Financial Accounting Fundamentals
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Financial Accounting Fundamentals — Key Facts for Sri Lanka A/L Examination
What is Accounting?:
- Language of business — communicating financial information
- Recording, classifying, and summarising business transactions
- Producing financial statements for decision-making
The Accounting Equation (Foundation of all accounting):
Assets = Liabilities + Capital
Assets − Liabilities = Capital (Owner's Equity)Key Terms:
| Term | Meaning | Sri Lankan Example |
|---|---|---|
| Asset | Resource owned by business | Land, building, machinery |
| Liability | Amount owed to others | Loans, creditors, overdraft |
| Capital | Owner’s investment | Initial capital, drawings |
Types of Business Transactions:
| Transaction | Effect on Equation | Example |
|---|---|---|
| Buy equipment for cash | Assets unchanged (one up, one down) | Equipment ↑, Cash ↓ |
| Buy on credit | Assets ↑, Liabilities ↑ | Inventory ↑, Creditors ↑ |
| Pay creditor | Assets ↓, Liabilities ↓ | Cash ↓, Creditors ↓ |
| Owner invests more | Assets ↑, Capital ↑ | Bank ↑, Capital ↑ |
⚡ A/L Exam Tip: The accounting equation ALWAYS balances. Every transaction has a dual effect!
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Financial Accounting Fundamentals — Detailed Study Guide
The Accounting Process
Step-by-Step Accounting Cycle:
1. Source Document → 2. Journal Entry → 3. Ledger → 4. Trial Balance → 5. Financial StatementsSource Documents (Evidence of transactions):
| Document | Evidence Of |
|---|---|
| Invoice | Sale or purchase on credit |
| Receipt | Cash received |
| Cheque counterfoil | Cash payment |
| Credit note | Return of goods sold |
| Debit note | Return of goods bought |
| Payslip | Employee wages |
Double Entry System (Every transaction has two effects):
Rule: Debit the receiver, credit the giver
Debit what comes in, credit what goes out
Debit expenses and assets, credit income and liabilitiesSri Lankan Chart of Accounts (Standard Classification):
| Class | Category | Debit/Credit |
|---|---|---|
| 1000 | Non-current assets (Fixed assets) | Debit ↑ |
| 1100 | Current assets | Debit ↑ |
| 2000 | Non-current liabilities | Credit ↑ |
| 2100 | Current liabilities | Credit ↑ |
| 3000 | Capital and reserves | Credit ↑ |
| 4000 | Revenue/Income | Credit ↑ |
| 5000 | Expenses | Debit ↑ |
Books of Prime Entry (Journals):
| Journal | Records |
|---|---|
| Sales journal | Credit sales |
| Purchases journal | Credit purchases |
| Returns inward journal | Returns from customers |
| Returns outward journal | Returns to suppliers |
| Cash book | Cash and bank transactions |
| General journal | All other transactions |
The Ledger and Trial Balance
** ledger Account Format** (T-Account):
Account Name
Dr. Cr.
|---------|----------||----------|---------|
| Date | Details | Amount | Date | Details | Amount |
|---------|----------||----------|---------|Golden Rules of Accounting:
| Type | Rule | Example |
|---|---|---|
| Personal accounts | Debit the receiver, credit the giver | Received cash from Mr. Perera: Dr. Cash, Cr. Mr. Perera |
| Real accounts | Debit what comes in, credit what goes out | Bought machinery: Dr. Machinery, Cr. Cash |
| Nominal accounts | Debit all expenses and losses, credit all incomes and gains | Commission received: Dr. Cash, Cr. Commission Income |
Trial Balance:
- List of all ledger balances
- Proves arithmetic accuracy of double entry
- Format: Account Name | Debit | Credit
| Trial Balance as at 31st December 2025 | Dr. | Cr. |
|---|---|---|
| Capital | 500,000 | |
| Drawings | 50,000 | |
| Land and Buildings | 800,000 | |
| Machinery | 200,000 | |
| Inventory (01.01.25) | 150,000 | |
| Purchases | 400,000 | |
| Sales | 850,000 | |
| Carriage Inwards | 20,000 | |
| Wages | 80,000 | |
| Rent | 30,000 | |
| Creditors | 100,000 | |
| Debtors | 120,000 | |
| Cash at Bank | 70,000 | |
| Cash in Hand | 5,000 | |
| Totals | 1,925,000 | 1,925,000 |
⚡ A/L Common Mistake: Trial Balance proves only that debits equal credits — NOT that entries were correct. A transaction could be completely wrong but still balance!
Financial Statements
Trading Account (Calculates Gross Profit):
Trading Account for year ended 31st December 2025
Rs. Rs.
