business accounting course notes _financial accounting
DESCRIPTION
financial accountingTRANSCRIPT
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COURSE STRUCTURE
AIM
The aim of the module is to provide non-accounting students with an academically
challenging and intellectually stimulating study of foundation accounting.
ASSESSMENT
Assessment in this module is entirely via coursework.
Course work will consist of three 1 hour class tests, to be completed on days 6, 9 and 12
and one two hour class test which will take place on day 15.
The first class test will have an assessment weighting of 10%.
The second class test will have an assessment weighting of 20%.
The third class test will have an assessment weighting of 20% and the #
Final two hour class test a weighting of 50%.
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READING LIST
Required Reading:
Atrill P., and McLaney, E., Accounting and finance for Non-Specialists, (6th ed), FT
Prentice Hall, 2008.
Recommended Reading:
Ryan B., Finance and Accounting for Business, (2nd ed), South Western Cengage
Learning, 2008.
Berry., A and Jarvis, R., Accounting in a business context, Thompson (2006)
Wood, F., and Sangster, A., Business Accounting 1, (11th Ed) Prentice Hall, 2008.
Websites:
Chartered Institute of Management Accountants (CIMA) www.cimaglobal.com
Association of Chartered Certified Accountants (ACCA) www.accaglobal.com
Journals:
The following journals are all of particular relevance to this module:
Accounting & Business Magazine
Management Accounting (UK)
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SESSION TOPIC
SESSION 1 INTRODUCTION & ACCOUNTING EQUATION
SESSION 2 DOUBLE ENTRY
SESSION 3 PRACTICE QUESTIONS
SESSION 4 TRIAL BALANCE & INVENTORY
SESSION 5 ESSAY WRITING
SESSION 6 CAPITAL & REVENUE
SESSION 7 FINANCIAL STATEMENTS
SESSION 8 ACCOUNTING ADJUSTMENTS & ANALYSIS
SESSION 9 MOCK TEST 1
SESSION 10 EXAM 1
SESSION 11 MANAGEMENT ACCOUNTING INTRODUCTION
SESSION 12 JOB COSTING
SESSION 13 PRACTICE QUESTIONS
SESSION 14 MOCK TEST 2
SESSION 15 EXAM 2
SESSION 16 MATERIAL PRICING
SESSION 17 REMUNERATION
SESSION 18 PRACTICE QUESTIONS
SESSION 19 MOCK TEST 3
SESSION 20 EXAM 3
SESSION 21 MANUFACTURING ACCOUNTS
SESSION 22 MANUFACTURING ACCOUNTS QUESTIONS
SESSION 23 REVISION
SESSION 24 MOCK TEST 4
SESSION 25 EXAM 4
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Introduction
The first question many people ask is “what is accounting?”
Basically accounting is broadly made up of two elements:
1. Recording business transactions - Book keeping
2. Presenting the information
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WHAT IS A BUSINESS?
A business is a commercial organisation which exists with a view to making a profit.
An organisation is an arrangement of people, pursuing common goals achieving results
and standards of performance.
Businesses will fall into 3 main categories.
Sole Trader
This is a business that is owned and operated by one person
Partnership
This type of business is owned by more than one individual, some of which will actively
be involved in the business and others may not.
The main advantage of being a
sole trader is that you can make
your own decisions. You will also
keep all of the profit that you
hopefully will make. However,
there are also disadvantages.
These include having unlimited
liability and also raising finance
could be a problem.
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Companies
A company is owned by shareholders and is operated on their behalf by a nominated
board of directors.
Responsibility for Financial Statements
The management of an enterprise has the primary responsibility for preparing and
presenting the enterprise's financial statements.
The Framework:
• Defines the objective of financial statements;
• Identifies the qualitative characteristics that make information in financial
statements useful; and
• Defines the basic elements of financial statements and the concepts for
recognising and measuring them in financial statements.
As with sole traders there will be
advantages and disadvantages in
entering into a partnership.
Advantages would include a wider
knowledge base and also more
people to share the workload.
Disadvantages would include losing
some control and maybe having to
compromise your opinions for the
good of the partnership.
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Users and their Information Needs
The principal classes of users of financial statements are present and potential investors,
employees, lenders, suppliers and other trade creditors, customers, governments and
their agencies and the general public. All of these categories of users rely on financial
statements to help them in decision making.
The framework also concludes that because investors are providers of risk capital to the
enterprise, financial statements that meet their needs will also meet most of the general
financial information needs of other users. Common to all of these user groups is their
interest in the ability of an enterprise to generate cash and cash equivalents and of the
timing and certainty of those future cash flows.
The framework notes that financial statements cannot provide all the information that
users may need to make economic decisions. For one thing, financial statements show
the financial effects of past events and transactions, whereas the decisions that most
users of financial statements have to make relate to the future. Further, financial
statements provide only a limited amount of the non-financial information needed by
users of financial statements.
While all of the information needs of these user groups cannot be met by financial
statements, there are information needs that are common to all users, and general
purpose financial statements focus on meeting these needs.
Management accounts
Management accounts are produced as often as a business wants them (usually
monthly). They are produced for internal use and will not, usually be seen by people
outside of the organisation. Management accounts can be prepared using the
company’s own internal policies.
Financial accounts
Financial accounts are usually produced annually. They are based on historical
information and are rarely used internally. Financial accounts are useful to many
different types of people who are not part of the organisation.
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Qualitative characteristics of financial statements
The four main characteristics are:
Understandability
Information should be presented in a way that is readily understandable by users who
have a reasonable knowledge of business and economic activities and accounting
and who are willing to study the information diligently.
Relevance
Information in financial statements is relevant when it influences the economic
decisions of users. It can do that both by
(a) helping them evaluate past, present, or future events relating to an enterprise and
(b) confirming or correcting past evaluations they have made.
