of trade receivables.
6. Maya took goods costing $600 for her own use; no entry has been made.

2. Partnerships

A partnership is a business owned by two or more people (usually 2 to 20) who share the profits and losses. Advantages over a sole trader: more capital, shared workload and skills, shared losses. Disadvantages: profits shared, possible disagreements, and (in an ordinary partnership) unlimited liability.

The partnership agreement

A written agreement normally sets out:

• the capital each partner contributes;
• the ratio in which residual profits and losses are shared;
• interest on capital (a reward for investing money) and its rate;
• partners’ salaries (a reward for extra work or responsibility);
• interest on drawings (a charge to discourage partners taking out too much cash);
• limits on drawings and rules for admitting or retiring partners.

If there is no agreement, the usual legal default is that profits and losses are shared equally, with no interest on capital, no salaries and no interest on drawings.

Appropriation account

The appropriation account follows the income statement and shows how the profit for the year is shared. Interest on drawings is added (it is charged to partners); interest on capital and salaries are deducted; the remainder (residual profit) is shared in the profit-sharing ratio.

Worked example: Ana and Ben

Ana and Ben share profits and losses 3:2. Capitals: Ana $60 000, Ben $40 000. Interest on capital 5% per annum. Ben receives a salary of $8 000. Interest on drawings: Ana $400, Ben $250. Profit for the year ended 31 December 2026 was $42 000. Drawings: Ana $15 000, Ben $18 000. Current account balances at 1 January 2026: Ana $1 200 credit, Ben $500 debit.

In the statement of financial position the capital section becomes: Capital accounts (Ana 60 000, Ben 40 000 = 100 000) plus Current accounts (Ana 6 590, Ben 3 110 = 9 700), total $109 700.

3. Limited companies

Key features

• Separate legal entity: the company can own assets, sue and be sued in its own name.
• Limited liability: shareholders can lose only the amount they invested in their shares, not their personal assets.
• Owned by shareholders, run by directors (ownership and control may be separate).
• Raises capital by issuing shares; continuity of existence when shareholders change.
• Must follow more legal regulation and publish financial statements.

• Issued share capital: the shares actually issued, at nominal (par) value.
• Retained earnings: accumulated profits not yet paid out as dividends. Opening retained earnings + profit for the year − dividends paid − transfers to reserves = closing retained earnings.
• General reserve: profits set aside (transferred from retained earnings) for future use, reducing the amount available for dividends. It is not cash.
• Dividends: the share of profit paid to shareholders. Dividends paid during the year are deducted from retained earnings, not shown as an expense in the income statement.
• Debentures / long-term loans: borrowing at a fixed rate of interest. Debenture holders are lenders, not owners; interest is an expense (finance cost) whether or not a profit is made. Shown as a non-current liability unless repayable within 12 months.

Worked example: Delta Ltd

Delta Ltd has issued 200 000 ordinary shares of $1 each and 50 000 8% preference shares of $1 each. It also has $50 000 6% debentures. For the year ended 31 December 2026: revenue $480 000; cost of sales $290 000; administrative expenses $70 000; distribution costs $45 000. At 1 January 2026, retained earnings were $38 000 and the general reserve $20 000. During the year the preference dividend was paid in full and an ordinary dividend of 5 cents per share was paid. The directors transferred $15 000 to the general reserve. Non-current assets total $320 000, current assets $140 000 and current liabilities $44 000.

4. Clubs and societies (non-profit organisations)

Clubs exist to provide facilities for members, not to make a profit. Terminology changes but the principles are the same.

• Accumulated fund = club assets − club liabilities. Opening accumulated fund + surplus (or − deficit) = closing accumulated fund.
• Subscriptions in arrears (owed by members) = current asset. Subscriptions in advance (paid early for next year) = current liability.
• Profit from a club activity (e.g. café) is calculated in a separate trading account and only the profit or loss is transferred to the income and expenditure account.

Worked example: Riverside Tennis Club

At 1 January 2026 the club had: bank $2 400; equipment $12 000; café inventory $400; subscriptions in arrears $300; subscriptions in advance $200.

At 31 December 2026: café inventory $500; subscriptions in arrears $500; subscriptions in advance $350; electricity owing $150; all equipment is depreciated at 10% of its year-end cost.

5. Manufacturing accounts

A manufacturer makes the goods it sells, so a manufacturing account is prepared before the income statement to find the cost of production of goods completed in the year.

Worked example: Kora Furniture

The cost of production replaces “purchases” in the income statement. With revenue $240 000, opening finished goods $14 000 and closing finished goods $16 000:

In the statement of financial position, all three closing inventories appear as current assets: raw materials $9 500, work in progress $6 000 and finished goods $16 000.

6. Incomplete records

Many small traders do not keep a full double-entry system. The accountant must reconstruct the figures from bank statements, invoices and lists of assets and liabilities.

