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ISBN: 978 1 5104 3665 7
eISBN: 978 1 5104 3671 8
© Sheila Robinson and Frank Wood 2018
Fifth edition published 2007
This sixth edition published in 2018 by Hodder Education,
An Hachette UK Company
Carmelite House
50 Victoria Embankment
London EC4Y 0DZ
www.hoddereducation.com
Impression number 10 9 8 7 6 5 4 3 2 1
Year
2021 2020 2019 2018
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Typeset in Bliss Light 11/13pt by Hart McLeod Ltd.
Printed in Italy
A catalogue record for this title is available from the British Library.
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Contents
Preface
How to use this book
PART 1 Introduction to principles of accounting
CHAPTER 1 Introduction to accounting principles
CHAPTER 2 Professional ethics
CHAPTER 3 The accounting system
CHAPTER 4 Accounting concepts
CHAPTER 5 The accounting equation and the statement of
financial position (balance sheet)
CHAPTER 6 The double entry system for assets, liabilities and
capital
CHAPTER 7 The double entry system for the asset of inventory
CHAPTER 8 The double entry system for expenses and
revenues
CHAPTER 9 Balancing off accounts
CHAPTER 10 The trial balance
Multiple-choice questions – Set 1 (1 to 20)
PART 2 Introduction to financial statements and ratios
CHAPTER 11 Introduction to trading and profit and loss accounts
(income statements)
CHAPTER 12 Statements of financial position (balance sheets)
CHAPTER 13 Financial statements: further considerations
CHAPTER 14 Introduction to accounting ratios
CHAPTER 15 Capital and revenue expenditure
Multiple-choice questions – Set 2 (21 to 40)
PART 3 Books of original entry
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CHAPTER 16 Business documentation
CHAPTER 17 Accounting for sales, discounts and internal
control
CHAPTER 18 Accounting for purchases
CHAPTER 19 Accounting for returns
CHAPTER 20 Cash book and cash discount
CHAPTER 21 Petty cash and the imprest system
CHAPTER 22 The general journal
CHAPTER 23 Control accounts
CHAPTER 24 Bank reconciliation statements
Multiple-choice questions – Set 3 (41 to 60)
PART 4 Accounting adjustments
CHAPTER 25 The nature of depreciation and calculations
CHAPTER 26 Double entry records for depreciation and the
disposal of assets
CHAPTER 27 Bad debts and provision for doubtful debts
CHAPTER 28 Accruals, prepayments and other adjustments for
financial statements
CHAPTER 29 The extended trial balance
CHAPTER 30 Inventory valuation
CHAPTER 31 Errors and their effect on accounting records
CHAPTER 32 Suspense accounts and errors
Multiple-choice questions – Set 4 (61 to 80)
PART 5 Financial statements of other organisations
CHAPTER 33 Receipts and payments accounts and income and
expenditure accounts
CHAPTER 34 Partnership accounts: an introduction
CHAPTER 35 New partners: entries on admission, goodwill and
premiums
CHAPTER 36 Costing principles
CHAPTER 37 Manufacturing accounts
CHAPTER 38 Accounting for limited liability companies
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CHAPTER 39 Accounting for cooperatives
CHAPTER 40 Analysis and interpretation of accounting
statements
Multiple-choice questions – Set 5 (81 to 100)
PART 6 Accounting for the entrepreneur
CHAPTER 41 The banking system and payroll accounting
CHAPTER 42 Single entry and incomplete records
CHAPTER 43 The business plan and cash flow projections
Multiple-choice questions – Set 6 (101 to 120)
PART 7 Technology, SBA and other considerations
CHAPTER 44 Computers and accounting systems
CHAPTER 45 School-based assessment (SBA) – research
project
Appendix A Glossary of accounting terms
Appendix B Downloadable model layouts for financial
statements and worksheets
Appendix C Answers to multiple-choice questions
Appendix D Answers to chapter exercises
Index
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Preface
This well established textbook is suitable for students studying for the CSEC
Principles of Accounts Examinations either at school or as a private candidate
and for students studying book-keeping and accounting for the first time and
starting on the path of a professional career seeking a qualification.
In this sixth edition of the textbook the new syllabus from the Caribbean
Examination Council ‘Principles of Accounts – CXC 10/G/SYLL 17’ has
been fully covered and students are advised to obtain a copy of the syllabus
from the Caribbean Examinations Council (CXC) website to ensure that they
are fully aware of the subject requirements.
The book has been refreshed and includes the latest changes and
developments in international accounting standards while taking into account
that the use of both International and Traditional terminologies varies across
the Caribbean.
The main changes to the terminology are as follows:
International
Traditional
Accounts payable
Creditors
Accounts receivable
Debtors
Income statement
Trading and profit and loss account
Inventory
Stock
Non-current assets
Fixed assets
Non-current liabilities
Long-term liabilities
Statement of financial position Balance sheet
Each chapter has been revised and refreshed and follows a logical structure
from the initial ‘Specific objectives’, working through the chapter topic, a
reminder summary and finally questions to practise and assess the students
competence. New chapters have been added to cover the new syllabus and
these include:
Chapter 2 – Professional ethics
Chapter 16 – Business documentation
Chapter 36 – Costing principles
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Chapter 41 – The banking system and payroll accounting
Chapter 43 – The business plan and cash flow projections
Acknowledgement of contributors
There have been many who have contributed to the production of this 6th
edition of Frank Woods PoA for the Caribbean, all of whom I would like to
thank.
I have appreciated the suggestions and contributions by the teachers and
lecturers in the Caribbean and in particular:
Wendy Wong Sing, FCCA CA, Chartered Accountant and Management
Consultant in Trinidad and Tobago, who has over 30 years’ experience in the
field of accounting.
Andrienne Jones, teacher with a Master Degree in Accounting and Head of
the Business Studies Department in Ardenne High School, Jamaica.
Anslem Ragoonanan, teacher of CSEC Principles of Accounts and
Business Studies at Preysal Secondary School in Trinidad and Tobago.
Thanks also to Malcolm Robinson for his continued support and
contributions and Stephen Clark who tirelessly assists me in the information
technology aspect.
Finally and by no means least, my sincere thanks go to Maureen Baldeo,
Field Editor – Caribbean, Hodder Education, for her tremendously hard work,
enthusiasm, and contributions to this edition.
Sheila Robinson
March 2018
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How to use this book
The book is structured into seven parts to provide a logical learning sequence
for students. There are four appendices and an index at the end of the book.
Chapter content
Each chapter starts with ‘Specific objectives’ to guide students and teachers
to the sequence of topics within. There are realistic examples of all
theoretical concepts and practices within each chapter. ‘Helpful Hints’ have
been included to guide students and teachers to topics which students have
had most difficulties with in the CSEC Principles of Accounts Examinations
over the years. Finally a reminder ‘Summary’ is shown at the end of each
chapter summarising the chapter contents.
End of chapter exercises
There are exercises at the end of each chapter varying in the levels of
difficulty, from simple to more complex. Some ‘Case study’ type questions
are included in appropriate chapters. These are especially helpful to students
writing the Paper 032 of the CSEC Principles of Accounts Examination. The
answers to all questions are found in Appendix D except for those marked
with an X after the question number. The answers to these extension (X)
questions can be found in the Teacher’s Manual on the Hodder Education
website (www.hoddereducation.com/POAResources).
Multiple-choice questions
Parts 1 to 6 are each followed by a set of 20 Multiple-choice questions for
students to check their progress, and to give them practice for their
examination. Answers to these appear in Appendix C.
Glossary, model layouts for financial
statements and worksheets
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A comprehensive glossary can be found in Appendix A. Model layouts for
the financial statements and worksheets are located in Appendix B and
these are also available for download from the website
(www.hoddereducation.com/POAResources).
Additional website support
Updated case studies and suggested solutions are also available at
www.hoddereducation.com/POAResources.
I hope that students new to book-keeping and accounting will enjoy this
subject as much as I have over the years and as much as the late Frank Wood
did, both as my teacher and mentor.
Sheila Robinson
March 2018.
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1 Introduction to accounting
principles
Specific objectives
After you have studied this chapter you should be able to:
• explain the concept and purposes of accounting
• identify the users of accounting information
• describe careers in the field of accounting.
1.1 Aims of a business
The aim of any business, whether large or small, is to be successful. To
achieve this, it is imperative that it practises sound management techniques:
• employs competent and skilled staff
• purchases goods/services competitively
• sells goods/services competitively
• manages the finances of the business
• makes a profit.
The owners of the business will have invested their own money into the
venture with the intention of making profits and having a sustainable and
successful business. The money they have invested, in accountancy terms, is
called ‘capital’ and this is used to provide funds to enable the business to start
trading. To ensure that the capital is not put at risk, a good financial control
system is vital.
1.2 Basic concept of financial control
Managing the financial aspect of any business is important to enable the
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business to trade effectively and create good relations with suppliers and
customers. The following example demonstrates this:
Exhibit 1.1 Basic concept of financial control
Example 1.1: Joe has recently had the opportunity to hire a small
woodworking business which previously made fencing panels and posts. He
has always wanted to have his own business so decides to go ahead and rents
the workshop, purchases timber and starts trading on 1 March. The timber
cost $15,000, and after machining it he was able to sell the resulting fencing
for $22,000.
During the first three months of trading his expenses amounted to $2,500.
Joe’s sales are as follows:
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Looking at the above example, you can see that Joe purchased his timber at
the right price to enable him to make a profit, before his expenses, of $7,000.
After paying his expenses amounting to $2,500 for his first three months of
trading, he is left with a profit of $4,500.
Helpful Hint!
Question:
Why is it essential to have good financial control?
Managing the finances of any business is the difference between success
and failure as can be seen in Exhibit 1.1. However, it must also be noted that
all businesses that provide goods or services must have a market in which to
sell their products. Having available good financial information enables
management with planning, budgeting and making financial decisions to
achieve success.
1.3 What is book-keeping?
Book-keeping is the process of recording business transactions and
managing such records in the books of accounts or by using a computerised
software accounting package. In other words, it simply means ‘keeping the
books of account’. It is the first stage in the accounting process. Some
computerised software accounting packages are Excel, Peachtree (Sage 50)
QuickBooks and Sage.
Accuracy in the recording process is crucial at the book-keeping stage.
Any errors that occur may be difficult to find at a later stage and can have a
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significant effect on the financial statement if not detected and corrected.
Therefore, it is important to take care when entering data initially to ensure
complete accuracy.
1.4 What is accounting?
Once the book-keeper has entered all the information in the accounting
system, the information is made available to the accountant. The accountant
will then present this information in the form of the financial statements, that
is, the trading and profit and loss account (income statement) and statement
of financial position (balance sheet), to the owner(s) and manager(s) of the
business. These reports are then used to aid the financial control and
management of a business. This involves analysis and interpretation of the
financial statements, forecasting and budgeting.
1.5 Importance and need for
accounting
As stated earlier, businesses must operate profitably otherwise they will cease
to exist. The financial statements produced by a business’s accounting
department aim to show clearly the profit or loss that has been made and the
financial position of the business.
The two most important statements are:
1 trading and profit and loss account (income statement)
2 the statement of financial position (balance sheet)
Both these statements have to be checked and verified by a firm of auditors
as part of the legal requirement for correct financial reporting. It is essential
that accurate financial information is available to the auditors to enable them
to fulfil their functions properly.
In producing these financial statements, the business must follow certain
accounting procedures and practices in a formal sequence. This sequence is
shown in Exhibit 1.2. Each part of the sequence is explained briefly.
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Exhibit 1.2 The accounting sequence
The financial reports and statements produced by this process are used by the
owners and managers to monitor the continuing viability of the business.
There are, however, other groups who are keenly interested in the activities
of the business. These include:
• Inland Revenue – collects employees’ and business taxes
• Investors – these may be private individuals, companies or banks, any or
all of which will want to monitor the performance of the business to ensure
that they will get a return on their investment
• Suppliers – this group will need to be sure of the financial stability of the
business before accepting orders
• Customers – they will need to be sure of the financial stability of the
business before placing orders
• Employees – a sound business with a good working environment will help
to keep employees’ morale high and will be able to attract high-calibre new
staff.
1.6 Types of business organisation
Business organisations are identified according to their structure and financial
make-up. The classification will determine an organisation’s legal status and
what financial reporting is required of the organisation. Business
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organisations fall into the following categories:
• Sole trader – An individual trading alone in his or her own name, or
under a recognised trading name. He or she is solely liable for all business
debts but when successful takes all the profits.
• Partnership – A group of more than two people and a maximum of
twenty, carrying on a particular business with a view to making a profit.
Partnerships will be covered in Chapter 34.
• Limited companies (both private and public):
(a) private limited company is a legal entity which must have at least
one shareholder and one director who may be the sole shareholder.
The liability is limited to the amount that they have agreed to invest.
(b) A public limited company is, again, also a legal entity with limited
shareholder liability, but, unlike a private company, it can ask the
public to subscribe for its shares.
• Non-trading organisations – Clubs, associations and other nonprofit-making organisations are normally run for the benefit of their
members to engage in a particular activity and not to make a profit. Their
financial statements will take the form of income and expenditure
accounts, to be covered in a later chapter.
• Cooperative society – A legally constituted business entity formed for
the explicit purpose of furthering the economic welfare of its members and
that of the wider society by providing them with goods or services.
Cooperative societies will be covered in a later chapter.
1.7 Careers in accounting
There are many opportunities open today for those who are considering a
career in accounting. Since accounting is essential to the successful operation
of all businesses, there will always be a need for trustworthy competent
accounting professionals to provide vital financial information to assist
management.
The areas in which one can pursue such a career range from working in the
public or private sector to working for large or small businesses, or
individually. These areas include:
• record keeping
• financial reporting
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•
•
•
•
•
•
taxation
auditing
corporate finance
consultancy
insolvency
forensic accounting.
Many people enter into their initial job without any qualifications and start
their career with on-the-job training while studying for further qualifications.
The following job opportunities would be available to them:
• accounts clerk
• auditing clerk
• accounts receivable clerk
• accounts payable clerk
• accounts assistant
• book-keeper
• bank clerk
• management trainee
• payroll clerk.
If, however, the prospective employee has a degree and has, or is working
towards, an accounting qualification with one of the accountancy bodies such
as Association of Accounting Technician (AAT), Association of Chartered
and Certified Accountants (ACCA), Institute of Management or Chartered
Institute of Public Finance, then the following positions would be possible to
attain:
• Company/public accountant
• Auditor
• Tax professional.
• Financial advisor
• Consultant
• Forensic accountant
Finance features at the heart of business throughout the world. Accounting
professionals work at all levels from office work to investment banking,
auditing and consultancy. The opportunities are endless.
Summary
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• The basis of business is trading with others and good financial
control is essential if the organisation is to succeed.
• Financial control means ensuring that the sales of a business are
greater than the cost incurred by the business, thus providing a
profit.
• The difference between book-keeping and accounting is shown.
• The two most important financial statements are:
– trading and profit and loss account (income statement)
– the statement of financial position (balance sheet).
• The accounting sequence involves recording, classifying and
summarising data and then communicating the information.
• A number of groups or agencies have a keen interest in the
financial performance of businesses. These include the Inland
Revenue, investors, suppliers, customers and employees.
• Businesses operate through various organisations such as a sole
trader, a partnership, private or public limited company and
cooperative society. Charitable clubs and societies operate as nonprofit-making organisations.
• There are many careers in the field of accounting whether working
for a small or large organisation. They range from starting as an
account clerk to becoming an accountant or working in auditing, tax
or as a financial advisor.
A glossary of terms can be found in Appendix A at the back of the book.
Helpful Hint!
Question:
How is the work of an accounts clerk (book-keeper) similar to that of
an accountant? How is it different?
Chapter 1 Exercises
1.1 State briefly the importance of good financial control to the
owners of a business.
1.2 There are a number of bodies or individuals, other than the
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owners, who will have an interest in the financial performance
statements of a business. List these interested parties and
explain briefly the reasons for their interest.
1.3X Profit is the most important aim of any business. Explain how
this can be attained.
1.4 What are the two most important financial documents that a
business needs to produce?
1.5X What qualities would an employer look for when interviewing a
prospective candidate for the position of accounts assistant?
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2 Professional ethics
Specific objectives
After you have studied this chapter you should be able to:
• understand the ethical principles in the field of accounting
• discuss ethical issues in the field of accounting
• distinguish between appropriate and inappropriate application of
accounting principles.
2.1 Introduction
This chapter introduces you to ethical principles in accounting which are
important to you in your studies or work in a financial environment. By
studying this chapter you will no doubt want to reflect on your own beliefs
and values and how they affect your everyday personal behaviour. As a
member of a family you will have been brought up to know the difference
between what is the ‘right thing to do’ and what is the ‘wrong thing to do’.
As you commence your career in the finance sector you become a member
of the profession and bring to your job not only your technical competence
but also, most importantly, the way you conduct yourself and make decisions.
From the personal perspective, ethics may be described as the morals
governing human behaviour. Professional ethics are more clearly defined
and often referred to as ‘a code of behaviour considered correct for a specific
group, association or profession’. Ethics are also influenced by the factors
outlined below.
2.2 Factors that influence ethical views
• Culture – what is immoral or illegal in some cultures is acceptable
behaviour in others. Thus, ethics can differ in different cultures.
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• Law – illegal behaviour is unethical even when the law differs between
countries. A company’s code of ethics always states that an employee must
abide by local laws of the country.
• Consequences – individuals react to ethical or unethical behaviour based
on the consequences.
• Code of ethics – when there is a code of ethics, behaviours are judged
based on the code.
2.3 Ethical codes
Professional ethics has been very much in the public domain recently
following some high-profile corporate failures (such as Enron, Barings Bank,
Worldcom etc.) which led to companies being questioned over their ethical
culture and behaviour. This resulted in the International Federation of
Accountants (IFAC), through its committee, issuing the ‘Code of Ethics for
Professional Accounting’ in 2001. The aim of the code was ‘to strengthen the
worldwide accountancy profession’ and this became mandatory for those
accounting bodies who are members of the IFAC.
Recently, revision of the code has been carried out by the International
Ethics Standards Board for Accountants (IESBA) to enhance high quality
ethical standards for members for use around the world.
As a student or member of a professional accountancy body you will be
expected to comply with your professional body’s code of ethics. In many
cases the professional bodies have included training courses as part of their
CPD (continuous professional development) programmes and have also
included the topic in their assessment programmes.
Through your employment you will also be required to adhere to your
employer’s own ethical codes.
2.4 Fundamental principles of ethical
behaviour from the IESBA Code of
Ethics
The IESBA Code requires accountants to adhere to the five fundamental
principles of ethical behaviour as follows:
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• Integrity – A professional accountant should be straightforward and honest
in all professional and business relationships.
• Objectivity – A professional accountant should not allow bias, conflict of
interest or undue influence of others to override professional or business
judgements. This means as an accountant in business you must have
independence of mind and judgement. If you are asked or encouraged to
become involved in unlawful activities, you must refuse.
• Professional competence and due care – A professional accountant has a
continuing duty to maintain professional knowledge and skill at the level
required to ensure that a client or employer receives competent professional
service based on current developments. This means that the accountant
must always be kept abreast of new developments in the field that are
relevant to what he/she does. A professional accountant should act
diligently and in accordance with applicable technical and professional
standards when providing professional services.
• Confidentiality – A professional accountant should respect the
confidentiality of information acquired as a result of professional and
business relationships and should not disclose any such information to third
parties without proper and specific authority unless there is a legal or
professional right or duty to disclose. Confidential information acquired as
a result of professional and business relationships should not be used for
the personal advantage of the professional accountant or third parties.
• Professional behaviour – A professional accountant should comply with
relevant laws and regulations and should avoid any conduct that discredits
the profession. This includes ensuring, for example, that advertisements
made by his or her firm are truthful and are not made to deceive the public
and rival firms.
Helpful Hint!
Study and practice tip:
Research any organisation failure or collapse in your country and
write a short note on it. Ask your teacher to have a class discussion
on one of the organisations researched by students in your class.
Practise writing a case study on the organisation. Compare the case
study you have written with that of your friend.
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These fundamental principles must be adhered to by professional accountants
and students alike when making professional judgements. Such decisions
must be able to withstand professional scrutiny if required at a later date.