Sales 850,000
Less: Returns inward (20,000)
-------
Net Sales 830,000
Opening Stock 150,000
Add: Purchases 400,000
-------
550,000
Less: Closing Stock (180,000)
-------
Cost of Goods Sold 370,000
-------
GROSS PROFIT (Net Sales − COGS) 460,000
======Profit and Loss Account (Calculates Net Profit):
Profit and Loss Account for year ended 31st December 2025
Rs. Rs.
Gross Profit (from Trading) 460,000
Add: Commission received 15,000
Discount received 5,000 20,000
--------
480,000
Less: Operating Expenses:
Carriage inwards 20,000
Wages 80,000
Rent 30,000
Telephone 8,000
Insurance 12,000
Depreciation 25,000 (175,000)
--------
NET PROFIT 305,000
======Statement of Financial Position (Balance Sheet):
Statement of Financial Position as at 31st December 2025
ASSETS Rs. Rs.
Non-Current Assets:
Land and Buildings 800,000
Machinery 200,000 1,000,000
Current Assets:
Inventory 180,000
Debtors 120,000
Cash at Bank 70,000
Cash in Hand 5,000
Prepaid Insurance 12,000 387,000
----------
Total Assets 1,387,000
==========
EQUITY AND LIABILITIES
Capital 500,000
Add: Net Profit 305,000
-------
805,000
Less: Drawings (50,000)
-------
Owner's Equity 755,000
Non-Current Liabilities:
10% Loan (repayable 2028) 200,000
Current Liabilities:
Creditors 100,000
Accrued expenses (Rent) 20,000
Bank overdraft 312,000 432,000
-------
Total Equity and Liabilities 1,387,000
==========⚡ A/L Key: Gross Profit = Sales − Cost of Goods Sold. Net Profit = Gross Profit − Operating Expenses.
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Financial Accounting Fundamentals — Complete Notes for A/L Sri Lanka
Accounting Principles and Concepts
Going Concern Concept:
- Business is expected to continue indefinitely
- Assets recorded at cost, not liquidation value
- Sri Lankan companies use historical cost unless otherwise stated
Accounting Period Concept:
- Business life divided into time periods
- Sri Lanka: Calendar year (January to December) or financial year
- Enables periodic measurement of profit
Matching Concept (Accruals Principle):
- Expenses matched to revenues they help generate
- Revenue earned in period → related expenses recognised in same period
- Example: Wages owing at year-end → accrued as expense this year
Revenue Recognition Principle:
- Revenue recognised when earned, not when cash received
- “Earned” = goods delivered or services rendered
- Credit sales: Revenue recognised at point of sale, not collection
Prudence/Conservatism:
- Anticipate losses but not profits
- Closing stock valued at LOWER of cost and net realisable value
- Provision for doubtful debts before profit is calculated
Consistency Concept:
- Same accounting methods used from period to period
- Changes must be disclosed in notes to accounts
Materiality:
- Items material (significant) must be disclosed separately
- Immaterial items can be aggregated
- Threshold varies by size of business
Adjustments to Financial Statements
Accruals and Prepayments:
Accrued Expenses (Expenses outstanding):
Example: Rent owed Rs. 20,000 at year-end
Adjustments:
1. In P&L: Add Rs. 20,000 to Rent expense
2. In Balance Sheet: Add Rs. 20,000 to Creditors/Accruals
Journal:
Dr. Rent Expense 20,000
Cr. Accrued Rent 20,000Prepayments (Expenses paid in advance):
Example: Insurance prepaid Rs. 12,000 (covers next year)
Adjustments:
1. In P&L: Only current period's share (e.g., Rs. 8,000)
2. In Balance Sheet: Prepaid expense of Rs. 4,000 as Current Asset
Journal:
Dr. Prepaid Insurance 4,000
Cr. Insurance Expense 4,000Depreciation:
Straight Line Method:
Depreciation = (Cost − Residual Value) / Useful Life
Example: Machine cost Rs. 200,000, residual Rs. 20,000, useful life 5 years
Annual Depreciation = (200,000 − 20,000) / 5 = Rs. 36,000
Journal:
Dr. Depreciation Expense 36,000
Cr. Accumulated Depreciation 36,000Closing Stock:
Closing stock Rs. 180,000
- Appears in Trading Account (added to purchases)
- Appears in Balance Sheet (Current Asset)
Effect on Cost of Goods Sold:
Opening Stock + Purchases − Closing Stock = COGS
150,000 + 400,000 − 180,000 = Rs. 370,000Provision for Doubtful Debts:
Example: Debtors Rs. 120,000, estimate 5% irrecoverable
Provision = 120,000 × 5% = Rs. 6,000