Method A: profit from the change in capital

A statement of affairs is a list of assets and liabilities on a given date; the difference is the owner’s capital (it is similar to a statement of financial position but prepared from incomplete information).

Method B: finding missing figures

When a full income statement is required, missing sales and purchases are found with control-account style workings, and mark-up or margin is used to link cost of sales and revenue.

Worked example: Leon Diaz

Leon paid suppliers $47 000 during 2026. Trade payables were $3 800 at the start and $4 200 at the end. Inventory was $6 000 at the start and $7 400 at the end. Leon sells all goods at a mark-up of 50%. Cash sales were $8 000; the rest were on credit. Trade receivables were $4 500 at the start and $5 100 at the end; discounts allowed were $400. Find purchases, revenue and the amount received from credit customers.

Leon should therefore have received $60 000 from credit customers. If the bank statement shows less, the difference may indicate an error, unrecorded drawings, or goods or cash stolen — a common follow-up question.

Choosing the right statement: summary

Why we calculate ratios

• A single figure (e.g. profit for the year of $24 000) tells you little on its own. A ratio relates one figure to another so that performance can be judged and compared.
• Ratios fall into three groups:
  • Profitability — how well the business turns revenue and capital into profit.
  • Liquidity — whether the business can pay its short-term debts as they fall due.
  • Efficiency (activity) — how well the business manages inventory, credit customers and credit suppliers.
• Comparisons can be made with previous years (inter-period), with other businesses (inter-firm), or with a target or industry average.

Profitability ratios

What each one tells you

• Gross margin: the gross profit earned on each $100 of sales. A fall usually means the business is paying more for goods, cutting selling prices, or suffering inventory losses (theft, damage).
• Mark-up: the percentage added to cost to arrive at selling price. It always gives a higher figure than gross margin for the same goods.
• Profit margin: the profit left from each $100 of sales after all expenses. If gross margin is steady but profit margin falls, expenses have risen relative to revenue.
• ROCE: the return the owner earns on the money invested. Compare it with the return available elsewhere (e.g. interest on a savings account) to judge whether staying in the business is worthwhile.
• Expense-to-revenue ratios (e.g. wages, rent, advertising, delivery ÷ revenue): show which expense is driving a change in profit margin.

Liquidity ratios and working capital

• Working capital is the amount available to finance day-to-day trading. A business with too little working capital may be unable to pay suppliers, lose cash discounts, or be refused further credit.
• The current ratio compares all current assets with current liabilities. A figure of around 1.5 : 1 to 2 : 1 is often regarded as comfortable, but the right level depends on the type of business.
• The liquid ratio leaves out inventory because inventory must first be sold (and the money perhaps collected from customers) before it becomes cash. Around 1 : 1 is often treated as satisfactory.
• A ratio that is too high is also a problem: it suggests money tied up in idle inventory, slow-paying customers or surplus cash that could be invested to earn a return.
• A large gap between the current and liquid ratios shows the business relies heavily on inventory.

Efficiency ratios

• Inventory turnover: how many times in the year the average inventory is sold and replaced, or how many days goods stay in the warehouse. A faster rate (more times, fewer days) usually means higher sales and less risk of goods becoming damaged or out of date. Perishable-goods businesses expect a very fast rate.
• Trade receivables turnover: the average time credit customers take to pay. Compare it with the credit terms allowed (e.g. 30 days). Longer collection means cash is tied up and the risk of irrecoverable debts grows.
• Trade payables turnover: the average time taken to pay credit suppliers. Taking longer keeps cash in the business, but going beyond agreed terms risks losing cash discounts, goodwill and future credit.
• Ideally the business collects from customers faster than it pays suppliers.

How to improve each ratio

Working capital: the cycle

The longer goods are held and the longer customers take to pay, the more working capital the business needs. Shortening the cycle improves liquidity without any extra capital.

Inter-period and inter-firm comparison

• Inter-period comparison: comparing the same business over two or more years to identify trends (is the business improving or getting worse?).
• Inter-firm comparison: comparing a business with another business, ideally in the same trade and of similar size, to judge relative performance.

Limitations of comparison

General limitations of ratio analysis

• Ratios are based on historic figures, so they may not predict the future.
• The statement of financial position shows the position on one day, which may not be typical (and can be window-dressed).
• Ratios ignore non-financial factors: staff quality and morale, customer loyalty, reputation, environmental impact, location.
• Ratios show symptoms, not causes — further investigation is needed.
• Historic cost means assets may be shown at values well below their current worth, distorting ROCE.

Users of financial statements

Worked example: comparing two years

Hana runs a stationery shop. All sales and purchases are on credit. Extracts from her financial statements are shown below.

Current assets: 2025 = 22 000 + 25 000 + 8 000 = $55 000; 2026 = 30 000 + 40 000 + 2 000 = $72 000. Current liabilities: 2025 = $22 000; 2026 = $36 000.