Problems can also arise, whether professional or personal, when deciding
what course of action to take in certain circumstances and how we are
influenced, for example:
• Personal – the need to behave within one’s integrity
• Business – adhering to your employer’s best interests
• Professional body – adhering to your association’s aims and standards.
2.5 Application of the ethical principles
The following ethical principles should be adhered to in the workplace:
• treat people with respect and courtesy
• act responsibly and honestly
• ensure confidentiality
• be accountable for your actions
• be trustworthy
• apply technical skills and competence
• comply with legal requirements and organisation laws and regulations
• avoid conflicts of interests.
2.6 Inappropriate applications of the
ethical principles
Unacceptable behaviour in the workplace would include the following:
• not working in the best interests of your employer
• being dishonest and untrustworthy
• disregarding confidentiality
• undermining colleagues
• causing conflict
• intimidation or harassment of colleagues to gain an advantage in a
particular area
• accepting bribes or gifts in return for a favour.
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2.7 Appropriate application of
accounting principles
When working in a financial environment, employees should comply with the
following principles:
• Competency – individuals must be competent and skilled in performing
their specific job.
• Willingness – individuals should act as willing members of a team.
• Communication – individuals must be able to communicate within the
team environment.
• Continuous training – individuals should undertake training to improve
and update skills (for example, CPD).
• Confidentiality – individuals must ensure confidentiality at all times.
• Openness – individuals should be open about their actions. This includes
providing full and complete information and reasoning behind a particular
decision.
• Trust – individuals must rely on information given by colleagues and trust
their judgements.
• Honesty – individuals should be honest and avoid telling lies. When there
is honesty, individuals will be trusted and respected.
• Accountability – individuals must understand their responsibility and must
be held accountable.
2.8 Inappropriate application of
accounting principles
Unfortunately, not all employees comply and work within the above
accounting principles and some may resort to unacceptable behaviour, such
as:
• fraudulent financial reporting (for example overstating/understating profit
and assets)
• failure to record all sales (especially cash sales)
• theft of inventory
• misappropriation of funds (stealing funds/embezzlement)
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• entering non-existent employees on the payroll (also called ‘ghost’
employees)
• tax evasion.
Helpful Hint!
Examination tip:
Be sure to know the fundamental principles of accountants and how
to apply them to real-life scenarios which can appear as case studies
on the examination paper.
2.9 Results of inappropriate application
of accounting principles
Penalties
The penalties resulting from inappropriate conduct and behaviour can have a
wide range of consequences which can have a serious effect on the
individual(s) involved, for example:
• loss of trust and integrity by the peer group
• disciplinary action by the professional body
• instant termination of employment
• prosecution leading to fines, imprisonment and a criminal record
• inability to gain further employment
• application for future financial loans rejected.
Summary
• Introduction to ethical principles from a personal perspective.
• Know the importance of ethical principles in accounting.
• Understand the fundamental principles of accounting:
– integrity
– objectivity
– professional competence and due care
– confidentiality
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– professional behaviour.
• Understand the application of ethical principles both in the
workplace and in accounting.
• Examine inappropriate application of ethical principles both in the
workplace and in accounting.
• Be aware of the consequences of inappropriate conduct and
behaviour in the workplace.
Chapter 2 Exercises
2.1 Name the five fundamental ethical principles issued by the
International Ethics Standards Board for Accountants (IESBA).
2.2X Amy is employed as an Accounts Assistant in the Finance
Department of Marshall Products Limited, where one of her
duties is to assist in payroll preparation. At a social event hosted
by her employer, her colleague William, who works in the
Marketing Department, asks her how much the Marketing
Manager earns. What would be Amy’s response to this request
and which fundamental ethical principle applies in this case?
2.3 From the list shown here, which items are not fundamental
ethical principles?
• Integrity
• Professional competence and due care
• Subjectivity
• Confidentiality
• Professional standards
2.4X George, who works in the Sales Department of The Green
Plastics Company, has been asked by his Manager, Mr
Johnson, to temporarily transfer to the Accounts Department and
assist in the preparation of the company’s annual budgets.
George would very much like to take up the transfer as it is an
area he really wants to work in. However, he feels he does not
have the necessary technical skills and is worried about taking
up the offer.
(a) What advice would you give to George about the offer of the
transfer?
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(b) Which accounting fundamental ethical principle applies in
this case?
2.5 (a) Discuss what you understand by ethical principles.
(b) Give three examples.
2.6X Clive works for AB Auditors and is presently working on the
accounts of Peak Limited. He is checking the payroll book and
notices that the company have recently taken on a new
employee, Jane Bold, to work as assistant in the packing
department. Clive decides to walk over to the packing
department and have a chat with a couple of the staff. He
enquires as to how the new assistant is getting along but is met
with blank expressions. They go on to inform Clive that there is
no one of that name employed in their department; he must have
been given the wrong information.
Clive, therefore, makes other enquiries and is very worried when
this person does not seem to exist. He decides to take the matter
further.
(a) What seems to be the situation here?
(b) What immediate action should Clive take?
(c) What action should AB Auditors take?
(d) What action should Peak Limited take?
2.7X Peter is a qualified accountant who works for a major
manufacturing company. He was involved in the following
incidents recently. For each incident, explain whether Peter has
acted properly in accordance with professional accountancy
ethics. If you think that Peter is in breach of a fundamental
ethical principle, state which principle has been breached.
(a) Peter’s Managing Director has asked him to prepare a
forecast of production costs for the next three months. As
he is preparing the forecast, the Production Manager visits
him to discuss the forecast. The Production Manager tells
Peter that unless he can reduce his forecasts of costs by
about 5%, the Production Manager will get into serious
trouble with the Managing Director. Peter and the
Production Manager have been good friends for several
years, and Peter agrees to do what he can to reduce the
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forecast costs.
(b) The Chairman of the company has purchased some
expensive evening gowns for his wife for an upcoming
fashion show. He tells Peter to record the costs of the
gowns as a company expense. He wants the gowns to be
put under expenses for new protective clothing for members
in the production department. Peter does what he is told.
(c) The Managing Director asks Peter if he can construct a
spreadsheet model for analysing expenses. Peter has never
constructed a spreadsheet before, but he does not want the
Managing Director to give the work to a junior accountant in
the department. He therefore says that he can construct the
spreadsheet. He thinks that if he takes the work home, his
sister will be able to help him. He knows that she is good
with spreadsheets and will probably help if he asks.
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3 The accounting system
Specific objectives
After you have studied this chapter you should be able to:
• describe and explain the accounting cycle
• understand the types of source documents used within an
organisation
• understand the need for books of original entry and what each is
used for
• appreciate how the books of original entry are used alongside the
ledgers using the double entry system of book-keeping
• distinguish between personal and impersonal ledgers
• distinguish between the different types of ledgers
• appreciate that at the end of the financial year the accounts are
balanced off and a trial balance prepared
• understand that from the final trial balance the financial statements
are prepared consisting of the trading and profit and loss account
(income statement) and statement of financial position (balance
sheet)
• distinguish between the different types of business organisations.
3.1 Introduction
This chapter aims to give an overview of the accounting cycle starting with
the source documents that are used initially to enter a transaction in the
books of account. It explains the books of original entry and provides an
introduction to the double entry system of book-keeping and the ledgers.
The difference between personal and impersonal accounts is discussed,
together with the meaning of real and nominal accounts.
Finally, a summary is given of the procedures followed by organisations at
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the end of the accounting year with ‘balancing off’ the accounts and the
preparation of the trial balance. From the final trial balance, the financial
statements are prepared which show the results of the year’s trading, the
trading and profit and loss account (income statement), together with the
statement of financial position (balance sheet), showing the financial
position of the organisation at a specific point in time.
All the topics covered in this overview chapter are dealt with thoroughly at
later stages in the book.
3.2 The accounting cycle
Traditionally, businesses operate on a 12-month cycle which may be the
same as the calendar year January to December or perhaps the same as the tax
year which runs from 6 April of one year to 5 April of the following year.
Alternatively, some businesses operate from the date the business first began,
for example 1 September of one year to 31 August of the following year.
During the 12-month period, the business receives many documents of a
financial nature that have to be entered in the books of account using either a
manual or a computerised system.
At the end of each month, the books are usually ‘balanced off’ and a trial
balance drawn up from which the financial statements may be prepared.
Also, at the end of each month, outstanding accounts are usually settled,
wages and salaries paid and money received during the month are all
recorded.
If the organisation uses a computerised system of accounting, a great deal
of useful information can also be obtained at the end of each month, such as
the amount of money outstanding each month and the length of time the debt
has been owing, and the amount of money that the organisation owes. Other
financial information is also available that enables management to carry out
an appraisal of the business, to budget and forward plan. While this
information is also available using a manual system of book-keeping, it is not
as readily available as from a computerised system.
It is usual for the financial statements of a business to be prepared on an
annual basis since they are required for taxation purposes and for the use of
the owner(s) of the business.
This chapter shows how source documents are recorded in the accounting
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records of an organisation and the various stages that are followed in
preparing the financial statements. This is illustrated in the following
diagram:
Exhibit 3.1 The accounting cycle for a profit-making organisation
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3.3 Source documents
Source documents are documents where original information is found, for
example, sales and purchase invoices and credit notes. All businesses and
organisations which are involved in either trading activities or providing a
service use these important documents.
Invoice An invoice is a document prepared by the seller when they sell
goods or provide services on credit. The invoice is usually numbered for easy
identification and for filing in a suitable storage system. It contains the
following information:
• seller’s name and address
• purchaser’s name and address
• purchaser’s order number and date
• date of delivery
• description of goods and services supplied including part number and
catalogue reference
• quantity and price per item
• total amount due
• terms and conditions of sale.
From a book-keeper’s point of view, the invoice is one of the most important
documents since details of the transaction need to be entered in the books of
account of both the seller and the buyer. In the seller’s records, the invoice is
a sales invoice and in the purchaser’s records it is a purchase invoice.
Credit note This document is raised by the supplier when goods have
been returned by the purchaser due to their being damaged, faulty or supplied
to the wrong specification, or when an overcharge has been made on an
invoice. The amount owed by the customer will be reduced by the amount of
the credit note. Credit notes are sometimes printed in red to distinguish them
from invoices.
Again, credit notes are important documents that need entering in the
books of both the supplier and purchaser.
Debit note If the supplier agrees, goods bought previously may be
returned. When this happens, a debit note is raised by the purchaser and sent
to the supplier giving details of the goods returned and the reason for their
return. The debit note shows that the purchaser expects the seller to bear the
charge.
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Bank paying-in slips These are forms used for paying money into a bank
account. The recipient of the money must record on the counterfoil of the
paying-in slip details of the amount paid and by whom so that the details may
be recorded in the organisation’s cash book.
Cheque and cheque counterfoil When a cheque is made out, it is
important to complete the counterfoil, entering details of the amount paid and
to whom together with any other relevant information. The payment will also
be recorded in the cash book.
Receipt This document acknowledges the receipt of money from a
customer and is often issued when a customer purchases goods for cash
rather than on credit. Again, counterfoils are completed and used to enter the
details of the receipt of cash in the cash book.
BACS (Bankers’ Automated Clearing Service) receipt This service
enables the transfer of money between banks and other financial
organisations. The supplier’s bank can receive payment direct from the
customer’s bank. The customer usually sends an advice to the supplier giving
details of the amount of the payment. The advice is used to record the receipt
in the books of account and later checked against the bank statement. This
topic will be covered fully in a later chapter.
Petty cash voucher A form used by anyone requesting payment for a
small item of expenditure incurred on behalf of the business. The form gives
details of the expense and should be signed and duly authorised. The petty
cash voucher expenditure is recorded in the organisation’s petty cash book.
This topic is covered fully in Chapter 21.
Correspondence Occasionally, correspondence from a customer may be
used as a source document to record a financial transaction that may be out of
the ordinary. This may occur when a customer is unable to pay an
outstanding amount and offers to settle the debt by giving the supplier an
asset. Such a transaction would be entered in the journal (refer to Chapter
22). Internal documents such as a memorandum from a senior member of the
organisation may be used in the same way.
It is important to note that all information of a financial nature must be
supported by a source document and it is from this document that the details
are entered in the business’s book-keeping system. Source documents may
also be referred to as prime documents.
Helpful Hint!
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Practice tip:
In your notebook, write a list of source documents without looking at
the section above. Then check to see if you missed any. Write a
short note to yourself on each one you missed to help you remember
what it is.
3.4 Books of original entry
These are books in which the transaction is first entered. There are separate
books for different types of transaction, as follows:
• The journal – this is used to record items that are much less common and
sometimes complicated and are not recorded in any other book of original
entry.
• Sales day book (also called sales journal) – a book used for listing sales
invoices. It gives details of the date of the sale, to whom and the amount of
the sale. Sales day books may also contain analysis columns to analyse
sales between different goods, departments and so on.
• Purchases day book (also called purchases journal) – this is similar to
the sales day book, but contains lists of purchase invoices received from
suppliers of goods or services. The purchases day book may also contain
analysis columns depending upon the accounting system.
• Returns outward book (also called purchases returns day book or
journal) – this is used to record goods returned to suppliers.
• Returns inwards day book (also called sales returns day book or
journal) – this is used to list any returns made by customers. This will lead
to a credit note being issued to them.
• Cash book – this is another book of original entry used to enter cash and
bank receipts and payments. The cash book provides a record of the
business’s bank account and also provides details of the amount of cash in
hand. It is both a book of original entry and part of the double entry system
as it contains the balances of both cash in hand and cash at bank.
• Petty cash book – a cash book used for making small (petty) payments,
details of which are entered from petty cash vouchers, supported if possible
by a receipt.
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3.5 An introduction to the double entry
book-keeping system
The system of double entry book-keeping is a method of recording
transactions in the books of account of a business. In the section above,
source documents, which provide all the relevant information, were discussed
followed by the books of original entry. The next important stage is to be
fully conversant with the double entry system of book-keeping.
Business transactions deal with money or money’s worth and each
transaction always affects two things. For example, if a firm buys goods
valued at $500 and pays for them by cheque, two things will have occurred:
1 the stock of goods is increased by $500
2 the money in the firm’s bank account will have decreased by $500.
If the firm then pays cash for a piece of equipment, then:
1 the money in the cash account will be reduced
2 the firm will have acquired equipment.
The dual aspect of treating each transaction is then recorded in an account.
An account shows us the ‘history’ of a particular business transaction, for
example, the bank account or equipment account. If manual accounting
records are kept, then each account is usually shown on a separate page. If a
computerised system is used, then each account is given a separate code
number. The following shows an example of an account.
Double entry book-keeping is shown using a step-by-step approach in
Chapters 6–8.
3.6 The ledgers
In a double entry system, the accounts, as mentioned above, are kept in a
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ledger. If the business is very small then only one ledger may be used, but
once the business expands it is better to have more than one ledger to allow
different members of staff to be able to record transactions at the same time.
Once details from the source documents are entered in the books of
original entry then the next stage of the book-keeping procedure is to show
the effect of the transactions by putting them into double entry accounts. The
different types of ledgers used are as follows (their alternative names are
shown in brackets).
Types of ledger
Sales Ledger
Purchase
Ledger
(Debtors Ledger (Creditors
– Accounts
Ledger –
Receivable)
Accounts
Payable)
Shows records of Shows records
customers’
of suppliers’
personal
personal
accounts
accounts
General Ledger
(Nominal Ledger)
Contains the remaining double
entry accounts, such as
expenses, income, assets,
capital
3.7 Classification of accounts
Accounts are divided into personal accounts and impersonal accounts.
Personal accounts are accounts that deal with people and firms – in other
words, the accounts receivable and accounts payable, accounts
receivable being people who owe money to the firm (debtors) and accounts
payable being people or firms to whom money is owed (creditors).
The accounts receivable accounts are maintained in the sales ledger, and the
accounts payable are kept in the purchases ledger.
Impersonal accounts are divided into real and nominal accounts.
• Real accounts are those which deal with possessions of the business: for
example, buildings, machinery, computer equipment, fixtures and fittings,
stock.
• Nominal accounts are those in which expenses and income are recorded:
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for example, sales, purchases, wages, electricity, commissions received.
Exhibit 3.2 The classification of accounts.
3.8 Balancing off accounts and the trial
balance
Businesses usually balance off their accounts at the end of each month and
prepare what is called a trial balance. The trial balance is prepared for
several reasons: first of all it is important to check periodically that the
transactions have been entered correctly in the books of account; second it is
useful to know how much money is outstanding and how much the business
owes. Also, with the use of computer accounting packages, the business can
easily prepare draft financial statements showing the profit or loss to date and
the financial position of the firm at a specific date. Both the trial balance and
the financial statements are dealt with in later chapters of this book.
3.9 Financial statements
At the end of the financial year, a trial balance is drawn up and from that and
other information and adjustments the financial statements are prepared by an
organisation. The financial statements include the following:
• trading and profit and loss account (income statement) which shows the
gross and net profits or losses made during the period
• the statement of financial position (balance sheet) which indicates the
financial position of the business at a particular point in time.
As the name implies, the final accounts are the end product of the
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recording of all the business transactions throughout the financial year. Once
prepared, they are used by the owner(s) of the business for information,
interpretation and planning purposes.
3.10 Summary of the accounting cycle
This chapter has shown how the accounting procedures of a business are
recorded and the information that is derived from those records. It may be
useful to list them once again at this point.
Source documents are received as follows:
Once the details of the transaction have been entered into the books of
original entry, the information is then entered into the ledgers by means of
the double entry system. This procedure is often referred to as posting.
Sales transactions are posted to the sales ledger, purchases transactions
are posted to the purchase ledger and items involving the real and nominal
accounts are posted to the general ledger.
At the end of each month, the books are balanced off and a trial balance
prepared to check the arithmetical accuracy of the book-keeping entries. At
the end of the accounting period, the final trial balance is used to prepare the
year-end accounts, that is, the trading and profit and loss account (income
statement) and statement of financial position (balance sheet). The accounts
are then presented to the owner(s) of the business for their information,
interpretation and action in the form of planning and budgeting for the next
accounting period.
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Helpful Hint!
Practice tip:
Draw your own diagram of the accounting cycle. Compare this with
Exhibit 3.1. How does your diagram compare?
3.11 Types of business organisation
Business organisations are identified according to their structure and financial
make-up. The classification will determine an organisation’s legal status and
what financial reporting is required of the organisation. Business
organisations fall into the following categories:
• Sole trader – An individual trading alone in his or her own name, or under
a recognised trading name. He or she is solely liable for all business debts
but when successful takes all the profits.
• Partnership – A group of two or more people, normally up to a maximum
of 20, carrying on a particular business with a view to making a profit.
Partnerships will be covered in Chapter 34.
• Limited companies (both private and public):
(a) A private limited company is a legal entity defined in the Companies
Act 2006 as ‘any company that is not a public company’. It must have
at least one shareholder and one director who may be the sole
shareholder. The shareholders have limited liability, that is, their
liability is limited to the amount that they have agreed to invest.
(b) A public limited company is, again, also a legal entity regulated by
the Companies Act 2006, with limited shareholder liability, but, unlike
a private company, it can ask the public to subscribe for its shares. This
topic is covered fully in Chapter 38.
• Non-trading organisations – Clubs, associations and other non-profitmaking organisations are normally run for the benefit of their members to
engage in a particular activity and not to make a profit. Their financial
statements will take the form of income and expenditure accounts, to be
covered in a later chapter.
• Cooperative society – A legally constituted business entity formed for the
explicit purpose of furthering the economic welfare of its members and
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that of the wider society by providing them with goods or services.
Cooperative societies are covered in Chapter 39.
Summary
• The accounting cycle shows the period in which a business
operates in its financial year. It involves recording all the trading
activities from source documents in the day books, posting to the
various ledgers and the preparation of the financial statements.
• All information that is entered into the book-keeping records comes
from a source document such as an invoice, credit note, debit note,
cheque, cheque book counterfoil, paying-in book, petty cash
voucher, etc.
• The books of original entry are used as a basis for posting the
transactions to the double entry accounts in the various ledgers.
• At the end of the accounting period the accounts are balanced off
and a trial balance prepared.
• The final trial balance is used to prepare the year-end accounts.
