amendment of a statement of financial position

10.1 Statement of Financial Position (Balance Sheet)

Learning objective

Students will be able to prepare, interpret and amend a statement of financial position so that the accounting equation always balances.

1. The accounting equation

• Assets = Liabilities + Equity

2. Classification of items

Category	Sub‑categories	Typical examples
Assets	Non‑current assets (fixed assets) Current assets	Property, plant & equipment, long‑term investments Cash, trade receivables, inventory, prepaid expenses
Liabilities	Non‑current liabilities Current liabilities	Bank loans (long‑term), debentures, lease obligations Trade payables, tax payable, short‑term borrowings
Equity	Share capital (issued capital) Share premium Reserves (revaluation, legal, other) Retained earnings (cumulative profit less dividends)	£1 000 000 ordinary share capital £50 000 share premium £20 000 revaluation reserve, £10 000 legal reserve Opening retained earnings + profit for the year – dividends

3. Why amendments may be required

• Correction of errors (e.g., omitted or double‑recorded items)
• Re‑classification of items (e.g., prepaid expense moved to non‑current assets)
• Inclusion of items that were omitted from the original statement
• Adjustments for new information (depreciation, inventory write‑down, impairment, etc.)

4. Systematic steps to amend a statement of financial position

1. Identify the item that needs amendment and the nature of the change.
2. Quantify the monetary impact.
3. Analyse which side(s) of the accounting equation are affected.
4. Record the appropriate journal entry (debit / credit).
5. Update the relevant line items in the balance sheet.
6. Re‑calculate totals to confirm Assets = Liabilities + Equity.
7. Document the amendment with a concise explanatory note (required by the Cambridge syllabus).

5. Worked example – Omitted inventory of £5 000

Item	Amount (£)
Non‑current assets	150 000
Current assets	80 000
Total assets	230 000
Current liabilities	50 000
Non‑current liabilities	70 000
Equity (share capital + retained earnings)	110 000
Total liabilities & equity	230 000

Journal entry to correct the omission

Debit   Inventory (Current Asset)      £5 000
   Credit   Retained earnings (Equity)          £5 000

Re‑presented balance sheet

Item	Amount (£)
Non‑current assets	150 000
Current assets	85 000
Total assets	235 000
Current liabilities	50 000
Non‑current liabilities	70 000
Equity (share capital + retained earnings)	115 000
Total liabilities & equity	235 000

6. Practice – Amend the balance sheet

Item	Amount (£)
Non‑current assets	200 000
Current assets	120 000
Total assets	320 000
Current liabilities	80 000
Non‑current liabilities	100 000
Equity (share capital + retained earnings)	140 000
Total liabilities & equity	320 000

1. Correct a £3 000 over‑statement of accounts payable.
2. Re‑classify £7 000 of prepaid expenses from current assets to non‑current assets.
3. Record straight‑line depreciation of £4 500 on equipment (cost £30 000, useful life 5 years, residual value £0).

Answer framework

• State the affected accounts (e.g., Accounts payable, Prepaid expenses, Accumulated depreciation).
• Show the debit and credit amounts for each amendment.
• Present the revised balance sheet after each step and verify that Assets = Liabilities + Equity.
• Provide a brief note for each amendment (e.g., “Correction of over‑stated accounts payable – £3 000”).

---

10.2 Statement of Profit or Loss (Income Statement)

Learning objective

Students will be able to prepare a profit or loss account, understand its link to equity, and amend it for errors or re‑classifications.

1. Structure of the profit or loss account (Cambridge 9609)

Section	Typical line items
Revenue	Sales of goods or services
Cost of sales	Opening stock + Purchases + Carriage‑in – Closing stock
Gross profit	Revenue – Cost of sales
Operating expenses	Selling, administrative, depreciation, amortisation
Operating profit	Gross profit – Operating expenses
Finance costs & income	Interest expense, interest income
Profit before tax (PBT)	Operating profit ± finance items
Tax expense	Applicable tax rate on PBT
Profit after tax (PAT)	PBT – Tax

2. Link to the balance sheet

• Net profit for the year is transferred to the equity section as retained earnings.
• Any amendment to the profit or loss account therefore requires a corresponding amendment to retained earnings (or to a reserve if the change relates to a prior‑period error).

3. Systematic steps to amend the profit or loss account

1. Identify the line item that is incorrect (e.g., an expense omitted).
2. Calculate the impact on profit before tax and profit after tax.
3. Record the correcting journal entry.
4. Adjust retained earnings in the equity section of the balance sheet.
5. Provide a concise explanatory note (required by the syllabus).

4. Worked example – Omitted selling expense of £2 000

Statement of profit or loss	£
Revenue	150 000
Cost of sales	90 000
Gross profit	60 000
Selling expenses (original)	10 000
Administrative expenses	12 000
Depreciation	5 000
Operating profit	33 000
Interest income	1 000
Interest expense	2 000
Profit before tax	32 000
Tax (30 %)	9 600
Profit after tax	22 400

Correcting journal entry

Debit   Selling expenses          £2 000
   Credit   Accounts payable                 £2 000

Effect on the profit or loss

• Operating profit falls to £31 000.
• Profit before tax falls to £31 000.
• Tax (30 %) = £9 300.
• Profit after tax falls to £21 700.

Corresponding balance‑sheet impact

• Accounts payable (current liability) ↑ £2 000.
• Retained earnings (equity) ↓ £700 (net reduction after tax).

---

10.3 Inventory Valuation & Depreciation

Learning objective

Students will understand the inventory valuation method required by Cambridge, calculate straight‑line depreciation, and recognise how both affect the balance sheet and profit or loss.