Materiality is a component of relevance. Information is material if its omission or
misstatement could influence the economic decisions of users.
Timeliness is another component of relevance. To be useful, information must be
provided to users within the time period in which it is most likely to bear on their
decisions.
Reliability
Information in financial statements is reliable if it is free from material error and bias and
can be depended upon by users to represent events and transactions faithfully.
Information is not reliable when it is purposely designed to influence users' decisions in a
particular direction.
There is sometimes a tradeoff between relevance and reliability - and judgment is
required to provide the appropriate balance.
Reliability is affected by the use of estimates and by uncertainties associated with items
recognised and measured in financial statements. These uncertainties are dealt with, in
part, by disclosure and, in part, by exercising prudence in preparing financial
statements. Prudence is the inclusion of a degree of caution in the exercise of the
judgments needed in making the estimates required under conditions of uncertainty,
such that assets or income are not overstated and liabilities or expenses are not
understated. However, prudence can only be exercised within the context of the other
qualitative characteristics in the Framework, particularly relevance and the faithful
representation of transactions in financial statements. Prudence does not justify
deliberate overstatement of liabilities or expenses or deliberate understatement of
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assets or income, because the financial statements would not be neutral and,
therefore, not have the quality of reliability.
Comparability
Users must be able to compare the financial statements of an enterprise over time so
that they can identify trends in its financial position and performance. Users must also
be able to compare the financial statements of different enterprises. Disclosure of
accounting policies is essential for comparability.
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The elements of financial statements
Asset is a resource controlled by the enterprise as a result of past events and from
which future economic benefits are expected to flow to the enterprise.
Liabilities are an entity’s obligations to transfer economic benefits as a result of past
transactions or events.
Equity is the residual amount found by deducting all liabilities of the entity from all of the
entity’s assets.
Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases in liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
Expenses are decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrences of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.
Recognition of the elements of financial statements
In order to recognise anything in the Balance Sheet and income statement it must meet
all three of the following criteria:
- Meet the definition of the element (as above)
- Probable future economic benefit will flow to or from the entity
- The item can be measured reliably
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The Fundamental Assumptions
Prudence
Due to the fact that lots of items within sets of accounts are subjective or uncertain then
a prudent approach must be adopted at all times. This basically means that
professional accountant will exercise a degree of caution in any judgements that have
to be made – to be sure that any assets have not be overstated and liabilities
understated.
Some key examples of this include any time a loss is foreseen then it MUS
recognised and accounted for immediately, and that profits can only be recognised
when they are realised.
The Fundamental Assumptions
When about to prepare a set of Financial Statements, it is
very important that the professional accountant follows
certain key assumptions.
Due to the fact that lots of items within sets of accounts are subjective or uncertain then
a prudent approach must be adopted at all times. This basically means that
professional accountant will exercise a degree of caution in any judgements that have
to be sure that any assets have not be overstated and liabilities
Some key examples of this include any time a loss is foreseen then it MUS
recognised and accounted for immediately, and that profits can only be recognised
When about to prepare a set of Financial Statements, it is
important that the professional accountant follows
Due to the fact that lots of items within sets of accounts are subjective or uncertain then
a prudent approach must be adopted at all times. This basically means that the
professional accountant will exercise a degree of caution in any judgements that have
to be sure that any assets have not be overstated and liabilities
Some key examples of this include any time a loss is foreseen then it MUST be
recognised and accounted for immediately, and that profits can only be recognised
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Going Concern
The concept of “Going Concern” means that the entity will be considered to be a
going concern unless there is evidence to suggest otherwise. This means that it will
continue to operate in business for the “foreseeable future”. This is assuming that the
entity has no plans to go into liquidation or to significantly curtail (reduce) the scale of
its operations.
Accruals
This principal is often referred to as the “Matching Principal”. It means that income and
expenses must be accounted for in the period to which they relate.
So in other words if you have earned some income then any expenses you incurred to
get it in the first place must be matched against it.
Consistency
To enable the performance of the entity to be compared year on year, items included
must be included consistently from one period to the next – in other words included on
the same basis.
This should remain the situation unless there are any changes required by the issue of
new accounting standards or where there has been a major change in the business
itself such that a different presentation would give a fairer picture.
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Fair Presentation
The Financial Statements must be presented fairly, in other words free from bias. IAS 1
includes detail on what specifically must be included to ensure that a fair presentation
is given;
• The entity has chosen and applied suitable accounting policies, which are
relevant to it, reliable and are understandable and comparable.
• The information is presented in such a way so that the user can understand,
compare and be able to draw relevant and reliable conclusions from it
• Where necessary additional disclosures have been included.
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The Accounting Equation
Assets consists of property of all kinds, such as building, machinery, inventory (stock held
for resale), and motor vehicles. Other assets include debts owed by customers to the
business and the amount of money held by the business in cash or in the bank.
Liabilities are amounts owed by the business to a third party, that is other than the
owner.
Capital is often called the owners equity, net worth or net assets. It represents the
amount of money owed by the business to the owner. It is equal to the funds invested in
the business initially by the owner plus any profits earned by the business, less any profits
taken out of the business by the owner (drawings).
Drawings are cash/goods or services taken from the business for the proprietors own
use. They reduce capital but are recorded separately.
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Three Basic Principles
1 Separate entity
A proprietor and the business are distinct. We look at the business from
Eg Fred puts £1,000 into his business. From the point of view of the business the dual
effect is
– it has £1,000 cash
– it owes Fred £1,000
The liability of a business to its proprietor is known as capital.
2 Dual effect
Every transaction has two effects.
Fred borrows £250 from Sid. The two effects are
– Fred has £250 in cash. The “having” is an ASSET
– Fred owes £250 to Sid. The “owing” is a LIABILITY
The two effects are equal and opposite, hence they balance.