These are the trading and profit and loss account (income
statement), which shows the profit or loss made for the period, and
the statement of financial position (balance sheet), which shows
the financial position of the business at a specific date.
• A summary of the accounting cycle is shown together with a recap
of the various stages of the accounting procedures.
• Businesses operate through various organisations such as sole
trader, partnership, private or public limited company and
cooperative society. Charitable clubs and societies operate as nonprofit-making organisations.
There is a Glossary of accounting terms in Appendix A at the end of the book.
Chapter 3 Exercises
3.1 Source documents in accounting are very important.
(a) Describe the contents of both an invoice and a credit note.
(b) State when each of these would be used.
3.2 The books of original entry are used to record initial accounting
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information and separate books are used for different types of
transactions. List the various books used and give a brief
explanation of their use.
3.3 For what purpose would you use the following ledgers?
(a) General or nominal ledger
(b) Sales ledger
(c) Purchases ledger.
3.4X Distinguish between personal and impersonal accounts, giving
examples of what each might contain.
3.5 Explain what is meant by ‘financial statements’ and state what
they consist of.
3.6 List the main types of business organisations and explain their
basic structure.
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4 Accounting concepts
Specific objectives
After you have studied this chapter you should be able to:
• appreciate the assumptions that are made when recording
accounting data
• explain why one set of accounts is used for several different
purposes
• understand what is meant by objectivity and subjectivity
• explain the basic concepts of accounting
• explain how the further overriding concepts of materiality, going
concern, prudence, realisation, consistency and substance over
form affect the recording and adjustments of data
• understand the importance of confidentiality.
4.1 Introduction
In the earlier chapters, accounting principles and accounting systems were
discussed and the source of financial data shown. The data is then recorded in
the books of account and later the financial statements, namely, the trading
and profit and loss account (income statement) and the statement of financial
position (balance sheet) are prepared. Recording of these transactions has
been based on certain assumptions which are known as accounting
concepts or rules of accounting.
These concepts or rules have been developed over the years to standardise
the recording of data and preparation of the financial statements, thus
enabling comparisons between different businesses to be more reliable and
easier to understand.
The financial statements are primarily for use by the owner(s) of the
business, but they are also required by the Inspector of Taxes to calculate the
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tax to be paid and by the bank if the business requires a loan. There may also
be other interested parties, such as prospective investors, suppliers, customers
and so on.
4.2 One set of financial statements for
all purposes
If it had always been the custom to draft different kinds of financial
statements for different purposes, so that one set could be given to your
banker, another set to a prospective purchaser of a business and so on, then
accounting would be different from what it is today. However, copies of the
same set of financial statements are given to all the different parties.
This means that a banker, a prospective buyer of the business, an owner
and all the other people with an interest see the same trading and profit and
loss account (income statement) and statement of financial position (balance
sheet). The interests of each stakeholder may be different, each one using the
financial statements for their own particular purpose. For example, the bank
manager would like to know how much the assets would sell for if the
business ceased trading. They would then see what the possibility would be
of the bank obtaining repayment of its loan or overdraft. Others would also
like to see the information in the way that is most useful to them. However,
only one set of financial statements is normally available for all these
different stakeholders. Thus the trading and profit and loss account (income
statement) and statement of financial position (balance sheet) are used for
many different purposes. For them to be of any use, the different parties have
to agree to the way in which they are drawn up.
Assume that you are in a class of students and that you have the problem of
valuing your assets consisting of ten textbooks. The first value you decide is
based upon how much you could sell them for. Your own guess is $50, but
the other members of your class may suggest they should be valued at
anything from $30 to $60.
Suppose that you now decide to put a value on their use to you. You may
well think that the use of these textbooks will enable you to pass your
examinations so you will get a good job. Another person may have the
opposite idea concerning the use of the textbooks. The use value placed on
the textbooks by others in the class will be quite different. Again, your value
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may be higher than those of some of your colleagues and lower than others.
Finally, you decide to value them by reference to cost. You examine the
receipts for the books which show that you paid a total of $90 for them. The
rest of the class may then agree that the cost valuation is a fair and equitable
means of assessing their value.
This is, in fact, the means used to value the assets of a business and is
referred to as the historical cost concept.
4.3 Objectivity and subjectivity
It is especially important in accounting that the procedures or methods used
are agreed and understood by everyone. This approach is said to be
objective. In the above example of the textbooks the amount eventually
agreed upon to value the asset of books was the cost price, known as the
historical cost concept, thus this method of valuation is said to be objective.
Valuing assets at their cost price means that you are adhering to the facts.
Everyone knows where the value came from and you are not using your own
judgement to arrive at a valuation.
When the approach is subjective, it means you wish to use your own
judgement or method of valuation, even though no one else may agree to it.
In the example of the textbooks, the value of the books depended upon the
importance of them to the user. To the person wishing to use them to obtain
qualifications to help them in their career, they may be of more value than to
someone using them to fill up a shelf in their bookcase.
The desire to provide the same set of accounts for many different parties,
and thus to provide a measure that gains their consensus of opinion, means
that objectivity is sought in financial accounting. If you are able to
understand this desire for objectivity, then many of the apparent
contradictions can be understood because it is often at the heart of the
financial accounting methods in use at the present time.
Financial accounting seeks objectivity and, of course, it must have rules
which lay down the way in which the activities of the business are recorded.
These rules are known as accounting concepts.
4.4 Basic accounting concepts
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Over the years, accounting systems have developed more for practical
reasons than for theoretical ones. Consequently, several basic procedures
have evolved that form the basic rules of accounting. As mentioned above,
these are often referred to as accounting concepts.
An accounting concept is an assumption that underlies the preparation of
the financial statements of the organisation. There are several accounting
concepts that are followed when preparing the financial accounts of a
business – all of which you may be required to know when taking an
examination.
The historical cost concept
The need for this has already been described in the example of valuing
textbooks. It means that assets are normally shown at cost price and this is the
basis for valuation of the asset.
The money measurement concept
Accounting is concerned only with these facts:
• it can be measured in money, and
• most people will agree to the ‘monetary’ value of the transaction.
This means that accounting can never tell you everything about a business.
For example, accounting does not show the following:
(i) whether the firm has good or bad managers
(ii) whether there are serious problems with the workforce
(iii) whether a rival product is about to take away many of its best customers
(iv) whether the government is about to pass a law that will cost the business
extra expense in future.
The reason that (i) to (iv) above, or similar items, are not recorded is that it
would be impossible to work out a money value for them that most people
would agree to. Some people think that accounting tells you everything you
want to know, but the above shows that this is not true.
Business entity concept (separate entity
concept)
This concept implies that the affairs of a business are to be treated as being
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quite separate from the personal activities of its owner(s).
The items recorded in the books of the business, are, therefore, restricted to
the transactions of the business. No matter what activities the proprietor(s)
are involved in outside the business, they are disregarded in the books kept
by the business.
The only time the personal resources of the proprietor(s) affect the firm’s
accounting records is when they introduce new capital into the business or
take drawings from it.
The dual aspect concept
This states that there are two aspects of accounting, one represented by the
assets of a business and the other by the claims against them. The concept
states that these two aspects are always equal to each other. In other words:
Helpful Hint!
Question:
Does accounting tell you everything about a business? Give reasons
for your answer.
Double entry is the name given to the method of recording the transactions
for the dual aspect concept.
4.5 Other important accounting
concepts
There are several other important accounting concepts which have become
accepted by the commercial world when preparing financial statements for a
business. These concepts have been used for many years without being
formally imposed on the accounting profession.
However, such is the importance of these concepts that the Companies
Act 2006 required that they be used as a basis for drawing up financial
statements. The following additional concepts are enforced by this Act.
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Going concern concept
This concept implies that the business will continue to operate for the
foreseeable future. In other words, it is assumed that the business will
continue for a long period of time. Therefore, when the financial statements
are prepared, that is, the trading and profit and loss account (income
statement) and statement of financial position (balance sheet), it is
assumed there is no intention of the business reducing in size or indeed
ceasing to trade in the future. Consequently, the assets would be valued using
the historical cost concept.
However, when a business ceases to trade as a going concern or the
owners decide to sell the business or perhaps the business goes into
liquidation, then the value of the assets can be quite different. In these
circumstances the saleable value of the assets would be used in the financial
statements, that is, the reduced value of the non-current assets (fixed
assets) instead of their cost.
Consistency
Even if we do everything already listed under concepts and conventions,
there will still be quite a few different ways in which items could be
recorded. Each business should try to choose the methods that give the most
reliable picture of the business.
This cannot be done if one method is used in one year and another method
in the next year, and so on. Constantly changing the methods would lead to
misleading profits being calculated from the accounting records. Therefore,
the convention of consistency is used. The convention says that when a
business has fixed a method for the accounting treatment of an item, it will
enter all similar items in exactly the same way when preparing the financial
statements in following years. Examples of when the consistency concept is
used include:
• methods of depreciation (see Chapter 25)
• inventory valuation (see Chapter 30).
However, it does not mean that the business has to follow the method until
the firm closes down. A business can change the method used, but such a
change is not taken without due consideration. When such a change occurs
and the profits calculated in that year are affected by a material amount,
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either in the profit and loss account itself or in one of the reports with it, the
effect of the change should be stated.
Prudence
Very often accountants have to use their judgement to decide which figure
they will take for an item. Suppose a debt has been outstanding for quite a
long time and no one knows whether it will be paid. Should the accountant be
an optimist in thinking that it will be paid, or be more pessimistic?
It is the accountant’s duty to see that people get the proper facts about a
business. They should make certain that assets are not overvalued and
similarly that liabilities should not be shown at values too low. Otherwise,
people might ill-advisedly lend money to a firm, which they would not do
had the proper facts been known.
The accountant should always be on the side of caution; this is known as
prudence. The prudence convention means that, normally, accountants will
take the figure that will understate rather than overstate the profit. Thus, they
should choose the figure that will cause the capital of the firm to be shown at
a lower amount rather than at a higher one. They will also normally make
sure that all losses are recorded in the books, but profits should not be
anticipated by recording them before they are realised.
Realisation
This concept holds the view that profit can only be taken into account when
realisation has occurred – in other words, until it is reasonably certain of
being earned. Profit is normally said to be earned when:
• goods or services are provided to the buyer
• the buyer accepts liability to pay for the goods or services
• the monetary value of the goods or services has been established
• the buyer will be in a situation to be able to pay for the goods or services.
Notice that it is not the time:
• when the order is received, or
• when the customer pays for the goods.
However, it is only when you can be reasonably certain as to how much will
be received that you can recognise profits or gains.
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The accrual concept or matching concept
This concept says that net profit is the difference between revenues and
expenses incurred in generating those revenues, namely
Determining the expenses used up to obtain the revenues is referred to as
matching expenses against revenues; that is why this concept is also called
the matching concept. The key to the application of the concept is that all
income and charges relating to the financial period to which the financial
statements relate should be taken into account without regard to the date of
the receipt or payment.
Sales are revenues when the goods are sold and not when the money is
received, which can be in a later period. Purchases are expenses when goods
are bought, not when they are paid for. As we shall see in a later chapter,
items such as rent, insurance, motor expenses and so on are treated as
expenses when they are incurred, not when they are paid for. Adjustments are
made when preparing financial statements for expenses owing and those paid
in advance.
By showing the actual expenses ‘incurred’ in a period matched against
revenues earned in the same period, a correct figure of net profit will be
shown in the profit and loss account (income statement).
You need to know and understand the above concepts when taking an
examination.
Substance over form
This concept is a requirement of Financial Reporting Standard FRS 5. The
legal form of a transaction can differ from its real substance. Where this
happens, accounting should show the transaction in accordance with its real
substance, which is basically how the transaction affects the economic
situation of the firm. This means that accounting, in this instance, will not
reflect the exact legal position concerning that transaction. An example
would be when a business rented a car under a lease that allowed it to
purchase the car at the end of three years for $10. The substance of the
agreement is hire purchase, but the form is rental. It should be treated as if it
were a hire purchase.
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4.6 Materiality
If an item is relatively small in value, then the concept of materiality applies
and as such the item does not need separate recording, for example the
purchase of a box of paperclips, a waste paper bin or calculator for the office.
These small items are regarded as ‘not material’ and would be recorded in a
general expense account such as ‘sundry expenses account’ whereas a noncurrent asset, such as a motor vehicle or plant and machinery, would be
classed as ‘capital expenditure’ (see Chapter 15).
4.7 The assumption of the stability of
monetary measures
Earlier in the chapter, we saw how accounting uses the historical cost concept
which states that the asset is normally shown at its cost price. This means that
accounting statements can be misleading, because assets will be bought at
different times at the prices then ruling, and the figures will be totalled up to
show the value of the assets in cost terms.
For instance, suppose that you bought a building 20 years ago for $20,000.
You now decide to buy an identical additional building, but the price has
risen to $40,000. You buy it, and the buildings account now shows buildings
at a figure of $60,000. One building is in the currency of 20 years ago, while
the other is at today’s currency value. The figure of $60,000 spent in total is
historically correct but cannot be used for much else.
When we look at financial statements, we must bear in mind the effects of
inflation and fluctuations in prices that have an effect on accounting
transactions. There are ways of adjusting accounts to make the figures more
useful, but these are outside the scope of this book.
4.8 Confidentiality
Although it is not a concept of accounting, employees who work in the
financial department of an organisation, and who have access to its financial
information, should recognise that this information is confidential. It should
not be disclosed to anyone within the organisation except those authorised to
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receive it.
It should only be disclosed ‘outside’ the organisation to such bodies as the
Inland Revenue or official government departments, as required by
government legislation.
The organisation’s auditors will also require access to the financial records
in order to prepare the organisation’s financial statements.
Summary
• Financial statements, that is, the trading and profit and loss
account (income statement) and statement of financial position
(balance sheet), are prepared by the owner(s) of a business for
their own use. However, the same financial statements may also
be used by other stakeholders, such as the bank, government
departments, potential investors, suppliers and customers.
• The need for general agreement on accounting issues has led to
the development of concepts and conventions that govern
accounting.
• It is important in accounting to use a method or procedure that
everyone can adhere to, this is known as ‘objectivity’; ‘subjectivity’
is using one’s own judgment or method of valuation.
• Various concepts have developed over the years which form the
basic rules of accounting. Such basic concepts include the
historical cost concept, money measurement, business entity and
dual aspect.
• There are other important concepts, recognised under the
Companies Act 2006, to be used when drawing up financial
statements. The concepts enforced by the Act include going
concern, consistency, prudence, realisation and accruals.
• Materiality is distinguishing between items that are of material
value and those that are not and recording them in the accounts
accordingly.
• It is assumed that monetary measures remain stable in that
accounts are not adjusted for inflation or deflation.
• Persons working in an accounting environment and having access
to financial information must adhere strictly to confidentiality
procedures.
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Chapter 4 Exercises
4.1 Which accounting concept is used in each of the following
accounting treatments? Explain your answer.
(a) The cost of a tape dispenser has been charged to an
expense account, although in fact it could still be in use in
ten years’ time.
(b) A sole proprietor has sold his private house, but has not
recorded anything about it in the business records.
(c) A debt has been written off as a bad debt even though there
is still a chance that the debtor eventually may be able to
pay it.
(d) A machine has been bought for an exceedingly low figure,
and it has been entered in the asset account at that figure
even though it is worth more.
(e) An expert says that the value of the management team to
the company is worth well over a million dollars, yet nothing
is entered for it in the books.
(f) A motor van broke down in December 2017. The repair bill
for it was not paid until 2018 yet it has been treated as a
2017 expense.
(g) A customer saw a carpet in 2017 and said he might well buy
it. He telephoned in 2018 and asked for the carpet to be
delivered. The item was not treated as a sale in 2017 but
was treated as a sale in 2018.
(h) The final day of the financial year saw the passing of a law
that would render trading in our sort of goods illegal, and the
business will have to close. The accountant says that our
stock figure cannot be shown at cost in the statement of
financial position (balance sheet).
(i) We have been told that we cannot show our asset of motor
cars at cost in one year and at cost plus the price increase
the next year when the manufacturer increases prices of all
cars, which also includes our unsold stock.
(j) We have shown all items of machinery costing less than
$100 as machinery operating expenses.
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4.2X When preparing the financial statement of your organisation,
name the accounting concepts you should follow to deal with
each of the following:
(a) Electricity consumed during the accounting period is still
unpaid at year end.
(b) The owner of the business has invested her private assets
in the business.
(c) A debtor who owes the business a large amount has been
declared bankrupt, and the outstanding amount due to the
business is now considered to be irrecoverable.
(d) The organisation has suffered substantial losses in the past
few years, and it is extremely uncertain whether the
organisation can continue to operate next year.
4.3X Accounting concepts and conventions are used in preparing
financial statements of a business.
(a) Briefly explain any three of the following concepts: (i) going
concern (ii) accruals (iii) consistency (iv) prudence.
(b) Objectivity is important in analysing and preparing
accounting information. Explain the term ‘objectivity’, giving
an example as to how it might be applied.
4.4 Explain briefly what you understand by the ‘historical cost’
concept. Give an advantage in using the cost method of
valuation.
4.5 In the following circumstances, which accounting concept would
be used?
(a) A debt owing to the business for some time has been written
off as a bad debt even though there is a chance that the
debtor may eventually pay
(b) John purchases a new hole punch for the office which he
says should last for several years. He is unsure which
account to charge it to and asks your advice.
(c) Diane runs a successful small café in the local town. She
says the success of the business has been attributed to her
staff who are worth several hundred dollars to her yet
nothing is entered in her books of account.
(d) Tom has just bought a canoe for his own personal use and
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wonders if he could charge it to the business.
4.6 Emily works for a firm of accountants and one of the firm’s clients
is Emily’s parents’ friends, Alice and George, who own several
businesses in the town. Emily’s father asks her how Alice and
George’s businesses are going and how much profit did they
make during the last year.
What should Emily do in these circumstances?
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5 The accounting equation and
the statement of financial
position (balance sheet)
Specific objectives
After you have studied this chapter you should be able to:
• understand the accounting equation
• understand what is meant by assets, liabilities and capital
• construct statements of financial position after different
transactions have occurred
• explain the meaning of the terms assets, capital, liabilities,
accounts receivable (debtor) and accounts payable (creditor).
5.1 The accounting equation
The whole of accounting is based upon a very simple idea, called the
accounting equation or the balance sheet equation. It sounds complicated,
but in fact it is easy to understand. It can be explained by saying that if a
business decides to set up and start trading, it will require resources.
Assuming that the owner of the new business supplies all the resources then
this can be shown as:
In accounting, special terms are used to describe many things. The amount of
the resources supplied by the owner is called capital. The actual resources
that are then in the business are called assets. This means that when the
owner has supplied all of the resources, the accounting equation can be
shown as:
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Usually, however, other people besides the owner have supplied some of the
assets. The amounts owing to these people for these assets are called
liabilities. The accounting equation has now changed to:
This is the most common way in which the accounting equation is presented.
It can be seen that the two sides of the equation will have the same totals.
This is because we are dealing with the same thing from two different points
of view: the value of the owners’ investment in the business and the value of
what is owned by the business and ultimately by the owners.
Unfortunately, with this form of the accounting equation, we can no longer
see at a glance what value is represented by the resources in the business.
You can see this more clearly if you switch assets and capital around to give
an alternative form of the accounting equation.
This can then be replaced with the words describing the resources of the
business:
It is a fact that no matter how you present the accounting equation, the totals
of both sides will always equal each other, and this will always be true no
matter how many transactions there may be. The actual assets, capital and
liabilities may change, but the total of the assets will always equal the total of
capital + liabilities. Or, reverting to the more common form of the accounting
equation, the capital will always equal the assets of the business minus the
liabilities.
Assets consist of property of all kinds, such as buildings, machinery,
inventories (stocks of goods) and motor vehicles. Other assets include debts
owed by customers and the amount of money in the bank.
Liabilities include amounts owed by the business for goods and services
supplied to the business and for expenses incurred by the business but still
outstanding. Funds borrowed by the business are also included.
Capital is often called the owner’s equity or net worth. It comprises the
funds invested in the business by the owner plus any profits retained for use
in the business less any share of the profits paid out of the business to the
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owner.