Why accounting concepts matter

• Concepts (also called principles or conventions) give a common framework so that financial statements are prepared in the same way by everyone.
• They make statements reliable and comparable between years and between businesses.
• Almost every adjustment you meet in other topics — depreciation, accruals, prepayments, provisions, inventory valuation — is justified by one or more concepts.

The accounting concepts

Remember the order as “B C D G H, three Ms, P R” — ten concepts, almost alphabetical.

Concepts behind common adjustments

Accounting policies and the qualities of useful information

• Accounting policies are the specific methods a business chooses to apply the concepts, e.g. which depreciation method and rate to use, how inventory is valued, what percentage provision is made for doubtful debts.
• Policies should be chosen so that the financial statements give information with the following qualities, and should be applied consistently.

There can be a conflict between qualities: waiting to obtain fully accurate figures increases reliability but reduces relevance because the information arrives late.

Ethical considerations in accounting

Accountants are trusted by owners, lenders, tax authorities and the public. Professional bodies expect them to follow these fundamental principles:

Examples of unethical practice

• Window dressing: making the statement of financial position look better than it really is at the year-end, e.g. delaying payments to suppliers so the bank balance looks healthy, or recording next year’s sales early.
• Overstating profit by not providing for depreciation or doubtful debts, or by valuing inventory above cost.
• Understating profit to reduce tax (tax evasion).
• Recording fictitious sales or assets, or omitting liabilities.
• Changing accounting policies only to manipulate reported profit.
• Passing on confidential customer or employee data, or using inside information for personal benefit.

Why ethical behaviour matters

• Users rely on the statements to make decisions; misleading figures can cause lenders, suppliers and investors to lose money.
• Unethical practice can lead to fines, prosecution and loss of professional membership.
• It damages the reputation of the business and the trust of customers and suppliers.

Technology in accounting

• Accounting software: once a transaction is entered, the software posts it to the ledgers, updates balances and produces the trial balance, financial statements and reports automatically.
• Automation: bank feeds import transactions directly; invoices can be scanned and read automatically; recurring entries (rent, loan repayments) and reminders to customers are generated without manual input.
• Cloud accounting: records are stored online and can be accessed from anywhere by the owner, staff and the accountant at the same time, with automatic backups and updates.
• Data security: financial and personal data must be protected using passwords, multi-factor authentication, access levels for different staff, encryption, regular backups, anti-virus software and staff training against fraud such as phishing.

Sustainability and the role of accounting

• Sustainability means meeting present needs without damaging the ability of future generations to meet theirs. Businesses are increasingly expected to consider their impact on the environment and society, not just their profit.
• Environmental costs include energy and fuel use, waste disposal, pollution clean-up, recycling schemes, carbon taxes or fines, and investment in cleaner equipment (e.g. solar panels, electric delivery vans).
• Role of accounting:
  • Identifying and recording environmental costs separately so managers can see and control them.
  • Measuring savings from sustainable choices (e.g. lower energy bills after installing insulation) to support investment decisions.
  • Sustainability reporting: providing information on carbon emissions, energy use, waste and social impact alongside the financial statements, so that stakeholders can judge the business’s wider performance.
  • Providing evidence to lenders, customers and investors who prefer to deal with responsible businesses.
• Limitations: many environmental effects are hard to measure in money (the money measurement concept), so they are not shown in the financial statements and must be reported in non-financial terms.
• Paperless accounting (digital invoices, cloud records) is itself a sustainable practice, linking technology and sustainability.

Question 1: Posting transactions and balancing accounts

Question 2: Three-column cash book with discounts

Question 3: Petty cash book using the imprest system

Question 4: Sales and purchases journals with ledger postings

Question 5: Preparing a trial balance

Question 6: Source documents and discounts

Question 7: Double entry and errors not revealed by a trial balance

Question 8: Advise on using accounting software

Question 1: Straight-line and reducing balance depreciation

Question 2: Provision for depreciation and disposal accounts

Question 3: Expense account with an accrual and a prepayment

Question 4: Income account: rent receivable

Question 5: Irrecoverable debts and the provision for doubtful debts

Question 6: Inventory valuation at the lower of cost and net realisable value

Question 7: Short answers on adjustments

Question 8: Advise on choosing a depreciation method

Question 1: Sole trader statements from a trial balance with adjustments

Question 2: Partnership appropriation account and current accounts

Question 3: Limited company income statement extract and equity

Advise question

Question 4: Club subscriptions account and income and expenditure account

Question 5: Manufacturing account

Question 6: Incomplete records using statements of affairs and mark-up

Question 1: Correction of errors and the suspense account

Question 2: Effect of errors on profit

Question 3: Bank reconciliation

Question 4: Sales ledger control account

Question 5: Calculating ratios

Question 6: Advise using ratios

Question 7: Accounting concepts and ethics