Accounting Principles and Financial Statements

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Accounting Principles and Financial Statements — Key Facts for Sri Lanka A/L Examination

Key Financial Statements:

1. Income Statement (Trading, Profit and Loss Account): Shows profitability over a period
2. Balance Sheet (Statement of Financial Position): Shows assets, liabilities, and equity at a point in time
3. Cash Flow Statement: Shows inflow and outflow of cash

Basic Accounting Equation:

Assets = Liabilities + Owner's Equity

OR

Assets - Liabilities = Owner's Equity

⚡ A/L Exam Tip: The accounting equation MUST always balance! Use this to check your work!

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🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Accounting Principles and Financial Statements — Detailed Study Guide

Fundamental Accounting Concepts

Business Entity Concept:

• Business is separate from its owner
• Owner investing in business is a liability
• Transactions recorded from business perspective only

Money Measurement Concept:

• Only transactions measurable in money are recorded
• Non-monetary events (employee morale, brand value) not in accounts
• Historical cost basis: Assets recorded at cost

Going Concern Concept:

• Assumes business will continue operations indefinitely
• Justifies recording assets at original cost (not liquidation value)
• If going concern is doubted, accounts must be restated

Dual Aspect Concept:

• Every transaction affects at least two accounts
• Debits must equal credits
• Basis of double-entry book-keeping

Matching Concept (Accrual Basis):

• Expenses matched with revenues they help generate
• Revenue recognised when earned, not when received
• Expense recognised when incurred, not when paid

Cost Concept:

• Assets recorded at purchase price
• Subsequent changes in value not recorded (except depreciation)
• Historical cost vs. market value

Revenue Recognition Concept:

• Revenue recognised when earned
• For goods: When ownership transfers
• For services: When service is performed
• Not when cash is received

The Accounting Equation

Understanding Assets, Liabilities, and Equity:

Assets (Resources owned):

Category	Examples
Non-current assets	Land, buildings, machinery, vehicles
Current assets	Cash, debtors, inventory, prepaid expenses
Intangible assets	Goodwill, patents, trademarks

Liabilities (Amounts owed):

Category	Examples
Non-current liabilities	Long-term loans, mortgages
Current liabilities	Creditors, bank overdraft, short-term loans

Capital/Equity:

Capital = Assets - Liabilities
Capital = Investment by owner + Accumulated profits - Drawings

Changes in the Accounting Equation:

Transaction 1: Owner invests cash

Assets (Cash) ↑ = Liabilities + Capital ↑
Cash ↑, Capital ↑ (investment)

Transaction 2: Purchase of equipment on credit

Assets (Equipment) ↑ = Liabilities (Creditors) ↑ + Capital (no change)
Equipment ↑, Creditors ↑

Transaction 3: Pay creditor

Assets (Cash) ↓ = Liabilities (Creditors) ↓ + Capital (no change)
Cash ↓, Creditors ↓

Transaction 4: Revenue earned (not yet received)

Assets (Debtors) ↑ = Liabilities (no change) + Capital ↑ (revenue)
Debtors ↑, Capital ↑ (revenue increases profit)

Transaction 5: Owner withdraws cash

Assets (Cash) ↓ = Liabilities (no change) + Capital ↓ (drawings)
Cash ↓, Capital ↓ (drawings)

⚡ A/L Key: Draw T-accounts to visualise how transactions affect the equation!

The Double Entry System

Debit and Credit Rules:

Account Type	Debit Effect	Credit Effect
Assets	Increase	Decrease
Liabilities	Decrease	Increase
Capital	Decrease	Increase
Revenue/Income	Decrease	Increase
Expenses	Increase	Decrease

T-Account Format:

DEBIT SIDE                          | CREDIT SIDE
------------------------------------|----------------------------------
Transaction details | Amount         | Transaction details | Amount
                   |                |                    |
                   |                |                    |
                   |                |                    |

Golden Rules of Accounting:

Account Type	Rule	Example
Assets	Debit what comes in, credit what goes out	Buy machine: Debit Machine
Expenses/Losses	Debit increase, credit decrease	Pay rent: Debit Rent Expense
Revenue/Income/Gains	Credit increase, debit decrease	Make sale: Credit Sales
Liabilities	Credit increase, debit decrease	Borrow money: Credit Loan
Capital	Credit increase, debit decrease	Owner invests: Credit Capital

Balancing Accounts:

1. Total both sides
2. Larger total goes on both sides
3. Find difference = Balance (debit or credit)
4. Enter balance on lesser side to make equal

Books of Prime Entry

Source Documents:

• Sales invoice
• Purchase invoice
• Cash receipt
• Cash payment voucher
• Credit note
• Debit note

Books of Prime Entry (Original Entry):

Book	Records
Sales Day Book	All credit sales
Purchases Day Book	All credit purchases
Sales Returns Day Book	Returns from customers
Purchases Returns Day Book	Returns to suppliers
Cash Book	Cash and bank transactions
General Journal	All other transactions

Cash Book Analysis:

Column	Contents
Date	Transaction date
Description	Narration
Folio	Page reference to ledger
Cash	Cash account transactions
Bank	Bank account transactions
Discount	Cash discounts

Three Column Cash Book:

• Cash column
• Bank column
• Discount column

Contra Entry (Transfer between cash and bank):

• Entry in both debit and credit columns
• “C” in folio column to indicate cross-reference

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🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Accounting Principles and Financial Statements — Complete Notes for A/L Sri Lanka

Financial Statements: Detailed Structure

Trading Account (First section of Income Statement):

Trading Account for the year ended [Date]

Particulars                          Rs.       Rs.
Opening Stock                              XXXX
Add: Purchases (net)                    XXXX
Less: Returns outward                     (XX)
                              ___________ _______
                              Available for sale XXXX
Less: Closing Stock                       (XXXX)
                              ___________ _______
Cost of Goods Sold                              XXXX
Gross Profit (if Sales > COGS)                  XXXX
                              ========= =========

Sales (net)                           XXXX
Less: Returns inward                    (XX)
Net Sales                              XXXX
Less: Cost of Goods Sold                (XXXX)
                              ___________ _______
Gross Profit                              XXXX
                              ========= =========

Profit and Loss Account (Second section):

Profit and Loss Account for the year ended [Date]

Particulars                          Rs.       Rs.
Gross Profit                               XXXX
Less: Expenses
  - Salaries and Wages                    XXXX
  - Rent and Rates                         XXX
  - Insurance                              XX
  - Depreciation                          XXXX
  - Bad Debts                               XXX
  - General Expenses                       XXX
                              ___________ _______
                              Total Expenses          XXXX
Net Profit (GP - Expenses)                     XXXX
Add: Other Income
  - Discount Received                        XXX
  - Commission Earned                       XXX
  - Interest Received                       XXX
                              ___________ _______
                              Net Profit              XXXX
                              ========= =========

Balance Sheet (Statement of Financial Position):

Balance Sheet as at [Date]

Particulars               Rs.       Rs.   | Particulars          Rs.       Rs.
ASSETS                                | EQUITY & LIABILITIES
Non-Current Assets                   | Capital Account
  Land and Buildings      XXXX       |   Opening Balance     XXXX
  Plant and Machinery     XXXX       |   Add: Net Profit      XXXX
  Motor Vehicles         XXXX       |   Less: Drawings       (XXX)
  Furniture and Fixtures   XXX       |                    ___________
  Less: Depreciation     (XXX)      |   Closing Capital      XXXX
  Net Book Value         XXXX        |                    | Non-Current Liabilities
Current Assets                       |   Long-term Loans     XXXX
  Inventory/Stock       XXXX        |                    |
  Trade Debtors         XXXX         | Current Liabilities
  Bills Receivable       XXX         |   Trade Creditors     XXXX
  Cash at Bank          XXXX        |   Bills Payable        XXX
  Cash in Hand           XXX         |   Bank Overdraft       XXX
  Prepaid Expenses       XXX         |   Accrued Expenses    XXX
  Total Assets          XXXXX       |   Total Liabilities  XXXXX
                              =========           =========

Sri Lanka Accounting Standards

SLFRS and LKAS Framework:

• Sri Lanka Financial Reporting Standards
• Aligned with IFRS (International Financial Reporting Standards)
• Issued by the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka)

Key Conceptual Framework:

1. Objective: Provide useful financial information
2. Qualitative Characteristics: Relevance, faithful representation, comparability, verifiability, timeliness, understandability
3. Elements: Asset, liability, equity, income, expense
4. Recognition and Measurement: When and how elements are recorded

Key Accounting Standards:

LKAS 1 - Presentation of Financial Statements:

• All material information presented
• Minimum line items specified
• Comparative information required

LKAS 2 - Inventories:

• Valuation at lower of cost and net realisable value
• FIFO or Weighted Average cost formulas
• Cost includes all direct costs

LKAS 16 - Property, Plant and Equipment:

• Initially measured at cost
• Subsequent measurement: Cost model or Revaluation model
• Depreciation required

LKAS 38 - Intangible Assets:

• Acquired intangible assets at cost
• Internally generated intangibles (research vs. development)
• Development costs capitalised under certain conditions

SLFRS 9 - Financial Instruments:

• Classification of financial assets
• Expected credit loss model
• Hedge accounting

SLFRS 15 - Revenue from Contracts with Customers:

• Five-step model for revenue recognition
• Performance obligations
• Transaction price allocation

Ratio Analysis

Purpose of Ratios:

• Assess financial performance
• Compare across periods
• Compare with other businesses
• Identify problems

Types of Ratio Analysis:

1. Liquidity Ratios (Can we pay short-term debts?):

Ratio	Formula	Ideal	Example
Current Ratio	Current Assets / Current Liabilities	2:1	2.5:1 = adequate
Quick Ratio (Acid Test)	(Current Assets - Inventory) / Current Liabilities	1:1	1.2:1 = acceptable

2. Profitability Ratios (Are we making profit?):

Ratio	Formula	Interpretation
Gross Profit Margin	(Gross Profit / Sales) × 100	Higher = better pricing/costs
Net Profit Margin	(Net Profit / Sales) × 100	Overall efficiency
Return on Capital Employed	(Net Profit / Capital Employed) × 100	Efficiency of use of funds
Return on Assets	(Net Profit / Total Assets) × 100	Asset efficiency

3. Efficiency Ratios (How well are assets used?):

Ratio	Formula	Interpretation
Stock Turnover	Cost of Goods Sold / Average Inventory	Higher = faster moving
Debtor Collection Period	(Trade Debtors / Credit Sales) × 365	Days to collect
Creditor Payment Period	(Trade Creditors / Credit Purchases) × 365	Days to pay
Asset Turnover	Sales / Total Assets	Efficiency of asset use

4. Long-term Solvency Ratios (Can we pay long-term debts?):

Ratio	Formula	Interpretation
Debt Ratio	Total Liabilities / Total Assets	Lower = less debt risk
Interest Coverage	Profit before Interest & Tax / Interest	Higher = better coverage
Debt-Equity Ratio	Total Debt / Total Equity	Lower = less leveraged

5. Market Ratios (For listed companies):

Ratio	Formula	Interpretation
Earnings Per Share (EPS)	Net Profit / Number of Shares	Higher = better for shareholders
Price-Earnings (P/E)	Market Price per Share / EPS	Lower = potentially undervalued

Ratio Comparison in Sri Lanka:

• Compare with industry averages
• Compare with similar companies
• Track changes over time
• Consider Sri Lankan economic context

Ledger Accounts and Trial Balance

The Ledger:

• Permanent collection of all accounts
• Each account shows all transactions affecting it
• Posted from books of prime entry

Posting from Cash Book to Ledger:

Cash Book (Bank Column) ----posting----> Bank Account in Ledger

Date | Description | Folio | Amount (Rs.)
-----|-------------|-------|---------------
     |            |       |

Trial Balance:

• List of all ledger balances
• Tests equality of debits and credits
• Starting point for financial statements

Trial Balance Format:

Trial Balance as at [Date]

Particulars        | Folio | Debit (Rs.) | Credit (Rs.)
------------------|-------|-------------|-------------
Land & Buildings  |       |   XXXXX     |
Plant & Machinery  |       |   XXXXX     |
Inventory         |       |   XXXXX     |
Trade Debtors     |       |   XXXXX     |
Cash at Bank     |       |   XXXXX     |
Cash in Hand     |       |   XXXX      |
Trade Creditors  |       |             |   XXXXX
Long-term Loan   |       |             |   XXXXX
Capital          |       |             |   XXXXX
Sales            |       |             |   XXXXX
Purchases        |       |   XXXXX     |
Wages & Salaries |       |   XXXX      |
Rent and Rates   |       |   XXXX      |
Discount        |       |   XXXX      |
                  |       |-------------|-------------
Totals           |       |   XXXXXX    |   XXXXXX
                  |       |=============|=============

⚡ A/L Key: A trial balance agreeing doesn’t mean accounts are correct — only that debits = credits. Omissions or errors can still exist!

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