5.2 The statement of financial position
(balance sheet) and the effects of
business transactions
The accounting equation is expressed in a financial statement called the
statement of financial position (balance sheet). The statement of financial
position (balance sheet) shows the financial position of an organisation at a
point in time. The statement of financial position and the balance sheet are
the same but the former name is now more commonly used in the world of
work.
Helpful Hint!
Question:
What are the meanings of the words ‘assets’, ‘liabilities’ and ‘capital’
in accounting? How do these meanings differ from your everyday use
of these words?
In other words, it presents a snapshot of the organisation at the date when
the statement of financial position was prepared. The statement of financial
position is not the first accounting record to be made, nor the first that you
will learn how to record, but it is a convenient place to start to consider
accounting.
Let us now see how a series of transactions affects the statement of
financial position (balance sheet).
The introduction of capital
On 1 May 2017, B. Blake started in business and put $50,000 into a bank
account for the business. The statement of financial position (balance sheet)
would appear:
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Note how the top part of the statement of financial position (balance sheet)
contains the assets and the bottom part contains the capital. This is the
convention in which information is always presented in the statement of
financial position (balance sheet).
The purchase of an asset by cheque
When Blake has a bank account, he can use cheques as payment. On 3 May
2017, Blake buys shop premises for $30,000, paying by cheque. The effect of
this transaction is that the cash at the bank is reduced and a new asset, shop
premises, appears:
Note how the two parts of the statement of financial position (balance sheet)
‘balance’, that is, the total of the assets equals the total of the liabilities.
The purchase of an asset and the incurring of
a liability
On 6 May 2017, Blake buys some goods for $5,000 from D. Smith and
agrees to pay for them sometime within the following two weeks. The effect
of this is that a new asset, inventory, is acquired, and a liability for the goods
is created. A person to whom money is owed for goods is known in
accounting language as an accounts payable (creditor).
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The statement of financial position (balance sheet) becomes:
Note how the liability (the accounts payable) is shown as a deduction from
the assets. This is how the calculation is presented in the most common form
of the accounting equation.
Sale of an asset on credit
On 10 May 2017, goods that had cost $1,000 were sold to J. Brown for the
same amount, the money to be paid at a later date. The effect is a reduction in
inventory (stock of goods) and the creation of a new asset. A person who
owes the firm money is known in accounting terms as an accounts receivable
(debtor). The statement of financial position (balance sheet) now appears as:
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Sale of an asset for immediate payment
On 13 May 2017, goods that had cost $2,000 were sold to D. Daley for the
same amount, Daley paying for them immediately by cheque. Here, one
asset, inventory, is reduced, while another asset, cash at bank, is increased.
The statement of financial position (balance sheet) now appears as:
The payment of a liability
On 15 May 2017, Blake pays a cheque for $3,000 to D. Smith in part
payment of the amount owing. The asset bank is therefore reduced, and the
liability of the creditor is also reduced. The statement of financial position
(balance sheet) now appears as:
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Collection of an asset
On 31 May 2017, J. Brown, who owes Blake $1,000, makes a part payment
of $750 by cheque. The effect is to reduce one asset, accounts receivable, and
to increase another asset, bank. The statement of financial position (balance
sheet) after these transactions is now shown as:
5.3 Equality of the accounting equation
It can be seen that every transaction has affected two items. Sometimes it has
changed two assets by reducing one and increasing the other. In other cases,
the effect has been different. You will notice, however, that in all cases apart
from the very first (when the owner started the business by putting in cash of
$50,000), no change has been made to the total of either section of the
statement of financial position (balance sheet) and the equality between the
two totals has remained the same. The accounting equation has held true
throughout the example and, in fact, always will.
The effect of each of the seven transactions, shown above, upon the two
sections of the statement of financial position (balance sheet) is now
illustrated in Exhibit 5.1.
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Exhibit 5.1
Each transaction has, therefore, maintained the same total for assets as for
capital + liabilities. This can be shown:
Exhibit 5.2
5.4 More detailed presentation of the
statement of financial position (balance
sheet)
The statements of financial position (balance sheet) shown in this chapter are
presented in what is referred to as the ‘vertical presentation’. This method
will be used throughout the book since it is the most common method of
presentation used today.
A more detailed statement of financial position (balance sheet) for B.
Blake is shown below reflecting the presentation you will learn in later stages
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of your studies.
You will have noticed the use of the terms non-current asset, current assets
and current liabilities. Chapter 12 contains a full and proper examination of
these terms. At this point we will simply say that:
• Non-current assets are assets which are expected to be kept for a few
years at least, for example buildings, machinery, fixtures, motor vehicles.
They are used in the business to enable it to carry on the purpose of earning
income and are not intended for resale.
• Current assets are assets which change from day to day, for example the
value of inventory goes up and down as it is bought and sold. Similarly, the
amount of money owing to us by debtors will change quickly, as we sell
more to them on credit and they pay their debts. The amount of money in
the bank will also change as we receive and pay out money.
• Current liabilities are those liabilities that have to be paid within the near
future, for example accounts payable for goods bought.
Helpful Hint!
Examination tip:
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Remember to always head your statement of financial position
correctly. Check to ensure that you have put in the name of the
company, name of the statement followed by the words ‘as at’ and
the relevant date.
Summary
• The whole of accounting is based on the accounting equation,
namely that resources supplied by the owner (the capital) will
always equal the resources in the business (the assets).
• Other people may also supply some of the assets to the business.
The name given to any amounts that are owed by the business to
other people is liabilities.
• When assets are supplied by other people as well as the owner of
the business the accounting equation becomes:
• The two sides of the accounting equation are represented by the
two sections of the statement of financial position (balance sheet).
• The statement of financial position (balance sheet) is a financial
statement prepared at a particular point in time. It contains assets,
capital and liabilities.
• The two totals of each part of the statement of financial position
(balance sheet) should always agree, that is, they balance.
• Every transaction affects two items in the accounting equation.
Sometimes that may involve the same item being affected twice,
once positively (going up) and once negatively (going down).
• Every transaction affects two items in the statement of financial
position (balance sheet).
There is a Glossary of accounting terms in Appendix A at the end of the book.
Chapter 5 Exercises
5.1 Fill in the gaps in the following table.
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5.2X Fill in the gaps in the following table.
5.3 In the following list distinguish the items that are liabilities from
those that are assets:
(a) Office machinery
(b) Loan from C. Shirley
(c) Fixtures and fittings
(d) Motor vehicles
(e) We owe for goods
(f) Cash at bank.
5.4X Classify the following items into assets and liabilities:
• Motor vehicles
• Premises
• Accounts payable
• Inventory
• Accounts receivable
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•
•
•
•
Owing to bank
Cash in hand
Loan from D. Jones
Machinery.
5.5 State which of the following are shown under the wrong
classification for J. Wong’s business.
5.6X Which of the following are shown under the wrong headings?
5.7 A. Smart sets up a new business. Before he actually sells
anything, he buys a motor vehicle for $8,000, premises at a cost
of $20,000 and inventory for $4,000. He did not pay in full for his
inventory and still owes $1,600 in respect of them. Smart also
borrows $12,000 from D. Bevan. After the events just described,
and before trading starts, he has $400 cash in hand and $2,800
cash at bank. You are required to calculate the amount of his
capital.
5.8X T. Chin starts a business. Before he actually starts to sell
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anything, he buys fixtures at $2,000, a motor vehicle for $5,000
and inventory for $3,500. Although he has paid in full for the
fixtures and the motor vehicle, he still owes $1,400 for some of
the goods. J. Preston had lent Chin $3,000. Chin, after the
above, has $2,800 in the business bank account and $100 cash
in hand. You are required to calculate his capital.
5.9 Draw up A. Foster’s statement of financial position (balance
sheet) as at 31 December 2017 using the following information.
5.10X Draw up Kelly’s statement of financial position (balance sheet)
as at 30 June 2018 from the following information.
5.11 Complete the columns to show how the assets, liabilities and
capital have been changed by the following transactions.
(a) We pay a supplier $700 in cash.
(b) We bought fixtures paying $2,000 by cheque.
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(c) We bought goods $2,750 on credit.
(d) The proprietor introduces another $5,000 cash into the firm.
(e) J. Walker lends the firm $2,000 in cash.
(f) A customer pays us $500 by cheque.
(g) We return goods costing $600 to a supplier whose bill we
had not paid.
(h) We bought additional shop premises paying $50,000 by
cheque.
5.12X Complete the columns to show how much the assets,
liabilities and capital have been changed by the following
transactions.
(a) We bought a motor van $5,000 on credit.
(b) We repaid by cash a loan owed to P. Smith $1,000.
(c) We bought goods for $1,500 paying by cheque.
(d) The owner puts a further $5,000 cash into the business.
(e) A customer returns to us $800 worth of goods. We agree to
make an allowance for them.
(f) We bought goods $2,200 on credit.
(g) The owner takes out $1,000 cash for his personal use.
(h) We paid a supplier $1,900 by cheque.
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5.13 C. Sangster has the following items in his statement of financial
position (balance sheet) as at 30 April 2017. Capital $18,900;
Loan from T. Sasso $2,000; Accounts payable $1,600; Fixtures
$3,500; Motor vehicle $4,200; Inventory $4,950; Accounts
receivable $3,280; Cash at bank $6,450; Cash in hand $120.
During the first week of May 2017, Sangster:
(a) bought extra stock of goods $770 on credit
(b) received $280 in cash from a customer
(c) bought extra fixtures $1,000 by cheque.
You are to draw up a statement of financial position (balance
sheet) as at 7 May 2017 after the above transactions have been
completed.
5.14X C. Samuels has the following statement of financial position
(balance sheet) as at 31 March 2017.
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Draw up a statement of financial position (balance sheet) on 10
April 2017 after the transactions have been completed.
The following transactions take place:
(a) 2 April Paid a cheque of $500 to a supplier.
(b) 8 April A customer paid C. Samuels $300 by cheque.
(c) 10 April L. Stennett is repaid $1,000 by cheque.
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6 The double entry system for
assets, liabilities and capital
Specific objectives
After you have studied this chapter you should be able to:
• understand what is meant by the double entry system
• explain how the double entry system follows the rules of the
accounting equation
• understand the rules for double entry book-keeping
• draw up ‘T accounts’ and understand the terms debit and credit
• record transactions affecting assets, liabilities and capital in the T
accounts.
6.1 Nature of a transaction
In Chapter 5, we saw how various events changed two items in the statements
of financial position. Events that result in such changes are known as
transactions. This means that if the proprietor of a business asks the price of
some goods but does not buy them, then there is no transaction. If he later
asks the price of some goods and buys them, then there is a transaction and
the two statement of financial position (balance sheet) items, that is,
inventory and cash at bank, will have changed.
6.2 The double entry system
The system of double entry book-keeping is a method of recording
transactions in the books of account of a business. In the previous chapter we
saw how every transaction affected two items. We now need to show these
effects when the transaction is first recorded in the books of account. The
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information for every item that is entered into the books of account is
obtained from a source document, that is, invoice, credit note, cheque book
stub, paying-in book, etc. The next important stage is to understand the
double entry system of book-keeping.
Business transactions deal with money or money’s worth and each
transaction always affects two things. For example, if a firm buys goods
valued at $1,000 and pays for them by cheque, two things have occurred:
1 the money in the firm’s bank account will have decreased by $1,000
2 the stock of goods is increased.
Here is another example: if a firm buys a motor van costing $7,000 and pays
for it by cheque then again two things have been affected:
1 the money in the firm’s bank account will have decreased by $7,000
2 the motor van will have been acquired for the business and the asset
account will have increased.
This is the book-keeping stage of accounting and the process used is called
double entry. Sometimes this may also be referred to as double entry bookkeeping; either term is correct.
In the previous chapter, a new statement of financial position was drawn
up after each transaction. This can be done quite easily if there are only a few
transactions per day. However, if there are hundreds of transactions per day
then it will become impossible to draw up numerous statements of financial
position. There simply would not be enough time to carry out such a task.
Therefore, instead of constantly drawing up amended statements of
financial position after each transaction, the double entry system is used. The
basis of this system is that transactions that have occurred are entered in the
books of account. An account shows us the history of a particular business
transaction. It is the place in the records where all the information referring to
a particular asset, liability or capital is entered, for example, the bank account
or motor van account. If manual records are kept, then each account is
usually shown on a separate page; if a computerised system is used, then each
account is given a separate code number and the information is stored on the
accounting package and back-up disks.
6.3 The accounts for double entry
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Each account should be shown on a separate page. The double entry system
divides each page into two halves. The left-hand side of each page is called
the debit side, while the right-hand side is called the credit side. The title of
each account is written across the top of the account at the centre – see
Exhibit 6.1. Note that the word ‘Debit’ is often shown in a short form as ‘Dr’
while ‘Credit’ is often shown as ‘Cr’.
Exhibit 6.1
From the start it is important to recognise that the words debit and credit in
book-keeping and accounting have quite specific meanings.
6.4 Rules for double entry
Double entry is relatively easy to learn and understand if the following four
rules are learnt and understood:
1 Double entry means that every transaction affects two things and should,
therefore, be entered twice in the accounts: once on the Debit side and
once on the Credit side. Later on in your studies you may have more than
two accounts to record a transaction, for example, when an item is
purchased and part of it is paid for in cash and part by cheque.
2 The order in which the items are entered does not matter – although
students may find it easier to deal with any cash or bank transaction first
using the ‘IN’ and ‘OUT’ principle which is explained in Section 6.5.
3 A Debit entry is always an asset or expense. A Credit entry is a liability,
capital or income.
4 Exhibit 6.2 shows the double entry rules for increasing or decreasing
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assets, liabilities or capital as discussed in Chapter 3.
Exhibit 6.2
Let us look once again at the accounting equation:
The double entry rules for liabilities and capital are the same, but they are the
opposite of those for assets. Looking at the accounts the rules will appear as:
In a real business, at least one full page would be taken for each account in
the accounting books. However, as we do not have enough space in this
textbook to put each account on a separate page, we will list the accounts
under each other.
6.5 The ‘IN’ and ‘OUT’ approach
To help students having difficulty deciding on which side of each account the
items should be entered, a useful hint is to think of the debit side being ‘IN’
to the account, and the credit side being ‘OUT’ of the account.
The following two examples show this approach.
Example 1: Paid cash $2,000 to buy machinery.
The double entry for this transaction would be as follows:
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Example 2: Took $500 out of the cash till of the business and paid it into the
bank account of the business.
The double entry for this transaction would be as follows:
6.6 T accounts
The type of accounts that are going to be demonstrated are known as T
accounts. This is because the accounts are in the shape of a T, as illustrated
in Exhibit 6.3.
Exhibit 6.3
The line divides the two sides and is the downstroke of the T.
6.7 Worked examples
The entry of a few transactions can now be attempted.
1 The proprietor starts the firm with $10,000 in cash on 1 August 2017.
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These are entered as follows:
The date of the transaction has already been entered. Now there remains the
description which is to be entered alongside the amount. The double entry to
the item in the cash account is completed by an entry in the capital account,
and therefore the word ‘Capital’ will appear in the cash account. Similarly,
the double entry to the item in the capital account is completed by an entry in
the cash account, therefore the word ‘Cash’ will appear in the capital account.
The completed accounts are therefore:
This method of entering transactions therefore fulfils the requirements of the
double entry rules as shown in Section 4.4. Now let us look at the entry of
some more transactions.
2 A motor van is bought for $6,500 cash on 2 August 2017.
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3 Fixtures are bought on credit from Shop Fitters for $1,500 on 3 August
2017.
4 We paid the amount owing in cash to Shop Fitters on 17 August 2017.
5 Transactions to date: taking the transactions numbered 1–4 above, the
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records will now appear as follows:
Before you read further, you are required to work through Exercises 6.4, 6.5
and 6.8 at the end of this chapter.
Helpful Hint!
Practice tip:
Re-write the above worked examples on the appropriate accounting
stationery.
A further worked example
Now you have actually made some entries in accounts, you are to go
carefully through the following example. Make certain you can understand
every entry.
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The accounts for the transactions are now shown. The letters (A) to (I)
correspond to the transactions (A) to (I) in the preceding table.
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6.8 Abbreviation of ‘Limited’
In this book when we come across transactions with limited companies, the
letters ‘Ltd’ are used as the abbreviation for ‘Limited Company’. Thus, you
will know that, if we see the name of a firm as T. Lee Ltd, then that business
will be a limited company. In our books the transactions with T. Lee Ltd will
be entered in the same way as for any other customer or supplier.
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Summary
• This chapter covers the concept of double entry book-keeping
whereby every transaction affects two things. Each item has to be
entered twice in the book-keeping records, once on the debit side
and once on the credit side of an account.
• The double entry system of accounting follows the rules of the
accounting equation.
• Transactions are entered into the accounts rather than directly into
numerous statements of financial position.
• The use of ‘T accounts’ to record information is discussed.
• This chapter contains a fully worked example illustrating how
transactions cause increases and decreases in assets, liability and
capital accounts.
Chapter 6 Exercises
6.1 Complete the table showing which accounts are to be debited
and which are to be credited.
(a) Bought motor van for cash.
(b) Bought office machinery on credit from J. Grant & Son.
(c) Introduced capital in cash.
(d) A customer, J. Beach, pays us by cheque.
(e) Paid a supplier, A. Barrett, in cash.
6.2 The following table is also to be completed, showing the
accounts to be debited and credited.
(a) Bought machinery on credit from A. Jackson & Son.
(b) Returned machinery to A. Jackson & Son.
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(c) A customer, J. Brown, pays us in cash.
(d) J. Smith lends us money, giving it to us by cheque.
(e) Sold office machinery for cash.
6.3X Complete the following table.
(a) Bought office machinery on credit from D. Isaacs Ltd.
(b) Paid a supplier, C. Jones, from owner’s private monies
outside the firm.
(c) A customer, N. Fox, paid us in cash.
(d) Repaid part of loan from P. Exeter by cheque.
(e) Returned some of the office machinery to D. Isaacs Ltd.
(f) A customer, N. Lyn, pays us by cheque.
(g) Bought motor van by cash.
6.4 Complete the following table showing which accounts are to be
debited and which to be credited.
(a) Bought motor lorry for cash.
(b) Paid supplier, T. Lee, by cheque.
(c) Repaid P. Lopez’s loan by cash.
(d) Sold motor lorry for cash.
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(e) Bought office machinery on credit from Ultra Ltd.
(f) A customer, A. Hill, pays us by cash.
(g) A customer, J. Cross, pays us by cheque.
(h) Put a further amount into the business by cheque.
(i) A loan of $200 in cash is received from L. Lowe.
(j) Paid a supplier, D. Lord, by cash.
6.5 Write up the asset and liability accounts in the records of D. Coy
to record these transactions.
6.6 Write up the asset and liability and capital accounts to record the
following transactions in the records of G. Powell.
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6.7 You are required to open the asset and liability and capital
accounts and record the following transactions for June 2017 in
the records of Digital Computer Systems.
6.8X Write up the asset, capital and liability accounts in the records
of C. Williams to record the following transactions.
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6.9X Write up the accounts to record the following transactions.
6.10X Write up the asset, capital and liability accounts in the books
of N. Morris to record the following transactions.
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7 The double entry system for
the asset of inventory
Specific objectives
After you have studied this chapter you should be able to:
• understand the need to use various accounts in recording the
movement of inventory, that is, sales, purchases, returns
inwards/sales returns and returns outwards/purchases returns
accounts
• record the purchase and sale of goods both by credit and cash
using the double entry system
• record the return of goods in the returns inwards account (sales
returns) using the double entry system when customers return
goods to the firm
• record the return of goods in the returns outwards account
(purchase returns) using the double entry system when the firm
returns goods to their supplier
• explain the meaning of the terms purchases and sales as used in
accounting
• understand the differences in recording sales for cash compared
with sales made on credit.
7.1 Introduction
As stated in Chapter 1, it is the aim of all commercial organisations to make a
profit and to remain in business. Exhibit 1.1 demonstrated the need to sell
goods for more than was paid for them and it is important to record the cost
of goods purchased and the sale of goods at the selling price. The accounts
needed to record these transactions are now considered.