1. Inventory valuation – lower of cost or net realisable value (NRV)

• Cost includes purchase price, import duties, transport, handling and any other costs directly attributable to bringing the inventory to its present location and condition.
• NRV = Estimated selling price – Estimated costs of completion and disposal.
• For the Cambridge syllabus the inventory is recorded at the **lower** of cost or NRV; FIFO, weighted‑average or specific identification are *not* examined.

Worked example – Cost vs. NRV

Item	Cost (£)	Estimated selling price (£)	Estimated disposal cost (£)	NRV (£)	Recorded value (£)
Finished goods	22 000	28 000	2 000	26 000	22 000 (cost is lower)
Obsolete stock	5 000	4 500	300	4 200	4 200 (NRV is lower)

2. Straight‑line depreciation (the only method examined)

Formula:

\[ \text{Depreciation expense per year} = \frac{\text{Cost of asset} - \text{Residual value}}{\text{Useful life (years)}} \]

Example

• Cost of equipment = £30 000
• Residual value = £0
• Useful life = 5 years

Annual depreciation = (£30 000 – £0) ÷ 5 = £6 000.

Journal entry each year

Debit   Depreciation expense (P&L)   £6 000
   Credit   Accumulated depreciation (contra‑asset)   £6 000

Effect on the statements

• Balance sheet: Net book value of the asset falls by £6 000 each year; accumulated depreciation (contra‑asset) rises by the same amount.
• Profit or loss: Depreciation expense reduces operating profit, and therefore retained earnings.

3. Practice – Apply inventory and depreciation

1. Closing inventory is £18 000. NRV is calculated at £16 500. Record the required adjustment.
2. Equipment purchased for £24 000 has a useful life of 8 years and a residual value of £4 000. Record the first year’s depreciation.

Suggested approach

• Determine the lower of cost (£18 000) or NRV (£16 500) → write‑down of £1 500.
• Journal entry: Debit Inventory £1 500; Credit Retained earnings £1 500 (or a specific inventory write‑down reserve if required).
• Depreciation calculation: (£24 000 – £4 000) ÷ 8 = £2 500 per year.
• Journal entry: Debit Depreciation expense £2 500; Credit Accumulated depreciation £2 500.

---

10.4 Ratio Analysis & Investment Appraisal

Learning objective

Students will be able to calculate key performance ratios, interpret their meaning, and perform the three investment‑appraisal techniques required for Cambridge 9609.

1. Core financial ratios (formulae and interpretation)

Ratio	Formula	Interpretation
Current ratio	Current assets ÷ Current liabilities	Liquidity – ability to meet short‑term obligations.
Quick (acid‑test) ratio	(Current assets – Inventory) ÷ Current liabilities	Liquidity excluding inventory, which may be less readily convertible to cash.
Gross profit margin	Gross profit ÷ Revenue × 100 %	Profitability of core trading activity.
Net profit margin	Profit after tax ÷ Revenue × 100 %	Overall profitability after all expenses and tax.
Return on capital employed (ROCE)	Operating profit ÷ (Non‑current assets + Working capital) × 100 %	Efficiency of capital utilisation.
Gearing ratio	Non‑current liabilities ÷ (Non‑current liabilities + Equity) × 100 %	Financial risk – proportion of long‑term funding that is debt.
Inventory turnover	Cost of sales ÷ Average inventory	How quickly inventory is sold and replaced.

2. Investment appraisal techniques (Cambridge 9609)

• Pay‑back period – Number of years required for cumulative cash inflows to equal the initial outlay. Simple, time‑based measure; does not consider the cost of capital.
• Accounting rate of return (ARR) – Average annual profit ÷ Initial investment × 100 %. Uses accounting profit rather than cash flow.
• Net present value (NPV) – Σ (Cash inflow ÷ (1 + r)^t) – Initial outlay, where r is the required rate of return (discount rate). Positive NPV indicates the project adds value.

3. Worked example – Pay‑back, ARR and NPV

Year	Cash inflow (£)
0 (initial outlay)	-40 000
1	15 000
2	15 000
3	15 000

Pay‑back period

• Cumulative cash flow after Year 2 = £30 000 (still below £40 000).
• Cumulative cash flow after Year 3 = £45 000 (> £40 000).
• Pay‑back = 3 years.

ARR

• Average annual profit = (Total cash inflows – Initial outlay) ÷ 3 = (£45 000 – £40 000) ÷ 3 = £1 667.
• ARR = (£1 667 ÷ £40 000) × 100 % ≈ 4.2 %.

NPV (discount rate 10 %)

\[ \begin{aligned} NPV &= \frac{15 000}{(1+0.10)^1} + \frac{15 000}{(1+0.10)^2} + \frac{15 000}{(1+0.10)^3} - 40 000\\ &= 13 636 + 12 397 + 11 270 - 40 000\\ &= - 697\;\text{(approximately)} \end{aligned} \]

Result: NPV is slightly negative, so the project would be rejected at a 10 % required return.

4. Quick practice

1. Calculate the current ratio and quick ratio for a company with:
   • Current assets £120 000 (including £30 000 inventory)
   • Current liabilities £80 000
2. Using the cash‑flow data above, compute the pay‑back period and state whether the project meets a pay‑back criterion of 2 years.

Suggested answers

• Current ratio = 120 000 ÷ 80 000 = 1.5.
• Quick ratio = (120 000 – 30 000) ÷ 80 000 = 0.9.
• Pay‑back period = 3 years → does not meet a 2‑year criterion.