Introduction to Financial Accounting - Incomplete Records

Some small businesses opt not to maintain a full set of double-entry bookkeeping records, often due to cost considerations or the perceived complexity of such systems. However, it is important to recognize that financial statements can still be prepared without complete records, through various accounting techniques that help reconstruct a clearer financial picture of the business.

Techniques for Preparing Financial Statements

Several techniques can be employed to prepare financial statements in the absence of complete records:

  1. The Accounting Equation

  2. Using Control Accounts

  3. Using Ratios

The Accounting Equation

The fundamental accounting equation serves as the backbone of financial accounting. It is expressed as follows:
Assets−Liabilities=Closing Capital\text{Assets} - \text{Liabilities} = \text{Closing Capital}
This equation is crucial as it forms the basis for the double-entry system of accounting, whereby every transaction impacts both sides of the equation.
Closing capital is calculated using the formula:
Closing Capital=Opening Capital+Capital Introduced−Drawings+Profit\text{Closing Capital} = \text{Opening Capital} + \text{Capital Introduced} - \text{Drawings} + \text{Profit}
This calculation reflects the net change in equity from the beginning to the end of the period.

Example of the Accounting Equation

For the year ending 31 December, Lisa's records indicate the following details:

  • Non-current Assets (NCA) at NBV:

    • 2018: £10,800

    • 2019: £11,200

  • Current Assets:

    • 2018: £11,082

    • 2019: £9,273

  • Liabilities:

    • 2018: £15,905

    • 2019: £15,706

  • Capital:

    • 2018: £5,977

    • 2019: £4,767

Drawings for the year amounted to £2,000.

Calculation of Profit Using Closing Capital

The formula to determine capital is:
Capital=Assets−Liabilities\text{Capital} = \text{Assets} - \text{Liabilities}
To reconcile the capital account for the year:

  • Drawings = £2,000

  • Balance brought forward (b/f) = £4,767

  • Balance carried down (c/d) = £5,977
    The net profit can be calculated as follows:
    This results in a calculated profit of
    Profit=Capital at year-end−Balance b/f−Drawings=£3,210\text{Profit} = \text{Capital at year-end} - \text{Balance b/f} - \text{Drawings} = £3,210

Example of Business Records - Archibald

For Archibald, the starting balance on 1 January 20X1 was £2,000. The end-of-year assets included:

  • Freehold shop: £4,000

  • Fixtures: £500

  • Stock: £10,300

  • Trade receivables: £500

  • Cash in till: £10

  • Cash at bank: £150

Liabilities included:

  • Mortgage: £3,000

  • Creditors: £7,000

  • Accrued mortgage interest: £100

Drawings for the year were £500, and depreciation on shop fittings is expected to decline by £50. Additionally, stock valuation showed a decrease from £300 to £50.

Profit Calculation Example

To calculate profit using the accounting equation, consider:

  • Change in net assets during the year = Profit + Capital introduced - Drawings.

  • Net assets at year-end = £5,060

  • Capital introduced = £2,000, Drawings = £500.
    Thus, the calculation of profit is:
    Profit=£5,060−£2,000+£500=£3,560\text{Profit} = £5,060 - £2,000 + £500 = £3,560

Using Control Accounts

Control accounts allow businesses to find missing figures by maintaining separate balances for different areas of their transactions. Common types of control accounts include:

  • Accounts Receivable Control Account: Tracks money owed by customers.

  • Accounts Payable Control Account: Monitors money owed to suppliers.

  • Bank Control Account: Manages cash flow through the bank.

  • Cash Control Account: Helps account for cash transactions directly.

Example of Control Accounts - Belinda

For Belinda, the opening and closing balances for the year ended on 31 December include:

  • Inventory: £5,227 (opening) and £4,892 (closing)

  • Trade Receivables: £6,387 (opening) and £7,221 (closing)

  • Trade Payables: £3,859 (opening) and £4,209 (closing)

  • Total payments included Trade Payables and personal expenses of £100/week.

Using Ratios for Missing Figures

Calculating ratios can help identify financial health and fill in missing financial data. Important ratios include:

  • Gross Profit Margin:
    Gross Profit Margin=Gross ProfitSales×100%\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100\%

  • Mark-Up:
    Mark-Up=Gross ProfitCost of Sales×100%\text{Mark-Up} = \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100\%

Exercise Examples

  1. Kyran

    • Inventory at 1 April 20X1: £450

    • Inventory at 31 March 20X2: £650

    • Purchases: £5,400, required to apply a mark-up of 20%.

  2. Jasbir

    • Inventory at 1 July 20X1: £9,672

    • Inventory at 30 June 20X2: £12,680

    • Sales for the year: £62,000, with a sales margin of 25% above cost.