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7.2 Inventory movements
A business, on any particular date, will normally have goods which have
been bought previously and have not yet been sold. These unsold goods are
known as the business’s inventory of goods. The inventory of goods in a
business is therefore constantly changing because some of it is bought, some
is sold, some is returned to the suppliers and some is returned by the firm’s
customers.
To keep a check on the movements of inventory, various accounts are
opened as shown in the table below:
Account
Purchases account
Sales account
Returns inwards/Sales returns
account
Returns outwards/Purchases
returns account
Reason
For the purchase of goods
For the sale of goods
For goods returned to the firm by
its customers
For goods returned by the firm to
its suppliers
As inventory is an asset, and these four accounts are all connected with this
asset, the double entry rules are those used for assets.
We shall now look at some specific entries in the following sections.
7.3 Purchase of inventory on credit
On 1 August 2017, goods costing $1,650 are bought on credit from D. Henry.
First, the twofold effect of the transaction must be considered so that the
book-keeping entries can be worked out. We have the following:
1 The increase in the asset of inventory. An increase in an asset needs a
debit entry in an account. Here the account is an inventory account
showing the particular movement of inventory; in this case it is the
‘purchases’ movement, so the account must be the purchases account.
2 There is an increase in a liability. This is the liability of the firm to D.
Henry because the goods supplied have not yet been paid for. An increase
in a liability needs a credit entry, so in order to enter this part of the
transaction a credit entry is made in D. Henry’s account.
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Here again, we can use the idea of the debit side being ‘in’ to the account,
and the credit side being ‘out’ of the account. In this case, purchases have
come ‘in’ – thus creating a debit in the Purchases account; whereas the goods
have come ‘out’ of D. Henry – needing a credit in the account of D. Henry.
7.4 Purchases of inventory for cash
On 2 August 2017, goods costing $2,200 were bought, cash being paid for
them immediately.
1 The asset of inventory is increased. Thus, a debit entry will be needed.
The movement of inventory is that of a purchase, so it is the Purchases
account which needs debiting. (Purchases have come ‘in’ – debit the
Purchases account.)
2 The asset of cash is decreased. To reduce an asset a credit entry is called
for, and the asset is that of cash so the Cash account needs crediting. (Cash
has gone ‘out’ – credit the Cash account.)
7.5 Sales of inventory on credit
On 3 August 2017, goods were sold on credit for $3,000 to J. Lee.
1 An asset account is increased. This is the account showing that J. Lee is a
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debtor for the goods and is classed as an account receivable. The increase
in the asset of accounts receivable requires a debit and the debtor is J. Lee,
so the account concerned is that of J. Lee. (Goods have gone ‘in’ to J. Lee
– debit J. Lee’s account.)
2 The asset of inventory is decreased. For this a credit entry to reduce an
asset is needed. The movement of inventory is that of ‘Sales’, so the
account credited is the Sales account. (Sales have gone ‘out’ – credit the
Sales account.)
7.6 Sales of inventory for cash
On 4 August 2017, goods were sold for $550, the cash for them being paid
immediately.
1 The asset of cash is increased. A debit in the Cash account is needed to
show this. (Cash has come ‘in’ – debit the Cash account.)
2 The asset of inventory is reduced. The reduction of an asset requires a
credit and the movement of inventory is represented by ‘Sales’. So, the
entry needed is a credit in the Sales account. (Sales have gone ‘out’ –
credit the Sales account.)
Helpful Hint!
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Question:
How is the purchase of inventory for cash different from the purchase
of inventory on credit? If you owned a business, how would you
prefer your purchases of inventory be made? Why?
7.7 Returns inwards or sales returns
Returns inwards or sales returns represent goods sold which have
subsequently been returned by a customer. This could be for various reasons,
such as:
• the goods sent to the customer are of the incorrect size, colour or model
• the goods have been damaged in transit
• the goods are of poor quality.
As the original sale was entered in the double entry system, the return of
these goods must also be entered using the same system.
On 5 August 2017, goods that had previously been sold to F. Lowe for
$290, have been returned by her.
1 The asset of inventory was increased by the goods returned. A debit
representing an increase of an asset is needed, and this time the movement
of inventory is that of ‘returns inwards’. The entry required therefore is a
debit in the returns inwards account. (The goods have come ‘in’ – debit the
returns inwards account.)
2 An asset is decreased. The debt of F. Lowe to the firm is now reduced,
and to record this a credit is needed in F. Lowe’s account. (The goods have
come ‘out’ of F. Lowe – credit F. Lowe’s account.)
An alternative name for a returns inwards account is a sales returns account.
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7.8 Returns outwards or purchases
returns
These represent goods that were purchased, and are now being returned to the
supplier. As the original purchase was entered in the double entry system, so
also is the return to the supplier of these goods.
On 6 August 2017 goods previously bought for $960 were returned by the
firm to K. Hogan.
1 The liability of the firm to K. Hogan was decreased by the value of the
goods returned to him. The decrease in a liability needs a debit, this time
in K. Hogan’s account. (The goods have gone ‘in’ to K. Hogan – debit K.
Hogan’s account.)
2 The asset of inventory is decreased by the goods sent out. A credit
representing a reduction in an asset is needed, and the movement of
inventory is that of ‘Returns Outwards’ so the entry will be a credit in the
Returns Outwards account. (The returns have gone ‘out’ – credit the
Returns Outwards account.)
7.9 A worked example
2017
May 1
May 2
May 5
May 6
May 10
Bought goods on credit $680 from D. Small.
Bought goods on credit $770 from A. Lyon & Son.
Sold goods on credit to D. Hughes for $600.
Sold goods on credit to M. Spencer for $450.
Returned goods $150 to D. Small.
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May 12
May 19
May 21
May 22
May 30
May 31
Goods bought for cash $1,000.
M. Spencer returned $160 goods to us.
Goods sold for cash $1,500.
Paid cash to D. Small $530.
D. Hughes paid the amount owing by him $600 in cash.
Bought goods on credit $640 from A. Lyon & Son.
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7.10 Special meaning of ‘Sales’ and
‘Purchases’
It must be emphasised that ‘Sales’ and ‘Purchases’ have a special meaning in
accounting language.
Purchases in accounting means the purchase of those goods that the firm
buys with the prime intention of selling. Sometimes the goods may be
altered, added to or used in the manufacture of something else, but it is the
element of resale that is important. To a firm that trades in computers, for
instance, computers are purchases. If something else is bought, such as a
motor van, such an item cannot be called purchases, even though in ordinary
language it may be said that a motor van has been purchased. The prime
intention of buying the motor van is for use by the company and not for
resale.
Similarly, Sales means the sale of those goods in which the firm normally
deals and which were bought with the prime intention of resale. The
description ‘Sales’ must never be given to the disposal of other items.
If we did not keep to these meanings, it would result in the different kinds
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of inventory accounts containing something other than goods sold or for
resale.
Helpful Hint!
Examination tip:
Double-check your entries in your answer booklet. Make sure that
you enter each entry in the appropriate account.
7.11 Comparison of cash and credit
transactions for purchases and sales
The difference between the records needed for cash and credit transactions
can now be seen.
The complete set of entries for purchases of goods where they are paid for
immediately by cash would be:
1 debit the purchases account
2 credit the cash account.
On the other hand, the complete set of entries for the purchase of goods on
credit can be broken down into two stages. First, the purchase of the goods
and, second, the payment for them. The first part is:
1 debit the purchases account
2 credit the supplier’s account.
The second part is:
1 debit the supplier’s account
2 credit the cash account.
The difference can now be seen. With the cash purchase, no record is kept of
the supplier’s account. This is because cash passes immediately and therefore
there is no need to keep a check of indebtedness (money owing) to a supplier.
On the other hand, in the credit purchase the records should show to whom
money is owed until payment is made.
A study of cash sales and credit sales will reveal a similar difference.
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Summary
• Goods must be sold at a higher price than the cost price to make a
profit. If sold at a lower price than the cost price, a loss would
occur.
• Various accounts are used to record the movement of inventory
because inventory is normally sold at a higher price than its cost.
• The accounts used to record the movement of inventory are:
– purchases account to record the purchases of inventory as debit
entries in the account since the goods come ‘IN’ to the firm
– sales account for the sale of the goods as credit entries in the
account because the goods go ‘OUT’ of the firm
– returns inwards/sales returns account to record goods that a
customer returns to the firm as debit entries since the goods are
returned ‘IN’ to the firm
– returns outwards/purchases returns account to record goods
that the firm returns to its suppliers as the goods go ‘OUT’ of the
firm.
• There is special meaning in accounting terms of ‘purchases’ and
‘sales’, namely that purchases refer to goods bought for resale.
Purchases of assets such as a motor van to be used in the
business are recorded separately in the asset account, motor van.
Sales refers to goods sold in the normal course of business. The
disposal of an asset such as equipment should never be recorded
in the sales account but recorded separately in a disposal account
to be discussed later.
• Purchases for cash are never entered in the supplier’s account
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while purchases on credit are always entered in the supplier’s
(creditor’s) account.
• Sales for cash are never entered in the customer’s account while
sales on credit are always entered in the customer’s (debtor’s)
account.
Chapter 7 Exercises
7.1 Complete the following table showing which accounts are to be
credited and which are to be debited.
(a) Goods bought, cash being paid immediately.
(b) Goods bought on credit from E. Flynn.
(c) Goods sold on credit to C. Grant.
(d) A motor van sold for cash.
(e) Goods sold for cash.
7.2 Similarly, complete this next table.
(a) Goods returned to H. Fong.
(b) Goods bought on credit from P. Franklin.
(c) Goods sold on credit to S. Mullings.
(d) M. Patterson returns goods to us.
(e) Goods bought being paid for by cheque immediately.
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7.3X Complete the following table showing which accounts are to be
credited and which are to be debited.
(a) Goods bought on credit from J. Reid.
(b) Goods sold on credit to B. Perkins.
(c) Motor vans bought on credit from H. Quarrie.
(d) Goods sold, a cheque being received immediately.
(e) Goods sold for cash.
(f) Goods we returned to H. Hardy.
(g) Machinery sold for cash.
(h) Goods returned to us by J. Nelson.
(i) Goods bought on credit from D. Singh.
(j) Goods we returned to H. Forbes.
7.4X Complete the following table.
(a) Goods bought on credit from T. Morgan.
(b) Goods returned to us by J. Thomas.
(c) Machinery returned to L. Jones Ltd.
(d) Goods bought for cash.
(e) Motor van bought on credit from D. Davies Ltd.
(f) Goods returned by us to I. Prince.
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(g) D. Picton paid us his account by cheque.
(h) Goods bought by cheque.
(i) We paid creditor, B. Henry, by cheque.
(j) Goods sold on credit to J. Mullings.
7.5 Enter the following transactions of K. Debrita for the month of
June 2018.
7.6 T. Luthan decided to start his own business and asks you to
assist by entering the following transactions in the books of
account for July 2018.
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7.7 Enter the following transactions in the books of A. Miller for the
month of August 2017.
7.8 Enter the following transactions in the records of E. Sangster.
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7.9X Ahmed has just started his own business selling computer
equipment and software. The following transactions took place
during his first month of trading, June 2018. You are required to
enter them into the books of account.
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8 The double entry system for
expenses and revenues
Specific objectives
After you have studied this chapter you should be able to:
• understand the concept of profit and loss by comparing revenue
with expenses
• see the effects of profits and losses on capital and the relationship
to the accounting equation
• understand why separate accounts are used for each type of
expense and revenue
• record expenses and revenues using the double entry system
• understand the term drawings, be able to record them and
recognise the effects of drawings on capital.
8.1 The nature of profit or loss
To an accountant, profit means the amount by which revenues are greater
than expenses for a set of transactions. The term revenues means the value
of goods and services that have been supplied to customers. The term
expenses means the value of all the assets that have been used up to obtain
those revenues.
If, therefore, we had supplied goods and services valued for sale at
$100,000 to customers, and the expenses incurred by us to be able to supply
those goods and services amounted to $70,000, then the result would be a
profit, calculated as follows:
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On the other hand, it is possible for expenses to exceed our revenues for a set
of transactions. In this case the result is a loss. For instance, a loss would be
incurred given the following details.
8.2 The effects of profit or loss on
capital
Businesses exist to make profits and so increase their capital. Let us look at
the relationship between profits and capital in an example.
On 1 January the assets and liabilities of a firm are:
• Assets: Fixtures $10,000; Inventory $7,000; Cash at bank $3,000
• Liabilities: Accounts payable $2,000
The capital is found by the formula:
In this case capital works out as:
During January the whole of the $7,000 inventory is sold for $11,000 cash.
On 31 January the assets and liabilities have become:
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The capital can be calculated:
It can be seen that capital has increased from $18,000 to $22,000 = $4,000
increase because the $7,000 inventory was sold for $11,000, a profit of
$4,000. Profit, therefore, increases capital:
On the other hand, a loss would reduce the capital so:
Helpful Hint!
Discussion:
Define ‘capital’. Why is it important in the start-up of any business?
What is the difference between share and loan capital?
8.3 Profit or loss and sales
Profit will be made when goods are sold at more than cost price, while the
opposite will mean a loss.
8.4 Profit or loss and expenses
In Section 8.1, it was shown that profit was made when the goods were sold
for more than the cost price. As well as the cost of the goods, a firm incurs
other expenses such as rent, salaries, wages, telephone and internet costs,
motor expenses and so on. Every extra $1 of expenses will mean $1 less
profit.
All expenses could be charged to one Expenses account, but it would then
be difficult to identify specific areas of the firm’s expenditure, such as the
amount spent on motor running costs or rent. To facilitate the need to know
different types of expenses, a separate account is opened for each type of
expense, for instance:
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In the same way that separate accounts are opened for each type of expense,
separate accounts are also opened for any additional revenue that the business
may receive, such as rent received or bank interest received. Again, separate
revenue accounts can be opened as follows:
It is purely a matter of choice in a business as to the nature of each expense or
revenue account. For example, an account for postage stamps could be called
‘Postage stamp account’, ‘Postage account’ or even ‘Communication
expenses account’. Also, some businesses amalgamate expenses – for
example, ‘Printing, stationery and advertising account’. Infrequent or small
items of expense are usually put into a ‘Sundry expenses account’ or
‘General expenses account’.
8.5 Debit or credit
We have to decide whether expense accounts are to be debited or credited
with the amounts involved. Assets involve expenditure by the firm and are
shown as debit entries. Expenses also involve expenditure by the firm, and
therefore should also be debit entries. Why? Because assets and expenses
must ultimately be paid for. This payment involves a credit to the bank
account (or cash account) so the original entry in the asset account or in the
expense account must be a debit.
An alternative explanation may also be used for expenses. Every expense
results in a decrease in an asset or an increase in a liability, and because of
the accounting equation this means that the capital is reduced by each
expense. The decrease of capital needs a debit entry and, therefore, expense
accounts contain debit entries for expenses.
Revenue is the opposite of expenses and, therefore, appears on the opposite
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side to expenses – that is, revenue accounts appear on the credit side of the
books. Pending the periodic calculation of profit, therefore, revenue is
collected together in appropriately named accounts, and until it is transferred
to the profit calculations it will need to be shown as a credit.
Consider, too, that expenditure of money pays for expenses, which are
used up in the short term, or assets, which are used up in the long term – both
for the purpose of gaining revenue. Both of these are shown on the debit side
of the accounts, while the revenue that has been gained is shown on the credit
side of the accounts.
8.6 Effect of transactions
A few illustrations will demonstrate the double entry required.
Example 1: Rent of $200 is paid in cash. Here the twofold effect is:
1 The total of the expense of rent is increased – a benefit goes ‘in’. As
expense entries are shown as debits, and the expense is rent, so the action
required is the debiting of the Rent account.
2 The asset of cash is decreased – money goes ‘out’. This means crediting
the Cash account to show the decrease of the asset.
Summary: Debit the Rent account with $200 – ‘in’.
Credit the Cash account with $200 – ‘out’.
Example 2: Motor expenses are paid with a cheque for $550. The twofold
effect is:
1 The total of the motor expenses paid is increased – a benefit is received
‘in’.
To increase an expenses account needs a debit, so the action required is to
debit the Motor expenses account – ‘in’.
2 The asset of money in the bank is decreased – money goes ‘out’. This
means crediting the Bank account to show the decrease of the asset – ‘out’.
Summary: Debit the Motor expenses account with $550 – ‘in’.
Credit the Bank account with $550 – ‘out’.
Example 3: $260 cash is paid for telephone expenses. The twofold effect is:
1 The total of telephone expenses is increased – a benefit received goes
‘in’. Expenses are shown by a debit entry, therefore, to increase the
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expense account in question, the action required is to debit the Telephone
expenses account.
2 The asset of cash is decreased – money goes ‘out’. This needs a credit in
the Cash account to decrease the asset.
Summary: Debit the Telephone expenses account with $260 – ‘in’.
Credit the Cash account with $260 – ‘out’.
It is now possible to study the effects of some more transactions showing
the results in the form of a table. See Exhibit 8.1.
Exhibit 8.1
These examples can now be shown in account form:
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8.7 Drawings
The owner may want to take cash out of the business for his or her private
use. This is known as drawings. Money taken out as drawings will reduce
capital.
Each amount taken as drawings will be debited to a drawings account and
at the end of the year this is transferred to the capital account and will be
explained later.
The following example illustrates the entries for drawings.
On 25 August 2017, the proprietor takes $200 cash out of the business for
his own use.
Sometimes goods are taken for private use. These are also known as
drawings. Entries for such transactions will be described in Chapter 27
Section 27.9.
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8.8 Revenues and double entry
We have just looked at instances of expenses being recorded. There will also
be the need to record revenues. We will now look at an example.
Example: On 5 June 2017 it is decided that part of a firm’s premises are
not needed at the moment. The firm lets someone else use the surplus space
and receives rent of $740 by cheque. Here the twofold effect is:
1 The asset of the bank is increased – money comes ‘in’. This means
debiting the bank account to show the increase of the asset.
2 The total of the revenue of rent received is increased – the benefit
comes ‘out’ of rent received so the action required is the crediting of the
Rent received account.
Summary: Debit the Bank account with $740 – ‘in’.
Credit the Rent received account with $740 – ‘out’.
This will therefore appear as:
Helpful Hint!
Examination tip:
Remember that when incurring an expense, the business receives
the benefit of that expense for example, stationery, therefore the
entry is always a debit in the expense account and a credit in either
the cash or bank account. The money goes ‘out’.
Summary
• The calculation of profit is achieved by comparing revenues with
expenses incurred in running the business.
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• A loss occurs when the expenses incurred are more than the
revenue earned.
• If a business makes a profit, that profit belongs to the owner of the
business and consequently their capital is increased by that
amount.
• It is important to record expenses in separate expense accounts to
enable the business to identify various areas of expense such as
motor expenses, stationery, etc.
• Different types of revenue should also be recorded in separate
accounts to provide information of the income received.
• The procedure for recording expenses and revenue in the various
accounts uses the double entry system.
• ‘Drawings’ are recorded in a separate account. They are then
deducted from the owner’s capital account and are never an
expense of the business.
Chapter 8 Exercises
8.1 Complete the following table, showing the accounts to be debited
and those to be credited.
(a) Paid rates by cheque.
(b) Paid staff by cash.
(c) Rent received by cheque.
(d) Received by cheque refund of insurance previously paid.
(e) Paid general expenses by cash.
8.2 Complete the following table.
(a) Paid rent by cash.
(b) Paid for goods by cash.
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(c) Received by cheque a refund of rates already paid.
(d) Paid general expenses by cheque.
(e) Received commissions in cash.
(f) Goods returned by us to T. Jones.
(g) Goods sold for cash.
(h) Bought office fixtures by cheque.
(i) Paid staff in cash.
(j) Took cash out of business for private use.
8.3X Complete the following table, showing the accounts to be
debited and those to be credited.
(a) Paid insurance by cheque.
(b) Paid motor expenses by cash.
(c) Rent received in cash.
(d) Paid rates by cheque.
(e) Received refund of rates by cheque.
(f) Paid for stationery expenses by cash.
(g) Paid staff by cash.
(h) Sold surplus stationery receiving proceeds by cheque.
(i) Received sales commission by cheque.
(j) Bought motor van by cheque.
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8.4X The following table should be completed.