A proprietor and the business are distinct. We look at the business from
Fred puts £1,000 into his business. From the point of view of the business the dual
ASSET
CAPITAL.
The liability of a business to its proprietor is known as capital.
Every transaction has two effects.
Fred borrows £250 from Sid. The two effects are
Fred has £250 in cash. The “having” is an ASSET
Fred owes £250 to Sid. The “owing” is a LIABILITY
The two effects are equal and opposite, hence they balance.
A proprietor and the business are distinct. We look at the business from its point of view.
Fred puts £1,000 into his business. From the point of view of the business the dual
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3 Accounting equation
The first two principles lead to the third, the accounting equation. The Balance Sheet
(SFP) is based on the accounting equation.
Net assets Propr ietor's funds
Asse ts – liab ilit ies Capital + profits (or – losses) – d rawings
=
=
A BUSINESS
1 Introduce capital
You inherit £100,000 and use it to create a retail business selling books and stationary
called Fox Books. What is the dual effect?
Dual effect
The business has cash of £100,000 (asset)
The business owes you £100,000 (capital)
Fox’s position is
Assets Capital
£ £
19
2 Buy inventory with cash
Fox buys 500 books. The cost of each book is £5. What is the dual effect?
Dual effect
Fox’s position is
Assets Capital
£ £
20
3 Buy inventory on credit
In reality a business will not always pay for its purchases with cash but is more likely to
buy things on credit.
Fox buys inventory of 200 diaries. Each diary costs £10. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
21
4 Buy a delivery van
The delivery van will be a fixed asset because it is available for continuing use in the
business.
Fox buys a delivery van for £1,000 cash. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
22
5 Sell inventory for profit
Fox sells 200 books for £15 each. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
23
6 Sell inventory (on credit) for profit
It is equally likely that a business will sell goods on credit. When goods are sold on credit
an asset of the business called a receivable (debtor) is generated.
Fox sells 100 diaries to Badger . Badger will pay £12.50 per diary at the end of the
month. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
24
7 Pay expenses
In reality Fox will have been incurring expenses from its commencement. Fox
received and paid a gas bill for £500. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
25
8 Take out a loan
In order to fund your future expansion plans for Fox £20,000 is borrowed from Lendit
Bank.
The loan is to be repaid in two years’ time. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
26
9 Payment to trade payables
Fox pays cash of £1,500 towards the £2,000 owed to the supplier. What is the dual
effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
27
10 Receive cash from receivables
Fox’s receivable sends a cheque for £1,000. What is the dual effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
28
11 Drawings
You withdraw £1000 from the business. Such a withdrawal is merely a repayment of
the capital you introduced. Your withdrawal is called drawings. What is the dual
effect?
Dual effect
Fox’s position is
Net assets Capital
£ £
29
Practice question
Edward started a business as a sports equipment retailer on 1 July 2011
(1) Started the business by paying £5,000 into a business bank account.
(2) Bought a 10 tennis rackets for £50 each in cash.
(3) Bought 5 table tennis tables on credit from P Pong, for £100 each.
(4) Sold all the tennis racquets to for £750 cash.
(5) Sold 4 of the table tennis tables on credit to B Bjorg for £300 each.
(6) Paid rent of £250 cash.
(7) Drew £100 in cash out of the business for living expenses.
(8) Paid P Pong £250 on account.
(9) Received £1,200 from B Bjorg in full settlement of the amount due.
(10) Bought a van for use in the business for £4,000 cash.
(11) Paid a telephone bill for £150 in cash
Requirements
Show the accounting equation which results from the above transactions made
during Edward’s first two weeks of trading.
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Alternative presentation
The accounting equation is often expressed in a financial position statement called the
balance sheet. It shows the financial position at a point in time (snapshot).
Balance Sheet as at 31 December 2010
Non – current assets
£
Buildings 138,000
Fixtures and fittings 33,750
Motor vehicles 12,740
184,490
Current assets
Inventory 13,777
Trade receivables 12,775
Cash 6,200
32,752
Current liabilities
Trade payables 12,445
Loan interest 1,000
Accruals 15,445
(28,890)
Net current assets 3,862
188,352
Non – current liabilities
Loan (20,000)
Net assets 168,352
Opening capital 152,465
Profit 51,787
Drawings (35,900)
168,352
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Balance sheet classifications:
Non-current assets – are assets purchased not with the primary intention to re-sell them,
but rather to assist in the generation of future income.
Eg
Current assets – are assets which are cash or will be converted into cash within one
year, that is inventory, receivables or cash
Current Liabilities – are those liabilities which have the date of the balance sheet.
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Edward Balance Sheet as at................
Non – current assets
Motor vehicles
Current assets
Inventory
Trade receivables
Cash
Current liabilities
Trade payables
________
Net current assets
NET ASSETS
Opening capital
Profit
Drawings
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Double Entry Bookkeeping
Introduction
Bookkeeping is “the recording of monetary transactions” of a business. Each company
will employ a bookkeeper to ensure all the accounting records are kept up to date.
Double entry bookkeeping
Double entry bookkeeping is the fundamental concept underlying accountancy. All
accounting transactions should be recorded using the double entry system.
Every transaction is recorded individually in ledger accounts, and these accounts are
kept in the Nominal Ledger.
Ledger Accounts
A ledger account is sometimes called a T Account. It is called this because it looks like
the letter T.
It has two sides – the left side will be classed as the Debit side and the Right will be the
Credit side.
DR T Account CR
Every transaction in the ledger accounts will have a debit transaction and a credit
transaction in another account.
