FINANCIAL ACCOUNTING:

PREPARING FINANCIAL
STATEMENTS

STUDY TEXT

Qualifications and Credit Framework

Q2022

This Study Text supports study for the following AAT qualifications:

AAT Level 3 Diploma in Accounting

AAT Level 3 Certificate in Bookkeeping

AAT Diploma in Accounting at SCQF Level 7

 FINANCIAL ACCOUNTING: PREPARING FINANCIAL STATEMENTS

CONTENTS
Page number
Introduction P.7
Unit guide P.11
The assessment P.27
Unit link to the synoptic assessment P.28
Study skills P.29

STUDY TEXT

Chapter
1 Double entry bookkeeping 1
2 Accounting for VAT and payroll 63
3 Capital and revenue expenditure 81
4 Depreciation 99
5 Disposal of capital assets 133
6 The extended trial balance – an introduction 165
7 Underlying accounting principles 169
8 Accounting for inventory 195
9 Irrecoverable and doubtful debts 217
10 Control account reconciliations 245
11 Bank reconciliations 277
12 Accruals and prepayments 289
13 Suspense accounts and errors 313
14 The extended trial balance – in action 339
15 Preparation of accounts for a sole trader 387
16 Partnership accounts 433
17 Incomplete records 477
18 The interpretation of profitability ratios 545
19 Appendix 1 – International accounting 563
terminology and the alternatives

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FINANCIAL ACCOUNTING: PREPARING FINANCIAL STATEMENTS

INTRODUCTION
HOW TO USE THESE MATERIALS

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STUDY TEXT
This study text has been specially prepared for the revised AAT
qualification introduced in February 2022.
It is written in a practical and interactive style:
• key terms and concepts are clearly defined
• all topics are illustrated with practical examples with clearly worked
solutions based on sample tasks provided by the AAT in the new
examining style
• frequent activities throughout the chapters ensure that what you
have learnt is regularly reinforced
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mistakes and help you focus on what is required to perform well in
your examination
• ‘Test your understanding’ activities are included within each
chapter to apply your learning and develop your understanding.

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 FINANCIAL ACCOUNTING: PREPARING FINANCIAL STATEMENTS

ICONS
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knowledge gained.

Definition
These sections explain important areas of Knowledge which must be
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Example
The illustrative examples can be used to help develop an understanding
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Test your understanding

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understanding of all the assessment areas.

Foundation activities
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your higher level skills.

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 FINANCIAL ACCOUNTING: PREPARING FINANCIAL STATEMENTS

Double-entry bookkeeping

Introduction
A sound knowledge of double entry underpins many of the learning
outcomes and skills required for Financial Accounting: Preparing Financial
Statements. It is essential knowledge in order to pass this unit and
learners will be assessed on double-entry bookkeeping in the examination
and so this must be very familiar ground. Although much of the content of
this chapter should be familiar, it is essential that it is covered in order to
build upon this basic knowledge in later Chapters.

ASSESSMENT CRITERIA CONTENTS

Use of the accounting equation (2.1) 1 Principles behind

Classification of ledger accounts (2.2) double-entry
bookkeeping
Purpose and use of books of prime 2 Overview of the
entry and ledger accounting (2.3) accounting system
Carry out financial period end routines 3 Rules of double-entry
(2.4) bookkeeping
Prepare an initial trial balance (6.1) 4 Double entry – cash
transactions
Prepare an adjusted trial balance (6.2) 5 Double entry – credit
transactions
6 The trial balance and
balancing a ledger
account
7 The financial
statements
8 Digital bookkeeping
systems

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 Double-entry bookkeeping: Chapter 1

1 Principles behind double-entry bookkeeping

1.1 Introduction
Double-entry bookkeeping is based upon three basic principles:
• the dual effect principle
• the separate entity principle
• the accounting equation.

1.2 The dual effect

Definition – The dual effect principle

The principle of the dual effect is that each and every transaction that a
business makes has two effects.

For example, if a business buys goods for cash then the two effects are
that cash has decreased and that the business now has made purchases.
The principle of double-entry bookkeeping is that each of these effects
must be shown in the ledger accounts by a debit entry in one account
and an equal credit entry in another account.
Each and every transaction that a business undertakes has two equal
and opposite effects.