(a) Sold surplus stationery, receiving proceeds in cash.
(b) Paid staff by cheque.
(c) Rent received for premises sublet, by cheque.
(d) Goods returned to us by B. Roberts.
(e) Commission received by us previously in error, we now
refund this by cheque.
(f) Bought machinery by cheque.
(g) Paid lighting expenses in cash.
(h) Insurance rebate received by cheque.
(i) Buildings bought by cheque.
(j) Building repairs paid in cash.
8.5 Enter the following transactions in the necessary accounts in
double entry.
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8.6 The following are the transactions of C. Little for the month of
May 2017. You are required to enter the transactions in the
appropriate accounts using the double entry system.
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8.7X Write up the following transactions in the books of J. Blake for
March 2017.
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8.8X Enter the following transactions in double entry.
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8.9X Write up the following transactions in the records of D. DaSilva.
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9 Balancing off accounts
Specific objectives
After you have studied this chapter you should be able to:
• understand what is meant by ‘balancing off’ accounts
• balance off accounts at the end of a period and bring down the
opening balance to the next period
• distinguish between a debit balance and a credit balance
• prepare accounts in a three-column format, as used in
computerised accounts.
9.1 Introduction
In the preceding chapter, the entries into the various accounts have been
shown. However, at the end of a period, usually monthly, each account will
require ‘balancing off’. Balancing off simply means finding the difference
between the total of the debit entries and the total of the credit entries in a
particular account. The difference between the two sides is known as the
‘balance’ and this figure is inserted on the side of the account that shows the
least amount of money. If both sides of the account are then totalled up, they
should agree, having inserted the balance; if they do not add up correctly,
then an error may have been made in the calculation of the balance or perhaps
in adding up the account. The calculation will then need to be rechecked.
Sometimes an account simply requires closing off; this is when both the
debit and credit sides total up to exactly the same amount and thus there is no
balance.
In the following examples, we will consider balancing off accounts at the
end of a period and bringing down the balances to the next accounting period.
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9.2 Accounts for customers (Accounts
receivable)
Where customers have paid their accounts
So far, we have considered how to record transactions in the accounting
books by means of debit and credit entries. At the end of each accounting
period, the figures in each account are examined to see what they reveal. One
of the most obvious reasons for this is to find out how much money our
customers owe us for goods we have sold to them. As mentioned above, this
procedure is usually carried out monthly.
We will now look at the account of one of our customers, K. Morgan, for
transactions in August 2017.
This shows that during the month we sold a total of $444 goods to Morgan,
and have been paid a total of $444 by him. At the close of business at the end
of August, he therefore owes us nothing. His account can be closed off on 31
August 2017 by inserting the totals of each side, as follows.
Notice that totals in accounting are shown with a single line above them, and
a double line underneath. Totals on accounts at the end of a period are always
shown on a level with one another, as shown in the following completed
account for C. Lee.
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In this account, C. Lee also owed us nothing at the end of August 2017, as
she had paid us for all sales to her.
If an account contains only one entry on each side and they are equal, you
do not need to include totals. For example:
Where customers still owe for goods
Not all of our customers will have paid their accounts by the end of the
month and will have amounts outstanding on their account. In these cases, the
totals of each side would not equal one another. Let us look at the account of
D. Thomas for August 2017.
You will see that the debit side adds up to $482 and the credit side adds up to
$158. The difference of $324 (that is, $482 – $158) represents sales of $206
and $118 not paid for and is, therefore, owing to us on 31 August 2017.
In double entry, we only enter figures as totals if the totals on both sides of
the account agree. We do, however, want to close off the account for August,
but show that Thomas owes us $324. If he owes $324 at close of business on
31 August 2017, then he will still owe us that same figure when the business
opens on 1 September 2017.
We show this by balancing the account. This is done in five stages.
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1 Add up both sides to find out their totals. Do not write anything permanent
in the account at this stage, but you could write the figures lightly in
pencil.
2 Deduct the smaller total from the larger total to find the balance.
3 Now enter the balance on the side with the smallest total. This means the
totals will now be equal.
4 Enter totals on a level with each other.
5 Now enter the balance on the line below the totals. The balance below the
totals should be on the opposite side to the balance shown above the totals.
Against the balance above the totals, complete the date column by showing
the last day of that period. Below the totals show the first day of the next
period against the balance. The balance above the totals is described as
balance carried down. The balance below the total is described as balance
brought down.
Thomas’ account when ‘balanced off’ will appear as shown in Exhibit 9.1.
Exhibit 9.1
We can now look at another account prior to balancing.
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We will abbreviate ‘carried down’ to ‘c/d’ and ‘brought down’ to ‘b/d’ from
now on.
Notes:
• The date given to ‘Balance c/d’ is the last day of the period which is
finishing, and ‘Balance b/d’ is given the opening date of the next period.
• As the total of the debit side originally exceeded the total of the credit side,
the balance is said to be a debit balance.
If accounts contain only one entry, it is unnecessary to enter the total. A
double line ruled under the entry will mean that the entry is its own total. For
example:
9.3 Accounts for suppliers (Accounts
payable)
Exactly the same principles will apply when the balances are carried down to
the credit side. We can look at two accounts of our suppliers which are to be
balanced off.
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We now add up the totals and find the balance, that is, stages 1 and 2. When
balanced these will appear as shown in Exhibit 9.2.
Exhibit 9.2
Before you read further, attempt Exercises 9.1, 9.2 and 9.3 at the end of this
chapter.
The type of accounts that have been demonstrated so far are often known
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as ‘T accounts’ (see Section 5.6) since the accounts are in the shape of a letter
‘T’. The following accounts show the three-column method, which is used in
computerised accounting systems.
9.4 Computers and accounts
Through the main part of this book, the type of account used shows the lefthand side of the account as the debit side and the right-hand side as the credit
side. However, when most computers are used, the style of the ledger account
is different. It appears as three columns of figures, there being one column for
debit entries, another column for credit entries and the last column for the
balance. If you have a current account at a bank, your bank statements will
normally be shown using this method.
The accounts used in this chapter will now be re-drafted to show the ledger
accounts drawn up in this way.
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You will notice in the above accounts that the balance is calculated after
every entry. This can be done quite simply when using a computer
accounting package since the software can automatically calculate the new
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balance after each entry.
Helpful Hint!
Examination tip:
Read your question carefully to see what type of accounting format
you are asked to use. If a form is provided in your answer booklet,
use it and do not draw your own form.
However, when manual methods are being used, it is often too much work
to have to calculate a new balance after each entry. Also, the greater the
number of calculations, the greater the possibility of errors. For these reasons,
it is usual for students to use two-sided accounts. However, it is important to
note that there is no difference in principle; the final balances are the same
using either method.
Summary
• This chapter describes what is meant by ‘balancing off’ accounts at
the end of a period.
• Balance off appropriate accounts at the end of a period and bring
down the opening balance to the beginning of the next period.
• Opening balances brought down on the debit side are referred to
as debit balances whereas those brought down on the credit side
are known as credit balances.
• ‘Customers’ (accounts receivable) are people or organisations who
owe money to the business. Their accounts in your accounting
records show a greater value on the debit side, hence they are
your ‘debtors’.
• ‘Suppliers’ (accounts payable) are people or organisations that the
business owes money to. Their accounts in your accounting
records show a greater value on the credit side, hence they are
your ‘creditors’.
• ‘T accounts’ are used generally for recording transactions where
there is a manual system of accounting.
• Computerised accounting packages use three-column accounts.
Illustrations preparing three-column accounts are shown.
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• Both ‘T accounts’ and the three-column accounts show the same
information and the balances will be identical whichever method is
used.
Chapter 9 Exercises
9.1 Enter the following items in the appropriate customers’ accounts
only; do not write up other accounts. Then balance off each of
these personal accounts at the end of the month. (Keep your
answer; it will be used as a basis for question 9.4X.)
9.2 Enter the following in the appropriate suppliers accounts only; do
not write up the other accounts. Then balance off each of these
personal accounts at the end of the month. (Keep your answer; it
will be used as the basis of question 9.5X.)
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9.3 Enter the following in the appropriate customers’ and suppliers’
accounts only; do not write up the other accounts. Then balance
off each of these personal accounts at the end of the month.
After completing this, state which of the balances represent
accounts receivable and which represent accounts payable.
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9.4X Redraft each of the accounts given in your answer to 9.1 in
three-column ledger style accounts as would be produced by a
computer (see Section 9.4 of the text).
9.5X Redraft each of the accounts given in your answer to 9.2 in
three-column ledger style accounts, as would be produced by a
computer (see Section 9.4 of the text).
9.6X Enter the following items in the personal accounts (i.e.
accounts payable) only, do not write up the other accounts.
Balance off each personal account at the end of the month.
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9.7X Enter the following items in the necessary personal accounts;
do not write up the other accounts. Balance each personal
account at the end of the month.
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9.8X Enter the following, personal accounts only. Bring down
balances at the end of the month. After completing this, state
which of the balances represent customers (accounts
receivable) and those which are suppliers (accounts payable).
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10 The trial balance
Specific objectives
After you have studied this chapter you should be able to:
• understand the purpose of the trial balance
• understand why trial balance totals should equal one another
• construct a trial balance from a given set of figures
• appreciate that some kinds of errors can be made but the trial
balance totals will still equal one another
• understand what steps to take if the trial balance does not balance
• outline the uses and limitations of the trial balance.
10.1 Introduction
A trial balance is an essential stage in ensuring the accuracy of the bookkeeping entries prior to the preparation of the financial statements. It is a list
of account titles and their balances in the ledgers on a specific date. The trial
balance lists the name of each account together with the balance shown in
either the debit or credit columns. Since every debit entry in double entry
book-keeping should have a corresponding credit entry, then provided no
errors have occurred, the two columns should agree when totalled.
It is important to note that the trial balance is not part of the double entry
system, it is merely a list of balances drawn up to check the arithmetical
accuracy of the book-keeping entries. It does, however, serve two purposes:
1 it checks the accuracy of the double entry transactions
2 it facilitates the preparation of the financial statements of the business (this
is a topic covered in Part 2 of this book).
10.2 Total debit entries = Total credit
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entries
Using the double entry system of book-keeping it has been shown that:
• for each debit entry there is a credit entry
• for each credit entry there is a debit entry.
All the items recorded in all the accounts on the debit side should equal in
total all the items recorded on the credit side of the books. We need to check
that for each debit entry there is also a credit entry. In order to do so, we
prepare a trial balance which may be drawn up at the end of a period.
Each account needs to be balanced off as shown in the previous chapter.
Then each balance is listed in the trial balance. If the outstanding balance is a
debit balance, then it would be entered in the debit column of the trial balance
and if a credit balance then this would be entered in the credit column. The
trial balance would then be totalled and if both sides agree then this is proof
that certain types of errors have not been made. However, some errors may
have occurred which the trial balance does not detect. This is discussed in
Section 10.5 and later in Chapters 31 and 32.
Using the worked exercise from Chapter 7, Section 7.9, the trial balance
would be as follows:
Exhibit 10.1
Here the two sides ‘balance’, in other words both the debit column and the
credit column add up to the same amount: $4,110.
This form of trial balance is the easiest to extract when there are more than
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a few transactions during the period and it is one accountants use. As
mentioned in the introduction to this chapter, the main purposes of preparing
a trial balance are to ensure that no errors have been made and to facilitate the
preparation of the financial statements. The financial statements consist of an
trading and profit and loss account (income statement) which shows how
much profit the business has earned in a period. The statement of financial
position (balance sheet) shows what the assets and liabilities of a business are
at the end of a period. Both these financial statements are dealt with in Part 2
of this book.
Helpful Hint!
Discussion:
Write a sentence on what the statement of financial position (balance
sheet) is and why it is important. Is it part of the financial statements
of a company? Why do you say so?
10.3 A worked example
The following accounts for K. Patterson have been entered up for May 2017
and balanced off.
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After each account has been balanced off, a trial balance can then be prepared
as follows:
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10.4 The uses of trial balances
Trial balances may be used:
• to check that the books ‘balance’, that is, that every debit entry has been
accompanied by a credit entry
• to ascertain the net amount of the error(s), should an error(s) have been
made
• as a basis from which the financial statements are prepared, that is, the
trading account, profit and loss account (income statement) and the
statement of financial position (balance sheet) (these are explained in Part
2).
10.5 Trial balances and errors
Students new to accounting often assume that when a trial balance ‘balances’
the entries in the accounts must be correct. This, however, may not be true. It
means that certain types of errors have not been made, but there are several
other types of errors that will not affect the balancing of a trial balance, such
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as omitting a transaction altogether. Another example might be a credit sale
of $87 to a customer that is inadvertently debited to the sales account instead
of being credited; the customer’s account then being credited instead of being
debited. Since both the debit and the credit entries are of the same amount,
this will not affect the agreement of the trial balance.
Examples of the errors which would be revealed, provided there are no
compensating errors that cancel them out, are: addition errors, using one
figure for the debit entry and another figure for the credit entry, entering only
one aspect of a transaction and so on. These will be considered in greater
detail in Chapters 31 and 32.
10.6 Steps to take if the trial balance
does not balance
If the trial balance does not balance, that is, the two totals are different, then
this is evidence that one or more errors have been made in either the double
entry book-keeping or in the preparation of the trial balance itself. In this
case, the following eight steps should be taken to locate the error(s).
1 If the trial balance is badly written and contains many alterations, then
rewrite it.
2 Add up again each side of the trial balance. If you added the numbers
‘upward’ the first time, then start at the top and work ‘downwards’ the
second time and vice versa.
3 Find the amount of the discrepancy and then check in the accounts for a
transaction of this amount and, if located, ensure that the double entry has
been carried out correctly.
4 Halve the amount of the discrepancy. Check to see whether there is a
transaction for this amount and, if located, ensure the double entry has
been carried out correctly. This type of error may have occurred if an item
has been entered on the wrong side of the trial balance.
5 If the amount of the discrepancy is divisible by nine, this indicates that
when the figure was originally entered it may have had digits transposed,
for example $63 entered in error as $36, or $27 entered as $72.
6 Check that the balance on each account has been correctly calculated and
entered onto the trial balance in the right column using the correct amount.
7 Ensure that every outstanding balance from all the ledgers and the cash
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book have been included in the trial balance and tick each balance after
ensuring it is entered correctly.
8 If the error has still not been identified, then the error must be sought in the
accounts themselves. It may be necessary to check all the entries from the
date of the last trial balance.
Helpful Hint!
Examination tip:
The Trial Balance is NOT part of the double entry but is a list of all
the debit and credit balances at a specific date. Provided no errors
have been made, the two columns in it should agree.
Summary
• A trial balance is a list of account titles and their balances in the
ledger at a specific date which is prepared to check the arithmetical
accuracy of the book-keeping entries.
• A trial balance also assists in the preparation of the financial
statements.
• A worked example of a trial balance is shown.
• The balancing of a trial balance does not always indicate that no
errors have been made since certain errors can be made and the
trial balance will still agree.
• The chapter shows what steps to take if a trial balance does not
balance.
Chapter 10 Exercises
10.1 You are to enter up the necessary accounts for the month of
May from the following details, and then balance off the accounts
and extract a trial balance as at 31 May 2017.
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10.2 Write up the accounts from the following details for the month of
March, and extract a trial balance as at 31 March 2017.
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10.3 The following transactions are to be entered up in the ledger for
June. Balance off all accounts and extract a trial balance as at
30 June 2018.
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10.4X You are required to enter the following transactions in the
necessary accounts for November 2017. At the end of the
month, balance off the accounts and prepare a trial balance.
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10.5X Record the following for the month of June, balance off all the
accounts, and then extract a trial balance as at 30 June 2018.
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10.6 Correct and balance the following trial balance.
10.7X From the following list of balances, prepare a trial balance as
at 31 December 2017 for Ms Anita Hall.
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Multiple-choice questions – Set 1 (1 to 20)
Each multiple-choice question has four suggested answers: (A), (B),
(C) or (D). You should read each question and then decide which
choice is best. Write down your answers on a separate piece of
paper. You will then be able to repeat the set of questions later
without the distraction of previously written attempts.
When you have completed a set of questions, check your answers
against those given in Appendix C.
1 Which of the following statements is incorrect?
(A) Assets + Capital = Liabilities
(B) Capital = Assets – Liabilities
(C) Liabilities + Capital = Assets
(D) Liabilities = Assets – Capital
2 Which of the following is not an asset?
(A) Cash at the bank
(B) Premises
(C) Inventory
(D) Accounts payable
3 Which of the following is a liability?
(A) Buildings
(B) Accounts receivable
(C) Loan from J. Henry
(D) Equipment
4 Which of the following is incorrect?
5 Which of the following statements is correct?
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6 Which of the following are incorrect?
(A) (i) and (ii)
(B) (ii) and (iii)
(C) (i) and (iii)
(D) None of them
7 Which of the following are incorrect?
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(A) (ii) and (iv) only
(B) (i), (ii) and (iii) only
(C) (ii) and (iii) only
(D) (iii) and (iv) only
8 Which of the following are correct?
(A) (i) and (iv) only
(B) (ii) and (iii) only
(C) (ii) and (iv) only
(D) (i) and (iii) only
9 Which of the following best describes the meaning of ‘Sales’?
(A) Items sold for cash or on credit
(B) Assets sold on credit
(C) The sale of items bought previously
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(D) Sale of items previously included in ‘Purchases’
10 Which of the following should not be called ‘Purchases’?
(A) Purchase of a motor van for use by a business
(B) Goods bought on credit
(C) Goods bought for cash
(D) Items bought for the prime purpose of resale
11 Which of the following are incorrect?
(A) (ii) and (iii)
(B) (i) and (ii)
(C) (iii) and (iv)
(D) (ii) and (iv)
12 Which of the following are correct?
(A) (i), (iii) and (iv) only
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(B) (i), (ii) and (iii) only
(C) All of them
(D) (i), (ii) and (iv) only
13 From the following information you are to ascertain the amount of
capital. Premises, $55,000, motor vehicles, $17,800, inventory,
$6,450, accounts receivable, $3,720, bank, $1,110, accounts
payable, $4,000, loan from D. Allen, $10,000.
(A) $60,080
(B) $65,580
(C) $70,080
(D) None of the above
14 Which of the following is correct?
(A) Capital is reduced by a loss.
(B) Profit does not affect capital.
(C) If there is no profit, there is no capital,
(D) A loan received will reduce capital.
15 Of the following, which are incorrect?
(A) (ii) and (iv) only
(B) (i), and (iv) only
(C) (i) and (iii) only
(D) (ii) and (iii) only
16 Which of the following are correct?
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(A) (i), (ii) and (iv) only
(B) (i) and (ii) only
(C) (i), (ii) and (iii) only
(D) (ii) and (iii) only
17 What is the balance on the following account on 30 June 2018?
(A) A debit balance of $601
(B) A credit balance of $1,129
(C) A credit balance of $528
(D) Nil
18 What was the balance on the account of P Norman in MC 17 on
23 June 2018?
(A) A credit balance of $96
(B) A debit balance of $96
(C) A credit balance of $528
(D) A debit balance of $528
19 Which of the following best describes a trial balance?
(A) Is the final account in the books
(B) Shows all the asset balances
(C) Is a list of balances on the books
(D) Discloses the financial position of a business
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20 When should the trial balance totals differ?
(A) Only when it is drawn up by the accountant
(B) When drawn up before the profit and loss account (income
statement) is prepared
(C) If drawn up halfway through the financial year
(D) Never
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11 Introduction to trading and
profit and loss accounts
(income statements)
Specific objectives
After you have studied this chapter you should be able to:
• understand why profit/losses are calculated
• calculate the cost of goods sold, gross profit and net profit
• close off sales, purchases and relevant expense accounts at the
end of the period, using double entry, by transferring the balances
to the trading account and profit and loss account (income
statement)
• transfer the net profit and drawings to the capital account at the
end of the period
• prepare the trading and profit and loss account (income statement)
from the information given in the trial balance
• recognise that an adjustment is needed for the inventory of unsold
goods at the end of a period
• understand that after drawing up the trading and profit and loss
account (income statement) all remaining balances are required for
preparation of the statement of financial position.