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It is important to learn which entries are “DEBITS” and which are “CREDITS”
DR T Account CR
Asset Increase Asset Decrease
Liability Decrease Liability Increase
Profit Decrease Profit Increase
We can put the balance sheet into this format plus trading transactions:
Dr Cr
Non current assets
Non current liabilities
Inventory
Receivables Payables
Bank Bank overdraft
Cash
Drawings Capital
Losses Profits
Purchases Sales
Expenses Income
Purchases - buying goods for which the business has the prime intention of re-selling.
Sales – the of those goods which the business normally buys with the intention of selling
to make a profit called GROSS PROFIT
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Example 1 – Edward again
Edward started a business as a sports equipment retailer on 1 July 2011
1st Started the business by paying £5,000 into a business bank account.
2nd Bought a 10 tennis rackets for £50 each in cash.
3rd Bought 5 table tennis tables on credit from P Pong, for £100 each.
4th Sold all the tennis racquets for £750 cash.
5th Sold 4 of the table tennis tables on credit to B Bjorg for £300 each.
6th Paid rent of £250 cash.
7th Drew £100 in cash out of the business for living expenses.
8th Paid P Pong £250 on account.
9th Received £1,200 from B Bjorg in full settlement of the amount due.
10th Bought a van for use in the business for £4,000 cash.
11th Paid a telephone bill for £150 in cash
Requirements
Show the accounting equation which results from the above transactions made
during Edward’s first two weeks of trading.
Bank/Cash
40
Once the ledger accounts have been completed they will need to be balance. In
order to do this you must:
I. Rule off the ledger account
II. Add up the largest side
III. Put the largest side total on both sides
IV. Insert the required amount to ensure the smallest side balances (carried down
figure).
V. Bring the carried down figure forward on the opposite side (bought down figure).
NOW GO BACK AND BALANCE THE LEDGER ACCOUNTS OF EDWARD
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1. F. Earls has the following assets and liabilities as of 30 November 2010: Accounts
payable 2,950, Equipment 10,500, Inventory 7,150, Motor Vehicle 5,290, Cash at
bank, 6280, Cash in hand 20 and Accounts receivable 5,790.
During the first week of December, Earls:
• Bought extra equipment on credit from P. Green for 1,500
• Bought extra inventory by cheque 670
• Accounts receivable paid to Erals 940 by cheque and 100 by cash
• Earls paid an account payable by cheque 950
• Earls puts an extra 500 cash into the business as capital.
Draw up a balance sheet after each of the above transactions have been
completed.
2. Write up the accounts for Charles to record the following transactions.
Dec 1 Started business with 1,000 in the bank
2 Bought a Motor Van for 1,000 paying by cheque
8 A loan from R. Kirk to the business of 2,000 cash is received
9 Paid 2,000 cash into the bank
10 Took 400 out of the bank for the cash till
11 Bought Motor Van on credit for 600, from P. Keenan
15 Paid P. Keenan 600 by cheque
16 Bought Fixtures by cheque for 500
20 Bought more fixtures on credit from A. Brown for 880
31 Bought more fixtures by cash 250.
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3. Enter the following transactions in double entry.
Nov1 Credit sales, C. Flanagan £465, S. Morgan £300, F. Hutchinson £645,
A. Adair £987.
Nov2 Credit purchases, N. Ward £123, F. Wood, £465, S. Duffy £786, N.
Hynd £56.
Nov5 Credit sales, C. Flanagan £560, S. Ruddle £560.
Nov6 Credit purchases, F. Wood £79, N. Hynd £560.
Nov7 Goods returned to us by F. Hutchinson £45, S. Ruddle £60
Nov9 Cash paid to us (the business) by A. Adair £900, S. Ruddle £500.
Nov10 We (the business) returned goods to N. Ward £19, N. Hynd £60.
Nov12 We (the business) received cheques from F. Hutchinson £600, C.
Flanagan £456.
Nov 25 We (the business) sold goods on credit to C. Flanagan £50, S.
Morgan £45.
Nov26 We (the business) paid by cheque the following, N. Ward £100, F.
Wood £465, N. Hynd £56.
Nov28 We (the business) returned goods to N. Ward £4.
4. Balance off the personal accounts above and identify which are accounts
receivable and which are accounts payable.
44
5. Enter up the necessary acounts and balance off the accounts at the end of the
month.
20X7
Sept 1 Sales on credit as follows: C Latham £250, R Patch £455
Sept 4 Purchases made on credit for £190 from D Moynihan
Sept 11 Goods returned form R Patch worth £170
Sept 20 Credit sales of £680 made to E Bright
Sept 24 Purchases made on credit for £370 from C Peck
Sept 25 Cheque received from C Latham for £250
Sept 30 We return goods to Moynihan worth £150
45
6. You are required to enter up the necessary accounts based on the following
information. All accounts should be balanced off and a trial balance should be
extracted as at 31 October 20X8.
20X8
Oct 1 Started business with £5,000 deposited in bank
Oct 4 Purchased delivery van for £1,800 paying by cheque
Oct 5 Bought office equipment on credit from Eves Ltd for £800
Oct 8 Paid for advertising £54 cheque
Oct 11 Withdrew £300 cash from bank
Oct 14 Bought stock on credit from: S Gabriel £56 and S Phipps £76
Oct 16 Returned stock to Gabriel worth £10
Oct 19 Sold goods on credit to: S Suckling £113 and C Dimmock £89
Oct 21 Paid for stationery £23 cash
Oct 22 Withdrew £275 from bank for personal use
Oct 26 Goods retuned by Suckling worth £27
Oct 29 Sales made on credit to J Rudling for £96
Oct 30 Commission received by firm: £29 cash
48
The Trial Balance
All the debit and credit balances extracted from the ledger accounts can then be
grouped together in a trial balance. This will check the accuracy of the entries made in
the ledger accounts.