Journal:
Dr. Bad Debts Expense 6,000
Cr. Provision for Doubtful Debts 6,000
In Balance Sheet:
Debtors (120,000 − 6,000) = Rs. 114,000 (net)Goods Destroyed by Fire (Insurance claim):
Example: Goods costing Rs. 25,000 destroyed, insured for Rs. 20,000
Journal:
Dr. Loss by Fire (P&L) 5,000
Dr. Sundry Debtors/Cash (Insurance) 20,000
Cr. Trading Account 25,000Capital vs Revenue Expenditure
Capital Expenditure (Benefits more than one year):
| Item | Treatment |
|---|---|
| Purchase of fixed assets | Capitalised (shown as asset) |
| Addition to existing asset | Capitalised |
| Legal fees on asset purchase | Added to asset cost |
| Cost of building extension | Capitalised |
Revenue Expenditure (Benefits only current year):
| Item | Treatment |
|---|---|
| Repairs and maintenance | Expensed in P&L |
| Consumables | Expensed |
| Salaries and wages | Expensed |
| Advertising | Expensed |
Capital vs Revenue Examples:
| Situation | Classification | Reason |
|---|---|---|
| Whitewash of building | Revenue | Maintenance, one year |
| New floor added to building | Capital | Increases value, longer life |
| Engine overhaul | Revenue | Keeps asset running, one year |
| Engine replacement | Capital | New asset, longer life |
⚡ A/L Exam Trap: Incorrect classification affects both profit and asset value. Watch for the word “improvement” vs “repairs”!
Double Entry — Extended Examples
Drawings and Capital:
1. Owner starts business with Rs. 500,000 cash:
Dr. Cash 500,000 / Cr. Capital 500,000
2. Owner takes Rs. 50,000 cash for personal use (drawings):
Dr. Drawings 50,000 / Cr. Cash 50,000
Note: Drawings REDUCE capital. At year-end, drawings
transferred to capital account (statement of changes in equity).Credit Purchases and Sales:
3. Bought goods on credit from Supplier for Rs. 100,000:
Dr. Purchases 100,000 / Cr. Creditors 100,000
4. Sold goods on credit to Customer for Rs. 150,000 (cost Rs. 100,000):
Dr. Debtors 150,000 / Cr. Sales 150,000
Dr. Cost of Goods Sold 100,000 / Cr. Inventory 100,000
Note: Two entries needed — one for revenue, one to record the cost.Returns and Adjustments:
5. Customer returned goods worth Rs. 10,000 (we credited customer):
Dr. Sales Returns 10,000 / Cr. Debtors 10,000
Dr. Inventory 10,000 / Cr. Cost of Goods Sold 10,000
6. Returned goods to supplier Rs. 5,000:
Dr. Creditors 5,000 / Cr. Purchases Returns 5,000
Dr. Cost of Goods Sold 5,000 / Cr. Inventory 5,000Statement of Changes in Equity
Format (Sri Lankan A/L):
Statement of Changes in Equity for year ended 31st December 2025
Capital Drawings Total
Rs. Rs. Rs.
Opening Balance 500,000 - 500,000
Add: Additional
Capital introduced - -
Add: Net Profit 305,000 - 305,000
-------
805,000 - 805,000
Less: Drawings (50,000) (50,000)
-------
Closing Balance 805,000 (50,000) 755,000
====== ======GCE A/L Sri Lanka Past Paper Tips
Common Structured Questions:
- “Explain the accounting equation and show how transactions affect it” (8 marks)
- “What is double entry system? Give five examples of transactions and their entries” (10 marks)
- “Prepare a Trading Account from the following information” (15 marks)
- “From the Trial Balance and additional information, prepare the Income Statement and Statement of Financial Position” (20 marks)
- “Distinguish between capital expenditure and revenue expenditure with examples” (8 marks)
Common Calculation Adjustments:
- Closing stock valuation
- Accrued and prepaid expenses
- Depreciation (straight line and reducing balance)
- Provision for doubtful debts
Key Formulas to Memorise:
Gross Profit = Net Sales − Cost of Goods Sold
COGS = Opening Stock + Purchases − Closing Stock
Net Profit = Gross Profit − Operating Expenses + Other Income
Owner's Equity = Capital + Retained Profits − Drawings⚡ A/L Strategy: In financial accounting problems, ALWAYS start by preparing the Trading Account to find Gross Profit, then the P&L Account to find Net Profit. Finally, use these to complete the Balance Sheet.
⚡ A/L Common Error: Students forget to record closing stock in BOTH the Trading Account AND the Balance Sheet. Closing stock appears in two places!
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