11.1 Purpose of the trading and profit
and loss account (income statement)
The trading and profit and loss account (income statement) is one of the
most important financial statements and, as stated in Chapter 1, it is a
requirement for correct financial reporting. Its purpose is to show how much
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profit or loss has been made over a period of time. It is prepared at least once
a year but could easily be made available for a shorter period if required,
especially with the use of a computerised accounting package.
The main purpose of the trading and profit and loss account (income
statement) is for the owners to be able to see how profitably the business is
being run. Chapter 1 details other groups which will be interested in the
financial results of a business such as the Inland Revenue. They will need to
calculate the tax to be paid by the business.
11.2 Uses of the trading and profit and
loss account (income statement)
One of the most important uses of the trading and profit and loss account
(income statement) is that of comparing the results obtained with the results
expected. In a trading organisation, much attention is paid to how much profit
is made, before deducting expenses. This is the gross profit and it appears in
the first section of the trading and profit and loss account (income statement).
The amount of gross profit is of major interest. In the next section of the
account the net profit is shown and again this is equally important to the
owners and other groups.
It would be possible to have one account called a trading account, and
another called a profit and loss account. Normally they are combined
together to form one account called the trading and profit and loss account
(income statement).
11.3 Horizontal and vertical format for
the trading and profit and loss account
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(income statement)
In Section 11.4, we will look at a trading and profit and loss account (income
statement) drawn up using the horizontal style. The left-hand side is the debit
side, while the right-hand side is the credit side of the accounts. These
accounts can therefore be seen as part of the double entry system, and
students should be able to understand why they show each item as a debit or a
credit.
In Section 11.8, we will see how the trading and profit and loss account
(income statement) can be shown using a vertical style.
11.4 Preparation of an income
statement using the horizontal style
A trial balance needs to be drawn up before a trading and profit and loss
account (income statement) can be prepared. This contains nearly all the
information needed. (Later in this book you will see that certain adjustments
have to be made, but we will ignore these at this stage.) Set out in Exhibit
11.1 is the trial balance for K. Williams made up to the end of his first year’s
trading. This information is needed to prepare his trading and profit and loss
account (income statement) for the year ended 31 December 2017. For now,
we will assume that K. Williams has no closing inventory at 31 December
2017.
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Exhibit 11.1
To calculate gross profit, remember that:
We could in fact calculate this by simply using arithmetic. However, we must
remember that we are using double entry methods. The answer will be the
same whether normal arithmetic or proper double entry methods are used. To
enable you to see fully how the calculations are performed using double
entry, we will show the balances for sales and purchases, as in Exhibit 11.1,
and how the entries are made to transfer these items into the calculations
within the trading account. The following steps should be carried out:
Step 1
Transfer the credit balance of the sales account to the credit of the trading
account
Debit: Sales account
Credit: Trading account
Step 2
Transfer the debit balance of the purchases account to the debit of the trading
account.
Debit: Trading account
Credit: Purchases account
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Remember that, in this case, there is no inventory of unsold goods. This
means that Purchases = Cost of goods sold.
Step 3
If sales are greater than the cost of goods sold, the difference is gross profit.
(If not, the answer would be a gross loss.) We will carry this gross profit
figure from the trading account part down to the profit and loss part. The
double entry for gross profit is:
Debit: Trading account
Credit: Profit and Loss account
The double entry for the above transfers is shown below in Exhibit 11.2.
Exhibit 11.2
Notice that, after the trading account has been completed, there are no
balances remaining in the sales and purchases accounts. They are now said to
be ‘closed’.
To calculate net profit and record it
Remember that:
Remember also (from Chapter 8) that:
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Helpful Hint!
Discussion:
Write a few short points to remind yourself of how the statement of
financial position (balance sheet) is different from the trading and
profit and loss account (income statement). What are the differences
in their formats?
The double entry needed to carry out these calculations is:
Step 1
Transfer the debit balances on expenses accounts to the debit of the profit and
loss account.
Debit: Profit and loss account
Credit: Expenses accounts
Step 2
Transfer the net profit, when found, to the capital account to show the
increase in capital.
Debit: Profit and loss account
Credit: Capital account.
The results are shown in Exhibit 11.3.
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Exhibit 11.3
11.5 Completion of capital account
You have seen that we credit the capital account with the amount of net
profit. We have, therefore, recorded the increase in capital.
In the trial balance, Exhibit 11.1, we can see that there are drawings of
$7,750. Drawings are withdrawals of capital.
After entering the net profit in the capital account, we can now complete
the account. To do this we transfer the drawings to the capital account.
Debit: Capital account
Credit: Drawings account
The completed capital and drawings accounts are shown in Exhibit 11.4.
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Exhibit 11.4
11.6 Inventory of unsold goods at end
of first accounting period
Usually some of the goods bought (purchases) have not been sold by the end
of the accounting period. We have already seen that gross profit is calculated
as follows:
However, Purchases only equals Cost of goods sold if there is no inventory at
the end of a period. We can calculate cost of goods sold as follows:
Remember, we are concerned here with the very first trading and profit and
loss account (income statement) of a business, where there is no opening
inventory. In Chapter 13 (Section 13.2) we will look at the later years of a
business.
Now let us look at the preparation of the trading and profit and loss
account (income statement) for L. Sands. Her trial balance is shown as
Exhibit 11.5 and was drawn up after her first year of trading.
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Note: On 31 December 2017, at the close of trading, L. Sands had goods
costing $3,000 which were unsold. The cost of goods sold figure will be:
The gross profit will be:
The net profit will be:
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The double entry for the above transactions is now shown in Exhibit 11.6:
Exhibit 11.6
To record the inventory we have entered the following:
Debit: Closing inventory account
Credit: Trading account
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The figures in Exhibit 11.6 show that there is now a balance on the inventory
account. We had to record it there because at 31 December 2017 we had an
asset, namely $3,000 of inventory (stock), but there was no record of that fact
in our books. We have now brought our records up to date by showing the
inventory in our accounts. Without the inventory accounts at 31 December
2017, our records would have been incomplete.
11.7 The capital account
The capital account for L. Sands can now be completed, thus:
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11.8 Preparation of the trading and
profit and loss account (income
statement) using the vertical style
The trading and profit and loss account (income statement) shown above is
written in the horizontal format to demonstrate how the double entry system
works. However, the trading and profit and loss account is more often shown
in the vertical format, and it is this format that we will use in future in this
book. You may wish to carry on preparing the horizontal format of trading
and profit and loss account (income statement) before drawing up the vertical
format, until you are sure you understand how to double enter directly into
the vertical format.
The trading and profit and loss account (income statement) of L. Sands, in
the vertical format, is shown below.
Exhibit 11.7
You can see that the figures used are exactly the same using either the
horizontal or vertical methods of display. This is a more modern method of
presentation. It is intended to make it easier to understand for those without
an in-depth understanding of accounting and the double entry system.
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11.9 The balances still in our books
Taking Exhibit 11.6, but including the adjustment for closing inventory of
$3,000, we can now see which balances still exist. We can do this by drawing
up a trial balance as it would appear once the trading and profit and loss
account (income statement) has been completed. This is shown in Exhibit
11.8.
The following accounts have been closed in this process:
The balances still in our books
Exhibit 11.8
Helpful Hint!
Examination tip:
After completing your trading and profit and loss account (income
statement) remember to check over your calculations to ensure
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accuracy This will help you obtain full marks for your answer in the
examination.
The one account that was not in the original trial balance was the inventory
account. It was not brought into our books until the trading account was
prepared. These balances will be used by us when we look at the statement of
financial position (balance sheet) in the next chapter. They are also carried
forward to the next accounting period.
Summary
• The trading and profit and loss account (income statement) is
prepared to determine the profit/losses made in the period.
• The chapter shows how to calculate the cost of goods sold, gross
profit and net profit.
• The chapter shows the preparation of the trading and profit and
loss account (income statement) from information in the trial
balance using both the horizontal and vertical methods of
presentation.
• The chapter shows how to close off the sales, purchases and
relevant expense accounts at the end of a period and post the
entries to the trading and profit and loss account (income
statement).
• The chapter shows how to transfer the net profit and drawings to
the capital account at the end of a period.
• The chapter shows how to treat inventory of unsold goods at the
end of a period.
• Any balances still remaining in the books of account after
preparation of the trading and profit and loss account (income
statement) represent assets, liabilities and capital. These balances
are entered into the statement of financial position (balance sheet)
and then carried forward to the next accounting period. See
Chapter 12 for more on this.
Chapter 11 Exercises
11.1 From the trial balance of H. Rabkin, who has been in business
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for one year, extract a trading and profit and loss account
(income statement) for the year ended 31 December 2017. A
statement of financial position (balance sheet) is not required.
Inventory at 31 December 2017 was $12,740. (Keep your
answer; it will be used later in Exercise 12.1.)
11.2 From the following trial balance of C. Wynter, who has been
trading for one year, you are required to draw up a trading and
profit and loss account (income statement) for the year ended 30
June 2017. A statement of financial position (balance sheet) is
not required.
Inventory at 30 June 2017 was $4,166. (Keep your answer; it will
be used later in Exercise 12.2.)
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11.3X From the following trial balance of F. Chaplin, draw up a
trading and profit and loss account (income statement) for the
year ended 31 December 2018. A statement of financial position
(balance sheet) is not required. Chaplin has been in business for
one year only.
Inventory at 31 December 2018 was $4,960. (Keep your answer;
it will be used later in Exercise 12.3X.)
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11.4X Extract a trading and profit and loss account (income
statement) for the year ended 30 June 2017 for F. Kidd. The
business has been in existence for one year. The trial balance as
at 30 June 2017 was as follows.
Inventory at 30 June 2017 was $9,960. (Keep your answer; it will
be used later in Exercise 12.4X.)
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11.5 From the following trial balance of G. Singh, extracted after one
year’s trading, prepare the trading and profit and loss account
(income statement) for the year ended 31 December 2018. A
statement of financial position (balance sheet) is not required.
Inventory at 31 December 2018 was valued at $10,192. (Keep
your answer; it will be used later in Exercise 12.5.)
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11.6X From the following trial balance of R. Cairns after his first
year’s trading, you are required to draw up a trading and profit
and loss account (income statement) for the year ended 30 June
2018.
Inventory at 30 June 2018 was valued at $11,498. (Keep your
answer, it will be used later in Exercise 12.6X.)
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12 Statements of financial
position (balance sheets)
Specific objectives
After you have studied this chapter you should be able to:
• define a statement of financial position (balance sheet)
• understand that a statement of financial position (balance sheet) is
prepared from the remaining balances in the trial balance after
preparation of the trading and profit and loss accounts (income
statement)
• explain why a statement of financial position (balance sheet) is not
part of the double entry system
• explain the meaning of the terms non-current assets, current
assets, current liabilities and non-current liabilities
• prepare a statement of financial position (balance sheet) using the
vertical method of presentation
• understand the importance of the term net current assets/working
capital
• know which items appear in the owner’s capital account.
12.1 Definition and content of a
statement of financial position (balance
sheet)
A statement of financial position, also called a balance sheet, is a financial
statement setting out the book values of assets, liabilities and capital at a
particular point in time. In simple terms, a statement of financial position
shows what a business ‘owns’ and what it ‘owes’ at a specific date. We will
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use the term statement of financial position from this point onwards but
you must remember that this means the same as balance sheet, especially
when looking at old accounting documents of companies.
Details of the assets, liabilities and capital have to be found in the records
of the business and then written out as a statement of financial position. It is
easy to find these details as they consist of all the balances remaining in the
records once the trading and profit and loss account (income statement) for
the period has been completed. All balances remaining have to be assets,
liabilities or capital since the other balances should have been closed off
when the trading and profit and loss account (income statement) was
completed.
12.2 Preparing a statement of financial
position
Let us look again at the trial balance of L. Sands (Exhibit 11.8) as on 31
December 2017 after the trading and profit and loss account (income
statement) had been prepared.
Exhibit 12.1
The statement of financial position can now be drawn up as at 31 December
2017 (Exhibit 12.2). This layout is the vertical method of presentation and is
further discussed in Section 12.4.
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Exhibit 12.2
12.3 No double entry in statements of
financial position
It may seem very strange to you to learn that statements of financial position
are not part of the double entry system.
When we draw up accounts such as the cash account, rent account, sales
account, trading and profit and loss account (income statement) and so on, we
are writing up part of the double entry system. We make entries on the debit
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and credit sides of these accounts.
In preparing a statement of financial position we do not enter anything in
the various accounts. We do not actually transfer the fixtures balance or the
inventory balance, or any of the others, to the statement of financial position.
All we do is to list the balances for assets, capital and liabilities to form a
statement of financial position. This means that none of these accounts have
been closed off. Nothing is entered in the accounts.
When the next accounting period starts, these accounts are still open
containing balances. As a result of business transactions, entries are then
made in these accounts to add to, or deduct from, the amounts shown in the
accounts using normal double entry.
If you see the word ‘account’ you will know that it is part of the double
entry system, and will include debit and credit entries. If the word ‘account’
cannot be used, it is not part of double entry. For instance:
Trial balance: A list of balances to see whether the records are correct.
Statement of financial position: A list of balances arranged according to
whether they are assets, capital or liabilities.
12.4 Statement of financial position
layout
You would not expect to go into a department store and see goods for sale all
mixed up and not laid out properly. You would expect the goods to be
displayed so that you could find them easily. Similarly, in the statement of
financial position we do not want the items shown in a random order; we
want them displayed so that useful information can be seen easily.
For users of the accounts, such as bank managers, accountants and
investors, conformity of layout is needed in order to make a comparison of
statement of financial position easier. The standard layout already shown in
Exhibit 12.2, is examined in more detail below.
Assets
Assets are shown under two headings: non-current assets and current assets.
Non-current assets
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Non-current assets were previously known as fixed assets and you will see
this term in old accounting documents. Non-current assets are assets that:
• are expected to be of use in the business for a long time
• are to be used in the business, and
• were not bought only for the purpose of resale.
Examples: buildings, machinery, motor vehicles, fixtures and fittings.
Non-current assets are listed first in the statement of financial position
starting with those that the business will keep the longest, down to assets with
the shortest life expectancy. For instance:
Non-current assets
1 Land and buildings
2 Fixtures and fittings
3 Machinery
4 Motor vehicles
Current assets
Current assets are assets that are likely to change in the near future and
usually within twelve months of the statement of financial position date.
They include stock of goods for resale at a profit, amounts owed by accounts
receivable, cash at bank and any cash in hand. These are listed starting with
the asset that is least likely to be turned into cash, finishing with cash itself.
The accepted order is listed as:
Current assets
1 Inventory
2 Accounts receivable
3 Cash at bank
4 Cash in hand
Liabilities
There are two categories of liabilities: current liabilities and non-current
liabilities.
Current liabilities
Current liabilities are liabilities due for repayment in the short term, usually
within one year. Examples are bank overdrafts or amounts due to creditors
for the supply of goods for resale.
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Current liabilities are deducted from the current assets, as shown in Exhibit
12.2, to give the net current assets or working capital. This figure is very
important in accounting since it shows the amount of resources the business
has in the form of readily available cash to meet everyday running expenses.
Non-current liabilities
Non-current liabilities were previously known as long-term liabilities. You
will see this term in old accounting documents.
Non-current liabilities are liabilities not due for repayment in the near
future. Examples are bank loans, loans from others such as friends or
relatives, and mortgages.
Helpful Hint!
Practice tip:
In your notebook, write a list of examples of assets and liabilities you
have come across. Then classify them into current and non-current
assets and liabilities. Ask a friend to check your classification.
Capital account
This is the proprietor’s or partner’s account with the business. It will start
with the balance brought forward from the previous accounting period, to
which is added any personal cash introduced into the business and the net
profit made by the business in this accounting period. Deducted from the
capital account will be amounts drawn from the business and any loss made
by the business. The final balance on the capital account should equal the net
assets or net liabilities figure – and hence the statement of financial position
balances. Exhibit 12.3 gives the standard format.
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Exhibit 12.3
Helpful Hint!
Examination tip:
Remember to always head your financial statement correctly. Check
to ensure that you have put in the name of the company, name of the
statement followed by the words ‘as at’ and the relevant date.
It is important to note that the statement of financial position shows the
position of the business at one point in time: the statement of financial
position date, that is, ‘as at 31 December 2017’. It is like taking a snapshot of
the business at one moment in time. On the other hand, the trading and profit
and loss account (income statement) shows the profit/loss of that business for
a period of time (normally a year), that is, ‘for the year ended 31 December
2017’.
Summary
• A statement of financial position (balance sheet) is a financial
statement which lists the book values of assets, liabilities and
capital ‘as at’ a given date.
• The statement of financial position is not part of the double entry
system.
• Most statements of financial position are set out using the vertical
method of presentation which shows the assets divided into two
categories, namely non-current assets and current assets followed
by current liabilities, non-current liabilities at a specific date. It
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•
•
•
•
•
shows what a business ‘owns’ and ‘owes’ at a particular point in
time.
The statement of financial position is prepared from the remaining
balances in the trial balance after the trading and profit and loss
account (income statement) has been extracted.
The term non-current assets means assets of a more permanent
nature such as land and buildings, equipment and motor vehicles
that are owned by the business. These are listed in the statement
of financial position in descending order with the most permanent
asset shown first.
The term current assets refers to assets that are likely to change
within one year, for example inventory, accounts receivable, cash
at bank and cash in hand. These are listed in order of liquidity with
the least liquid of the assets shown first: inventory and the most
liquid asset shown at the bottom, that is, cash in hand.
The term net current assets or working capital is an important
figure in accounting since it represents the amount of readily
available resources available for paying everyday running
expenses.
The capital account contains money invested by the owner of the
business plus the net profit for the period less amounts taken out
by the owner in the form of ‘drawings’. If there is no net profit, then
a net loss will have been incurred.
Chapter 12 Exercises
12.1 Complete Exercise 11.1 by drawing up a statement of financial
position as at 31 December 2017 for H. Rabkin.
12.2 Complete Exercise 11.2 by drawing up a statement of financial
position as at 30 June 2017 for C. Wynter.
12.3X Complete Exercise 11.3X by drawing up a statement of
financial position as at 31 December 2018 for F. Chaplin.
12.4X Complete Exercise 11.4X by drawing up a statement of
financial position as at 30 June 2017 for F. Kidd.
12.5 Complete Exercise 11.5 by drawing up a statement of financial
position as at 31 December 2018 for G. Singh.
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12.6X Complete Exercise 11.6X by drawing up a statement of
financial position as at 30 June 2018 for R. Cairns.
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13 Financial statements: further
considerations
Specific objectives
After you have studied this chapter you should be able to:
• understand that carriage inwards on goods purchased is treated as
part of the cost of goods sold
• realise that carriage outwards is an expense to be entered in the
profit and loss account
• adjust financial statements properly for both the opening and
closing inventory of the period
• explain why the cost of putting goods into a saleable condition
should be charged to the trading account
• record returns inwards and returns outwards in the trading and
profit and loss account
• prepare a trading and profit and loss account (income statement) if
either a gross profit/net profit is made, or alternatively, if a gross
loss/net loss is incurred.
13.1 Carriage
When a firm buys goods from a supplier, the cost of delivering or
transporting the goods also has to be paid. In accountancy terms, this cost of
transport is often referred to as ‘carriage’. Carriage charges for transporting
goods purchased into a firm are known as carriage inwards, whereas
carriage charges for the delivery of goods to a firm’s customers are known as
carriage outwards.
Carriage inwards
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When goods are purchased, the cost of carriage inwards may be included as
part of the price, or, alternatively, the firm may have to pay for it separately.
Suppose the firm was buying exactly the same goods from different
suppliers. One supplier might sell them for $100 and not charge anything for
carriage. Another supplier might sell exactly the same goods to you for $95,
but you would have to pay $5 to a haulage firm for carriage inwards, that is, a
total cost of $100. Therefore, to keep the cost of buying goods shown on the
same basis, carriage inwards is always added to the purchases in the trading
account. When charging carriage inwards to the trading account the following
transfer is made:
Debit: Trading account
Credit: Carriage inwards account
Carriage outwards
Carriage outwards is the cost of delivering the goods to the firm’s customers.