EXAMPLE
The following are the balances on the accounts of Christine at 31 December 2010
£
Sales 47,140
Purchases 26,500
Trade receivables 7,640
Trade payables 4,320
General expenses 9,430
Loan 5,000
Fixtures & fittings 7,300
Motor vehicles 2,650
Drawings 7,500
Rent and rates 6,450
Electricity 1,560
Bank overdraft 2,570
Capital 10,000
Required
Prepare Christine’s trial balance as at 31st December 2010
50
Some errors will be identified by extracting a trial balance:-
• Transposition error
• Unequal entries
• Extraction error
Some errors will not be identified by a trial balance:-
• Compensating error
• Error of omission
NOW COMPLETE THE TRIAL BALANCE FOR EDWARD
52
Other movements in Inventories:
Dr Cr
Non current assets
Non current liabilities
Inventory
Receivables Payables
Bank Bank overdraft
Cash
Drawings Capital
Losses Profits
Purchases Sales
Expenses Income
Returns inwards Returns outwards
53
Example 2
Arathusa had the following transactions during July 2011.
1st Started a business with £10,000 cash.
2nd Purchased a display units for cash, £200.
3rd Paid rent for the premises for one month, £100.
4th Purchased goods on credit from Lion worth £1,000.
5th Returned goods to Lion to the value of £200.
6th Paid insurance for one month of £40.
7th Sold half of the goods on credit to Leopard for £400.
8th Took £60 cash for his own expenses.
9th Leopard returned half of the goods purchased.
10th Sold the remainder for the goods for cash of £420.
Required
Write up the relevant ledger accounts to record the above transactions then balance
the accounts.
58
Different Types of Profit
Profit & Loss Account
£
Sales X
Cost of goods sold (X)
__
GROSS PROFIT X
Other Income X
Expenses (X) incurred during the day to day operations
__
NET PROFIT X
__
Other income – eg bank interest received, rent received, commission received
Expenses – eg telephone, motor expenses, electricity, rent, wages & salaries
60
Practice Question
Clooney commences business on 1 April 2011. The following transactions take place in
his first two weeks of trading.
1 April Invests £50,000 in to a business bank account
1 April Purchases £5,000 worth of goods on credit from Pitt
2 April Clooney returned £1,000 worth of goods to Pitt
2 April Sells half of the remaining inventory for £6,000 to Downey on credit
4 April He writes a cheque to pay for the goods he received from Pitt
5 April Pays his rent for April of £450 by cheque
6 April Downey returns half the goods he purchased to Clooney
7 April He sells the balance of his inventory for £6,000 on credit to Diggs
10 April Purchased goods on credit for £7,000 from Pitt
11 April Withdraws £500 for his personal expenses
14 April He purchases a delivery van for £7,000 cash
Required
Prepare the ledger accounts of Clooney for the first two weeks of trading and the trial
balance at 14th April.
What is Clooney’s gross profit & net profit for the first two weeks of trading?
67
Profit & Loss Account
Sales
Less sales returns
______
Less cost of goods sold
Purchases
Less purchase returns
_____
Less closing inventory
_____
______
GROSS PROFIT
Expenses – Rent
______
NET PROFIT
W1 Closing inventory
Purchases
Returns
Sold
Sales Returns
Sold
Sales Returns
Sold
Purchases
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Effect upon the Capital Account
The net profit generated will increase the amount the business owes to the owner
Looking at Clooney £
Opening capital of the business was
Now complete the balance sheet of Clooney from your trial balance. The net profit you
have calculated will be added to the capital section as below:
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Clooney Balance Sheet
Non-current assets £ £
Motor van
Current assets
Inventory (same as in Gross Profit calc)
Receivables
-
Bank
Current liabilities
Payables
Net current assets
NET ASSETS
Capital
Profit for the period
Less Drawings
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The owner/s will be very interested in the capital figure as it represents the amount of
money the business owes them. For this reason, the full details of movements in the
capital account are provided.
A business will have many credit suppliers and customers so the accounts will need to
be kept separately so balances due with and from each can be identified. These will
be called personal accounts.
Example - Nedge
Enter the following transactions in double entry, balance off the personal accounts,
and identify which are accounts receivable and accounts payable.
1 Jan Credit sales, K.Tyler £900, H Ford £600, L Aitchison £1,200, D Bird £1900.
2 Jan Credit purchases, B Ward £500, A Curtis £930, L Durnall £1,500, G Powell £110.
5 Jan Credit sales, K.Tyler £1,000, L Larkin £1,100.
6 Jan Credit purchases, A Curtis £150, G Powell £1,200.
7 Jan Goods returned to the business by L Aitchison £100, L Larkin £100
9 Jan Cash paid to the business by D Bird £1,500, L Larkin £900.
10 Jan The business returned goods to B Ward £50, G Powell £60.
12 Jan The business received cheques from L Aitchison £1,100, K.Tyler £900.
25 Jan The business sold goods on credit to K.Tyler £80, H Ford £70.
26 Jan The business paid by cheque the following, B Ward £200, A Curtis £900, G
Powell £110.
28 Jan The business returned goods to B Ward £10.
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Other considerations
Carriage – when goods are delivered from suppliers or sent to customers, the cost of
delivering the goods is often an additional cost to goods purchased, or an additional
cost to the business for delivering the goods to the customer free of charge.
Carriage inwards – the cost incurred when goods are delivered by suppliers. This is
added to the cost of purchases in the calculation of gross profit.
Carriage outwards – the cost to the business to deliver goods to the customer. This
becomes a cost to the business if it is not recharged to the customer. It is deducted
from gross profit, like other costs, to calculate net profit.
81
Inventory and the second year of a business
Continuing with Edward from our first day. Here is his trial balance at the end of his first
two weeks of trading.