1.3 The separate entity concept

Definition – The separate entity concept

The separate entity concept is that the business is a completely
separate accounting entity from the owner.

Therefore, if the owner pays personal money into a business bank account
this becomes the capital of the business which is owed back to the owner.
Similarly, if the owner takes money out of the business in the form of
drawings then the amount of capital owed to the owner is reduced.
The business itself is a completely separate entity in accounting terms
from the owner of the business.

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 Double-entry bookkeeping: Chapter 1

Test your understanding 3

Musgrave starts in business with capital of £20,000, in the form of cash
£15,000 and non-current assets of £5,000.
In the first three days of trading Musgrave has the following transactions:
• Purchases inventory £4,000 on credit terms, supplier allows one
month's credit.
• Sells some inventory costing £1,500 for £2,000 and allows the
customer a fortnight's credit.
• Purchases a motor vehicle for £6,000 and pays by cash.
The accounting equation at the start would be:
Assets less liabilities = Ownership interest
£20,000 – £0 = £20,000
Required:
Re-state in values the accounting equation after all the transactions had
taken place.

2 Overview of the accounting system

2.1 Overview of the accounting system

A business may enter into a large number of transactions on a daily basis.
It is quite clear that keeping track of all transactions can be a detailed
process.
To ensure that a business does keep track of all sales earned, purchases
and expenses incurred, the transactions are recorded in an accounting
system.

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 FINANCIAL ACCOUNTING: PREPARING FINANCIAL STATEMENTS

• Business transaction
1

• Business document
2

• Books of prime entry

3

• Ledger accounts
4

• Trial balance
5

1 Initially a business transaction will take place; a credit sale, a credit

purchase, a cash sale, a cash purchase, another expense either paid
from the bank or by cash, cash paid into the bank, withdrawal of cash
from the bank and owner’s drawings.
2 A business document will be produced e.g. an invoice.
3 The transaction and details from the business document will be
entered into the books of prime entry. A book of prime entry is
where a transaction is first recorded. There are several books of
prime entry which may also be referred to as ‘day books’.
4 The transactions that have been recorded in the books of prime entry
are transferred into ledger accounts as part of the general ledger
on a regular basis. Ledger accounts are used as part of the double-
entry accounting system.
5 An initial trial balance is a list of all of the ledger accounts in the
accounting system and is used as a control to check that
transactions have been recorded correctly in the double-entry system
prior to the preparation of the financial statements.

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 Double-entry bookkeeping: Chapter 1

2.2 Books of prime entry

A book of prime entry is the place where the transaction (which is detailed
on a business document) is first recorded in the books of the business.
Books of prime entry may also be referred to as day books. There are
several day books which will be briefly reviewed in this chapter:

Purchases day Sales returns

Sales day book
book day book

Purchases
Petty cash
returns day Cash book
book
book

Discounts Discounts
allowed day received day Journal
book book

Definition – Sales day book

The sales day book is simply a list of the sales invoices that are to be
processed for a given period (e.g. a week).

Definition – Sales returns day book

The sales returns day book is simply a list of the credit notes that are to
be processed for a given period (e.g. a week).

Definition – Purchases day book

The purchases day book is simply a list of the purchases invoices that
are to be processed for a given period (e.g. a week).

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 FINANCIAL ACCOUNTING: PREPARING FINANCIAL STATEMENTS

8.2 Benefits of using digital bookkeeping systems

Simple data entry Automatic generation

Automation of tasks
and efficiency of reports

Integration with other

Reduction of errors
systems

Simple data entry and efficiency

• Manual data entry is more time consuming than processing
transactions digitally.
Automatic generation of reports
• Automatically creates a trial balance from the general ledger
accounts.
Automation of tasks
• Processes recurring entries.

Definition – Recurring entries

A recurring entry is a journal entry that is recorded in every accounting
period.

• Makes duplication of automated and manual entries possible.

• Automatically balances the cash book.
• Automatically completes the transfer of data from the books of prime
entry to the ledgers.
• Automatically completes the transfer of data into the control
accounts.
• Automatically reconciles the receivables and payables ledgers to
their respective control accounts.

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