Edward Trial Balance
Dr Cr
Bank/cash 1,700
Capital 5,000
Purchases 1,000
P Pong (Payables) 250
Sales 1,950
B Bjorg (Receivables) -
Rent 250
Drawings 100
Van 4,000
Telephone 150
7,200 7,200
The accounting equation at the end of the two weeks was as follows:
£
Assets Van 4,000
Inventory 100
Receivables -
Cash (1850 – 150) 1,700
–––––
5,800
Liabilities Payables (250)
–––––
5,550
–––––
£
Capital 5,000
Profit (800 - 150) 650
–––––
5,650
Drawings (100)
–––––
5,550
–––––
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The equation could also be expressed as follows:
Edward Balance Sheet
Non-current assets £ £
Motor van 4,000
Current assets
Inventory 100
Receivables -
Cash 1,700
–––––
1,800
Current liabilities
Payables 250
–––––
1,550
–––––
5,550
–––––
Capital 5,000
Profit for the period 650
–––––
5,650
Less Drawings 100
–––––
5,550
–––––
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Lets now use these details as if it was the end of the accounting period. The closing
inventory of £100 is now the opening inventory for the next accounting period. This will
be adjusted in the calculation of cost of goods sold within the profit and loss account
as follows:
£
Sales X
Less sales returns (X)
______
X
Less cost of goods sold
Opening inventory 100
Purchases X
Less purchase returns (X)
_____
X
Less closing inventory (X)
_____
(X)
______
GROSS PROFIT X
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Capital & Revenue Expenditure
Capital expenditure is incurred when a business spends money either to buy non-
current assets or add to the value of non-current assets
Revenue is spent on running the business on a day-to-day basis
Consider a delivery van:
Capital/Revenue Asset/Expense
Purchase price of the van
Motor insurance
Car tax
Adding a lift to the back of the van
Other examples:
£1,500 spent on machinery, of which;
£1000 relates to improvements
£500 relates to repairs
Rendering & painting the outside of a
new building
Three years later, painting the same
Building
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Revenue expenditure is shown as a cost in the Trading, profit and loss account
Capital expenditure will result in an increase in non-current assets in the Balance Sheet
The difference is important as it affects the profit of the business and the assets of the
business which in turn impacts upon owners’ capital.
In the same way that purchasing a non-current asset is capital expenditure the
proceeds from the disposal of a non-current asset is a capital receipt and not sales
revenue.
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Financial Statements
Profit & Loss Account for the year ended........
Sales
Less sales returns
Less cost of goods sold
Purchases
Less purchase returns
Less closing inventory
GROSS PROFIT
Other income
Expenses
Rent
Electricity
Telephone
Wages
Stationary
Cleaning
89
Balance Sheet
Non-current assets £ £
Buildings
Equipment
Motor vehicles
Current assets
Inventory (same as in Gross Profit calc)
Receivables
-
Bank
–-––––
Current liabilities
Overdraft
Payables
–––––-
Net current assets
––-–––
NET ASSETS
––-–––
Capital
Profit for the period
–––-––
Less Drawings
––-–––
––-–––
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Practice Question
From the following trial balance of Bonnie, you are asked to draw up a profit and loss
account (income statement) for the year ended 31 March 2011 and a balance sheet
as at that date.
Dr Cr
£ £
Advertising 410
Bank 11,990
Capital as at 1 April 2010 153,700
Carriage inwards 460
Carriage outwards 390
Cash in hand 1,754
Drawings 23,080
Equipment 37,000
Insurance 1,500
Inventory as at 1 April 2010 8,660
Motor repairs 1,180
Premises 150,000
Purchases 199,990
Rates 8,700
Rent 6,520
Returns inwards 750
Returns outwards 1,120
Sales 336,000
Sundry expenses 656
Trade receivables 17,900
Trade payables 23,120
Vehicles 24,000
Wages 19,000
513,940 513,940
Inventory as at 31 March 2011 was valued at £23,710
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Bonnie
Income statement for year ended 31 March 2011
£ £
Sales
Less Returns inwards
Net turnover
Less Cost of goods sold
Opening inventory
Add Purchases
Less Returns outwards
Add Carriage inwards
Less Closing inventory
Gross profit
Less Expenses
Wages
Insurance
Advertising
Motor repairs
93
Bonnie
Balance Sheet as at 31 March 2011
£ £
Non-current Assets
Premises
Equipment
Vehicles
Current Assets
Inventory
Trade receivables
Bank
Cash
Current Liabilities
Trade payables
Financed by:
Capital
Add Net profit
Less Drawings
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Depreciation
Expenditure
Capital Revenue
Balance Sheet Profit & Loss
Assets
Buildings
Machinery
Costs
One off expenses
Electricity
Repairs
Including
“Improvement to an asset”
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Materiality Concept
The Framework that we looked at in chapter 1 says;
“Information is material if its omission or misstatement could influence the economic
decisions of users.”
This means that a company will normally have a capital expenditure limit based on
materiality. Above this monetary limit the asset is recorded in the balance sheet as it is
considered to meet the above definition.
Below the limit the asset will be written off as a cost in the profit and loss account.
Non-current assets
Generally non-current assets will be owned by the business for more than one year.
They are carried in the balance sheet as capital expenditure but are used within the
business on a day to day basis to help generate income rather than resold. They are
initially recorded at their HISTORICAL COST.
As a result of their continued use, most non-current assets will wear out over time or use.
In accordance with the accruals or matching concept the cost of consuming these
assets need to be matched with the income they generate but based on the
accounting:
Asset is in the Income is in the
Balance Sheet Profit & Loss Account
This does not follow matching. To solve this problem we will use DEPRECIATION.
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Depreciation
“Depreciation is the systematic allocation of the depreciable amount of an asset over it
useful life.”
Depreciable amount - The cost of an asset less its residual value.
Residual value - The estimated amount that an entity would currently obtain from
disposal of the asset, after deducting the estimated costs of disposal.
Useful life is;
- The period over which an asset is expected to be available for use by an entity;
or
- The number of production or similar units expected to be obtained from the
asset by the entity
Useful life is a matter of judgement.
Methods of depreciation
There are two main methods of calculating depreciation:
Straight line (based on time)
(Cost – residual value)
______________________ = constant depreciation charge
useful life of the asset
Eg If a delivery van was bought by a business for £22,000. The van has an expected life
within the business of four years, after which it could sell it for £2,000.
The cost of depreciation would be:
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If the van was expected to be scrapped after the four years and had no residual value,
the cost of depreciation would be:
Remember we considered the difference between capital and revenue. Consider the
delivery van as it gets older – would you expect revenue expenditure to increase or
decrease?
Why?
Practice Question
Violet purchased a pressing machine for £23,000. Violet estimated that the machine
will last 5 years and will have a residual value of £3,000. How much depreciation will be
charged each year?
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Example – Choice of policy
Pete purchased a non-current asset on 1st July for £50,000. The asset has an expected
useful life of 5 years and a residual value of £5,000. Pete has a year end of 31
December.
If the business is attempting to ‘match’ costs with the revenues (sales) from the use of
the non-current asset then it may be more appropriate to use a different method of
calculating depreciation.
100
Reducing balance
NBV x selected % = falling depreciation charge
(NBV is cost less accumulated depreciation)
Using the same delivery van costing £22,000 but applying a reducing balance rate of
20%. The depreciation cost for the first three years would be;
Over time the depreciation charge reduces but as the asset ages the repairs and
maintenance increases.
101
It could be argued that the reducing balance method is better at matching the total
costs (capital and revenue) of a non-current asset with the revenues (sales) generated
from its use.
Accounting Entries:
Once you have calculated the depreciation charge it will be entered into the
accounts via a journal.
The journal for depreciation is:
Dr Depreciation expense (Profit and loss account)
Cr Accumulated Depreciation (Balance Sheet)
Choice of method
The purpose of depreciation is to spread or allocate the total cost of a non-current
asset over the periods in which it is to be used.
The method chosen should be that which allocates cost to each period in accordance
with the proportion of the overall economic benefit from using the asset over its useful
life (the total period over which it is going to be used).
The choice is subjective but is supported by accounting policies and concepts:
Accruals/Matching
Going concern
Both of which we considered earlier
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Increases in value of non-current assets
All non-current assets are initially recorded at their HISTORICAL COST ie what you paid
for them.
According to IAS 16 it is possible to carry your asset at its market value rather than
historical cost. This adjustment is referred to as a REVALUATION.
Dr Non-current asset
Cr Revaluation reserve
The new increased value of the asset is then depreciated over its remaining useful
economic life
Example
Willow buys a machine on 1 January 2002 for £500,000. The machine has an estimated
useful economic life of ten years with a residual value of £20,000. A straight line method
of depreciation was adopted.
On 1 January 2007 willow decides to revalue its machine to £750,000 in line with IAS 16.
The useful economic life remains unchanged.
Required:
Show how the revaluation would be accounted for and the subsequent depreciation
charge following the revaluation.
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Land and Buildings
Due to its nature land does not normally require depreciation. Only land subject to
extraction eg coal mines or oil fields would be depreciated.
Buildings however must be depreciated as although the value of property generally
increases over time a building suffers wear and tear also.
IT IS IMPORTANT TO REMEMBER THAT DEPRECIATION IS A METHOD OF ALLOCATING THE
COST OF A NON-CURRENT ASSET TO THE PROFIT AND LOSS ACCOUNT IT IS NOT A
VALUATION METHOD.
Net book value is merely the difference between the cost or valuation of the asset and
the accumulated depreciation to date. It does not represent the market value of the
asset.
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Investment Properties
These types of properties have an accounting standard of their own SSAP 19.
There are defined as
Investment property
An interest in land and/ or buildings:
• In respect of which construction work and development have been completed
and
• Which is held for its investment potential, any rental income being negotiated at
arm’s length
Investment properties should NOT be depreciated instead they are included in the
balance sheet at market value and a revaluation reserve created.
Note: IAS 40 the international standard for investment properties states that the gains
and losses arising on the property are included in the profit and loss account.
105
IAS 8 Accounting policies, Changes in accounting estimates and errors
Accounting policies
The specific principles, bases, conventions, rules and practices applied by an entity in
preparing and presenting the financial statements.
SELECTING ACCOUNTING POLICIES
In selecting accounting policies an entity must firstly consider the requirements of the
applicable accounting standards.
In all other situations policies should be selected so as to result in information that is
relevant and reliable in line with the framework.
Relevant – to the economic decision making needs of users; and
Reliable
• Faithful representation
• Reflect the substance
• Neutral, free from bias
• Prudent
• Complete
Consistency – when a business chooses to treat certain transactions in a particular way
it should continue to treat similar transactions in the same way.
Disclosure
As each business will adopt its own set of accounting policies its is important for
comparability that each business discloses its chosen policies. That way any differences
in policies can be taken into account when comparing different businesses.
This will include the chosen policy for depreciation – the useful life for the straight line or
the percentage used for reducing balance method.
106
Changing accounting policies
An accounting policy may be changed if and only if the new policy will give a more fair
representation of the transactions and balances of the entity. We discussed the idea of
FAIR PRESENTATION (TRUE & FAIR VIEW) in chapter 1. A change in accounting policy
should be to meet this concept and not to improve the figures reported.
Remember – accounting information should be free from bias.
107
QUESTIONS TO BE ATTEMPTED IN CLASS
1. Which of the following is not a reason for providing for depreciation of non-current
assets?
A Wear and tear of assets
B Technical obsolescence
C Assets may increase in value
D Depletion
2. An asset was purchased on 1.1.20X3 for £5,500 and is to be depreciated at 20%
reducing balance. What would be the net book value of the asset as at 31.12.20X5?
A £3,300
B £2,200
C £3,520
D £2,816
3. Keeping the same depreciation policy even if it may not give a realistic asset value
at the year end is an example of:
A Prudence
B Accruals
C Going concern
D Consistency
4. Equipment was purchased on 1.1.20X6 for £25,000 and is to be depreciated at 30%
reducing balance. What would be the net book value of the asset as at 31.12.20X7?
A £12,250.
B £10,000.
C £5,250.
D £17,500.
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5. The accruals concept states that:
a) Transactions should be recorded at historical cost
b) A company can not change its accounting policy
c) A business should be consistent in how it treats accounting transactions both within
an accounting period, and from one period to the next
d) Revenues and costs for an accounting period should be matched in order to
calculate the profit for the period.
6. The buildings from which the business trades, should not be depreciated because:
a) They increase in value with the passage of time
b) IAS 40 (Investment property) states they may not be depreciated
c) The accruals concept indicates that they are not subject to depreciation
d) None of the above.
7. Depreciation is:
a) Transferred to the Depreciation Account
b) The salvage value of a non-current asset
c) The part of the cost of anon-current asset consumed during its period of use by the
business
d) The amount of money spent in replacing assets.
109
R Grey is in business as a wholesale supplier of motor equipment. The following is his trial
balance as at 31 March 2011.
DR CR
£ £
Capital (at 1 April 2010) 9,000
Accounts payable 10,000
Bank 400
Accounts receivable 16,000
Drawings 11,000
Insurance 500
Wages 12,600
Opening inventory 5,000
Purchases 62,000
Rent 1,500
Sales 100,000
Motor vehicle 10,000
119,000 119,000
You are provided with the following additional information.
1. The value of closing inventory at 31 March 2011 was £6,000.
2. Depreciation of £6,000 is to be charged this year for the motor vehicle.
3. Goods taken for personal use during the year was estimated to be worth £1,000.
Required:
Prepare R Grey’s income statement for the year to 31 March 2011 and a Balance Sheet
as at that date.
112
Accounting Ratios and Analysing Accounts
Introduction
Accounting ratios are used to enable us to analyse and interpret financial statements
(accounts). They can also be of use when preparing financial statements from
incomplete records.
Margin Mark up
£ % £ %
Sales X 100 Sales X 120
Cost of sales (X) 80 Cost of sales (X) 100
Gross Profit X
20 X 20
If we look at the following trading account:
Sales 5,000
Cost of sales 4,000
Gross profit 1,000
Gross profit mark-up is
Gross profit margin is
113
Example
Margin 25% Sales £1,000
Required:
What is the gross profit and cost of sales?
£ %
Sales
Cost of sales
Gross profit
Example
Mark-up 25% Cost of sales £600
Required:
What is gross profit and sales?
£ %
Sales
114
Cost of sales
Gross profit
Example
Mark-up 10%
Sales £6,600
Opening inventory £300
Closing inventory £500
Required:
Complete a trading account from the above information.
£ %
Sales
Cost of sales
Opening inventory
Purchases (Balancing Figure)
Closing inventory
Gross profit
115
Example
Margin 5%
Purchases £2,840
Opening inventory £800
Closing inventory £600
Required:
Complete a trading account from the above information.
£ %
Sales
Cost of sales
Opening inventory
Purchases
Closing inventory
Gross profit
116
Calculating missing figures
Using the information that you have and the cost structure it is possible to calculate
missing figures in the trading account eg if inventory is lost or damaged or if
sale/purchase invoices go missing.
Example – lost inventory
Margin 20%
Sales £100,000
Opening inventory £1,000
Closing inventory (after fire) £3,000
Purchases £82,000
Required:
Complete a trading account from the above information.
Sales
£ £ %
Cost of sales
Opening inventory
Purchases
Closing inventory
Inventory lost in fire (balancing figure)
Gross profit
117
Example – purchases
Margin 25%
Sales £150,000
Opening inventory £10,000
Closing inventory £20,000
Purchases ?
Required:
Complete a trading account from the above information.
Sales
£ £ %
Cost of sales
Opening inventory
Purchases - (balancing figure)
Closing inventory
Gross profit
118
Example – sales
Mark-up 20%
Sales ?
Opening inventory £15,000
Closing inventory £30,000
Purchases £120,000
Required:
Complete a trading account from the above information.
Sales – (balancing figure)
£ £ %
Cost of sales
Opening inventory
Purchases
Closing inventory
Gross profit
119
Gross Profit Margin
Gross Profit
_______________ x 100
Sales Revenue
The gross profit margin represents the amount of gross profit generated for every £100 of
sales revenue.
It is referred as an accounting ratio and is used as a test of profitability and the pricing
policy of a business.
Consider the following:
Trading, profit and loss account for the year ended 31 December....
2009 2010
£ £
Sales
7,000 8,000
Cost of sales
(5,600) (7,000)
Gross profit
1,400
1,000
Calculate the gross profit margin for each year
2009 2010
120
Now consider the information you have:
Increased/Fallen
What has happened to sales?
What has happened to cost of sales?
Gross profit margin has therefore
Can you think of any reasons for this?
• Cost of goods sold have increased without an increase in selling price
Why would you not increase selling price?
• Perhaps goods have been wasted or stolen resulting in higher cost but not
increased income
• There may have been a change in the types of goods sold what we call the
SALES MIX
• Perhaps the sales price has been reduced without a drop in cost of the goods
Why would this be done?