It is an expense and not part of the selling price of the goods. Carriage
outwards is always charged as an expense in the profit and loss account as
follows:
Debit: profit and loss account
Credit: Carriage outwards account
Exhibit 13.1 shows the items in a trial balance necessary for the trading and
profit and loss account (income statement) for the year ended 31 December
2017 for G. Grant.
Exhibit 13.1
The closing inventory on 31 December 2017 was $6,500.
We can now show the trading and profit and loss account (income
statement) completed.
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Helpful Hint!
Discussion:
What does the word ‘carriage’ mean in accounting? Write a short
sentence to remind yourself of how carriage inwards is different from
carriage outwards.
13.2 The second year of a business
You will recall that in Chapter 11, Section 11.6, the trial balance for L. Sands
for the year ending 31 December 2017 was shown. From the trial balance, her
trading and profit and loss account (income statement) was prepared at the
end of her first year of trading.
In Chapter 12, Section 12.2, her statement of financial position as at 31
December 2017 was prepared and this was shown in Exhibit 12.2.
In this chapter we will assume that Ms Sands carries on her business for a
further year. After carrying out the double entry procedures for the year, a
new trial balance is needed for the year ending 31 December 2018 and this is
shown below as Exhibit 13.2. Closing inventory at this date was valued at
$5,500. From this trial balance her financial statements for her second year of
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trading can now be prepared.
Exhibit 13.2
Adjustments needed for inventory
Previously we have prepared the accounts for new businesses only. When a
business starts it has no inventory brought forward. L. Sands started her new
business on 1 January 2017 so her first year of trading ended on 31 December
2017 when she had a closing inventory of $3,000. Therefore, when preparing
her trading and profit and loss account (income statement) for that year we
are only concerned with the closing inventory figure of $3,000. When we
prepare the trading and profit and loss account (income statement) for the
second year, we can now see the difference.
In the trading and profit and loss account (income statement) for the first
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year of trading, that is, the year ended 31 December 2017, only one inventory
figure appears, that is, the closing inventory $3,000. This figure of closing
inventory for the year ended 31 December 2017 becomes the opening
inventory for the second year of trading and will be entered into the trading
account in Ms Sands’ second year of trading. Therefore, both opening and
closing inventory figures are shown in the trading and profit and loss account
(income statement) for the year ended 31 December 2018.
The inventory figure shown in the trial balance given in Exhibit 13.2 is that
brought forward from the previous year on 31 December 2017. It is,
therefore, the opening inventory. The closing inventory at 31 December 2018
can only be found by inventory checking assuming that it amounts to $5,500.
Inventory checking is when a business checks its quantities of materials and
goods and places a value on them.
The opening and closing inventory account figures for Ms Sands for the
two years can now be summarised as follows:
Double entry for inventory
To enable you to understand the double entry aspect of inventory, both the
inventory account and the trading account for L. Sands for the year ended 31
December 2018 are shown below:
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The inventory at 31 December 2018 is $5,500 and had not been entered into
the accounts previously. The entries above show how this has been recorded
using double entry:
Debit: Inventory account $5,500
Credit: Trading account $5,500
Calculation of cost of goods sold
Let us now calculate the cost of goods sold for L. Sands for the year ended 31
December 2018:
The gross profit can now be found by taking into consideration the effect the
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closing inventory has on the gross profit. Remember that sales less cost of
goods sold equals gross profit therefore:
Now the trading and profit and loss account (income statement) and
statement of financial position can be drawn up as shown in Exhibits 13.3
and 13.4.
Exhibit 13.3
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Exhibit 13.3
13.3 Financial statements
The term financial statements is often used to mean collectively the trading
and profit and loss account (income statement) and the statement of
financial position which are produced at the end of a trading period. They
used to be referred to as final accounts but this term can be quite misleading
since none of the financial statements are really accounts in the book-keeping
sense. Many people do, however, still refer to them as the final accounts or
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simply the accounts of a business.
13.4 Other expenses in the trading
account
The costs of putting goods into a saleable condition should be charged in the
trading account. In the case of a trader, these are relatively few. An example
might be a trader who sells clocks packed in boxes. If he bought the clocks
from one source and the boxes from another source, both of these items
would be charged in the trading account as purchases. In addition, if a person
is paid wages to pack the clocks, then such wages would be charged in the
trading account. The wages of the person packing the clocks would be the
only wages in this instance concerned with ‘putting the goods into a saleable
condition’.
The wages of shop assistants who sold the clocks would be charged in the
profit and loss account.
For goods imported from abroad, it is usual to find that the costs of import
duty, marine insurance and freight charges are also treated as part of the cost
of goods sold and are, therefore, debited to the trading account.
13.5 Returns inwards and returns
outwards
When firms deal with the purchase and sale of goods, it is inevitable that
there are occasions when goods have to be returned by the purchaser to the
supplier because they are damaged, faulty or perhaps not to the specification
ordered. The goods will be returned to the supplier accompanied by a returns
note which gives details of the goods being returned and the reason together
with details of the order number, date, etc.
Returns outwards (also called purchases
returns)
When a business returns goods to a supplier for one of the above-mentioned
reasons, they are known as returns outwards or purchases returns. The
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book-keeping entries are as follows:
Debit: Supplier’s account (that is, the creditor)
Credit: Returns outwards (or purchases returns) account
The returns outwards account is kept separate from the purchases account to
enable a check to be made on the amount of goods being returned.
Returns inwards (also called sales returns)
If goods are returned by a customer (debtor) then they are referred to as
returns inwards or sales returns. The book-keeping entries would be as shown
below:
Debit: Returns inwards (or sales returns) account
Credit: Customer’s (debtor’s) account
The returns inwards are again kept separate from the sales account to enable a
check to be made on the amount of goods being returned to the firm.
13.6 Dealing with returns in the trading
account
In Chapter 11 the returns inwards and returns outwards accounts were
deliberately omitted so that the first sight of the trading and profit and loss
account (income statement) would not be too difficult. Since a large number
of firms will return goods to their suppliers (returns outwards), and have
goods returned to them (returns inwards), then these returns must be taken
into consideration when calculating the gross profit.
In the trading account, the returns inwards and returns outwards are dealt
with as follows:
• returns inwards should be deducted from sales
• returns outwards should be deducted from purchases.
In Exhibit 13.3, if sales had been $72,000, returns inwards $5,000, purchases
$44,600 and returns outwards $2,000, then the trading account would have
appeared as in Exhibit 13.5.
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Exhibit 13.5
Helpful Hint!
Practice tip:
Many students have difficulty deciding whether returns inwards
should be deducted from sales or purchases figures and vice versa.
The same applies to the returns outwards figure. The following
illustration shows that the returns are always deducted from the
figure on the opposite side so forming a ‘X’ on the trial balance:
13.7 Losses incurred by a business
So far, we have looked at the situation in which both a gross profit and a net
profit have been made by a business. This will not always be the case in
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every business. For all kinds of reasons, such as poor trading conditions, bad
management, or unexpected increases in expenses, the business may trade at
a loss for a given period. We will look at two cases: V. Baker, who made a
gross profit but a net loss for the year, and J. Errol, who made both a gross
loss and a net loss. The details for the trading and profit and loss account
(income statement) for the year ended 31 December 2017 for Baker and Errol
are as follows:
The trading and profit and loss account (income statement) for each business
can now be prepared, see Exhibits 13.6 and 13.7.
Exhibit 13.6
In the above example of V. Baker, a gross profit of $4,700 was made but
since expenses of $6,300 were greater than that, the final result is a net loss of
$1,600.
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Exhibit 13.7
In the above example of J. Errol, a gross loss of $1,200 occurred since the
cost of goods sold amounted to $34,200 while sales were only $33,000.
Added to this gross loss of $1,200 were the expenses of $3,900 for the period
and a resultant net loss of $5,100.
Recording losses in the capital account
If a net loss occurs, then it will be recorded in the owner’s capital account as
follows:
Debit: Capital account
Credit: Profit and loss account.
13.8 Step-by-step guide to preparing
financial statements (preliminary level)
Many students have difficulty in the preparation of the financial statements
and in remembering the layout. The following step-by-step guide should help
you in their preparation.
Preparing the financial statements
1 Before starting the exercise, rule lines connecting each item in the trial
balance. This avoids selecting a wrong figure, which can easily happen
under the stress of an examination.
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2 Decide into which section of the financial statement each item should be
entered before you start, that is, trading account, profit and loss account
section or the statement of financial position. On the left-hand side of the
trial balance use the following abbreviations to identify where each item
should be entered:
• T for trading account
• P/L for profit and loss account
• SF for statement of financial position.
3 An almost inviolable rule:
• Each item displayed in the trial balance must only be entered once in
the financial statements.
• Any item below a trial balance exercise should be dealt with twice (that
is, in the exercises following notice the closing inventory figure is
shown under the totals of the trial balance. This figure should be dealt
with twice: once as the closing inventory in the trading account and
second in the statement of financial position under the heading ‘current
assets’).
Dealing with adjustments in financial
statements
1 Returns inwards and returns outwards:
a returns inwards – deduct from sales in the trading account
b returns outwards – deduct from purchases in the trading account.
2 Carriage inwards and carriage outwards:
a carriage inwards – add to purchases in the trading account
b carriage outwards – charge as an expense in the profit and loss account.
Helpful Hint!
Examination tip:
Remember to write a complete heading for all statements you are
preparing.
Note: In Appendix B you will find a model layout of the trading and profit
and loss account (income statement) and statement of financial position of a
sole trader. Further step-by-step instructions in the preparation of the
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financial statements are also shown in Chapter 28.
Summary
• The name ‘carriage’ means the cost of transport.
• Carriage inwards is the cost of transporting the goods purchased
‘into’ the firm and, as such, is always added to the cost of
purchases in the trading account.
• Carriage outwards is the cost of delivering the goods sold to the
customers and is shown as an expense in the profit and loss
account.
• When a new business first starts it has no opening inventory;
however, at the end of the first year of trading inventory checking is
carried out to ascertain the amount of inventory unsold, the closing
inventory.
• The closing inventory of one year becomes the opening inventory
of the next year.
• An inventory account is updated to record the closing inventory
figure and to carry forward the balance from one period to the next.
• When preparing a trading account for the first year of business only
the closing inventory figure is shown since there is no opening
inventory.
• In the second year of business both the opening and closing
inventory figures are shown in the trading account.
• The calculation of the figure for cost of goods sold is shown, which
appears under this heading in the trading account.
• The returns inwards should always be deducted from the sales and
the returns outwards deducted from the purchases; both are shown
in the trading account.
• The preparation of the trading and profit and loss account (income
statement) is shown including adjustments for returns inwards,
returns outwards, carriage inwards, and both opening and closing
inventories in the trading account. Carriage outwards is shown as
an expense in the profit and loss account.
• A statement of financial position is shown indicating the entry of the
closing inventory figure under the ‘current asset’ section.
• Any expenses incurred with getting the goods into a saleable
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condition are charged in the trading account.
• How to prepare a trading and profit and loss account (income
statement) if either a gross loss or net loss occurs is explained.
• A step-by-step guide to preparing financial statements at
preliminary level is given.
Chapter 13 Exercises
13.1 From the following details, draw up J. Grant’s trading account
for the year ended 31 December 2017.
13.2X The following details for the year ended 31 March 2018 for C.
Black are available. Draw up the trading account for that year.
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13.3 From the following trial balance of R. Mendez, draw up a
trading and profit and loss account (income statement) for the
year ended 30 September 2017, and a statement of financial
position as at that date.
Inventory at 30 September 2017 was $2,946.
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13.4 Use the following trial balance from the books of B. Rousseau
on 30 April 2017 to prepare her trading and profit and loss
account (income statement) and a statement of financial position
for the year ended 30 April 2017.
Inventory at 30 April 2017 was $4,998.
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13.5X The following is the trial balance of J. Singh as at 31 March
2018. Draw up a set of final accounts.
Inventory at 31 March 2018 was $22,390.
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13.6X L. Binns drew up the following trial balance as at 30
September 2018. You are to draft the trading and profit and loss
account (income statement) for the year to 30 September 2018
and a statement of financial position as at that date.
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Inventory at 30 September 2018 was $27,475.
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14 Introduction to accounting
ratios
Specific objectives
After you have studied this chapter you should be able to:
• understand the difference between mark-up and margin
• use accounting ratios to calculate missing figures in financial
statements
• understand the relationship between mark-up and margin
• calculate and analyse ratios on profitability.
14.1 Introduction
So far we have looked at the records of sole traders and small businesses that
use the double entry system of book-keeping. However, many such
organisations do not keep such full records and often only enter a transaction
once using a single entry system. Many also fail to record every
transaction, resulting in incomplete records. Chapter 42 deals with this in
more detail.
In this chapter you will see how the use of the ratios, margin and mark-up
can be used to calculate missing figures from incomplete records and to show
the relationship between profit and selling price, and profit and cost price,
respectively.
14.2 Mark-up and margin
Helpful Hint!
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Practice tip:
Students often confuse the relationship between the selling price and
profit (margin) and cost price and profit (mark-up). This can easily be
remembered using the mnemonic ‘Mrs Muc’, shown in Exhibit 14.1
The purchase cost, gross profit and selling price of goods or services may be
shown as:
The gross profit when shown as a fraction or percentage of the cost price is
known as the mark-up. The gross profit when shown as a fraction or
percentage of the selling price is known as the margin.
The mark-up and margins can now be calculated using this example:
Exhibit 14.1
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14.3 Calculating missing figures
We can use ratios to complete trading accounts where some of the figures are
missing. For ease of illustrating this fact, all examples in this chapter:
• assume that all the goods in a business have the same rate of mark-up
• ignore wastages and theft of goods.
Example 1: The following figures apply for the year 2017 for M. Smart:
A uniform rate of mark-up of 20% is applied. To find the gross profit and the
sales figure, first of all, we enter the figures we already know in the trading
account.
Answer:
It is known that:
and you know that you can use mark-up to find profit, because:
Thus:
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Therefore:
The trading account can now be completed as shown below:
Example 2: Another firm, J. MacDonald, has the following figures for 2017:
A uniform rate of margin of 25% is in use.
Required: Find the gross profit and the figure of purchases.
First, enter these figures in the trading account.
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Answer:
Rearranging items:
Now the following figures are known:
The two missing figures (A) and (B) are found by normal arithmetical
deduction:
The completed trading account can now be shown:
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This technique is found to be very useful by retail stores when estimating the
amount to be bought if a certain sales target is to be achieved. Alternatively,
inventory levels or sales figures can be estimated given information as to
purchases and opening inventory figures.
14.4 The relationship between mark-up
and margin
As both of these figures refer to the same profit but are expressed as a
fraction or a percentage of different figures, there is a relationship between
them. If one is known as a fraction, the other can soon be found.
If the mark-up is known, in order to find the margin you need to take the
same numerator to be the numerator of the margin. Then, for the denominator
of the margin, take the total of the mark-up’s denominator plus the
numerator. An example can now be shown:
If the margin is known, to find the mark-up take the same numerator to be the
numerator of the mark-up. Then, for the denominator of the mark-up, take the
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figure of the margin’s denominator less the numerator:
14.5 Other accounting ratios
There are some ratios that are often used to compare one period’s results
against those of a previous period. Three ratios in most common use are:
• ratio of gross profit to sales
• ratio of net profit to sales
• rate of inventory turnover or stockturn.
Gross profit as percentage of sales
The basic formula is:
This is the amount of gross profit for every $100 of sales. If the answer
turned out to be 15% this would mean that for every $100 of sales, $15 gross
profit was made before any expenses were paid.
This ratio is used as a test of the profitability of the sales. Even if sales are
increased it may not mean that the gross profit will increase. The trading
accounts in Exhibit 14.2 illustrate this.
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Exhibit 14.2
In the year 2016 the gross profit as a percentage of sales was:
In the year 2017 it became:
Sales had increased, but as the gross profit percentage had fallen by a
relatively greater amount, the gross profit had fallen. There can be many
reasons for such a fall in the gross profit percentage.
• Perhaps the goods being sold have cost more, but the selling price of the
goods has not risen to the same extent.
• Perhaps, in order to increase sales, reductions have been made in the selling
price of goods.
• There could be a difference in how much has been sold of each sort of
goods, called the sales mix, between this year and last, with different kinds
of goods carrying different rates of gross profit per $100 of sales.
• There may have been a greater wastage or theft of goods.
• These are only some of the possible reasons for the decrease. The point of
calculating the ratio is to show that the profitability per $100 of sales has
changed. The business would then try to find out why and how such a
change has taken place.
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Net profit as percentage of sales
Here the formula is:
This calculation will show how much net profit has been made for every
$100 of sales. It brings the expenses into the calculation, as opposed to the
gross profit percentage, which ignores expenses. Changes in the ratio will be
due either to:
• the gross profit ratio changing; and/or
• the expenses per $100 of sales changing.
When changes are due to expenses, they will be examined to see if anything
can be done in future to minimise the expenses and ensure that a reasonable
net profit is made.
Rate of inventory turnover or stockturn
Every business should operate both to keep its inventory to as low a figure as
possible without losing profitability, and to sell its goods as quickly as
possible. The inventory turnover ratio measures how well the firm is
managing to do these things. Any increase in inventories or slowdown in
sales will show a lower ratio.
The ratio is calculated as follows:
(that is, the number of times inventory is turned over within the period).
If only the opening and closing inventories are known, the average
inventory is found by adding these two figures together and dividing them by
two (that is, averaging them). That is the usual situation in examinations.
Using the figures for D. Clive that is,
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we can calculate the inventory turnover for 2016 and 2017 as follows:
Instead of saying that the inventory turnover is so many times per annum, we
could instead say on average how long we keep inventory before we sell it.
We do this by the following formula:
• to express it in months: 12 ÷ Inventory turnover = x months
• to express it in days: 365 ÷ Inventory turnover = x days
From Exhibit 14.2:
Helpful Hint!
Write each of the above formulae in your notebook. Read each one
aloud three times after writing. Write each one before you use it in
future exercises, until you are confident that you know all of them.
All the above figures are rounded off to the nearest decimal point.
Summary
• Both margin and mark-up are based upon the formula, cost price +
gross profit = sales. When the gross profit is shown as a
percentage of the cost price this gives us the mark-up. If the gross
profit is shown as a percentage of the selling price this gives us the
margin. Remember Mrs MUC!
• Mark-up and margin can be used to ascertain missing figures in
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incomplete records.
• If the mark-up is known as a fraction, then the margin, as a
fraction, can easily be calculated.
• If the margin is known as a fraction, then the mark-up, as a
fraction, can easily be calculated.
• The use of profitability ratios enables the profitability of the
business to be monitored.
Note: Analysis and interpretation of accounts is dealt with in more
detail in Chapter 40.
Chapter 14 Exercises
14.1 (a) If an item costs $20 and is sold for $25, what are the markup and margin, expressed as percentages?
(b) If the mark-up on a unit is 33¹/₃%, what is the margin?
(c) If the margin is 16²/₃%, what is the mark-up?
14.2X (a) If an item costs $60 and is sold for $90, what are the markup and margin, expressed as percentages?
(b) If the margin on a unit is 50%, what is the mark-up?
(c) If the mark-up is 50%, what is the margin?
14.3 J. Jackson is a trader who marks up the selling price of his
goods to 25% above cost. His books give the following
information at 31 July 2017.
You are required to create a trading account for Jackson
showing:
(a) the cost of goods sold
(b) the value of purchases during the year
(c) the gross profit made by Jackson.
14.4 P.R. Masters produces from his trial balance at 31 August 2018
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the following information.
Masters has a ‘mark-up’ of 50% on ‘cost of sales’. His average
inventory during the year was $4,000.
You are required to:
(a) calculate the closing inventory for Masters at 31 August
2018
(b) prepare his trading account for the year ended 31 August
2018
(c) ascertain the total amount of profit and loss expenditure that
Masters must not exceed if he is to maintain a net profit on
sales of 10%.
14.5X A business has a rate of inventory turnover of seven times.
The average inventory is $4,200. Trade discount allowed is 33¹/₃
% of all selling prices. Expenses are given as 70% of gross
profit. Calculate:
(a) cost of goods sold
(b) gross profit
(c) sales
(d) total expenses
(e) net profit.
14.6X The following figures relate to the retail business of W.
Watson for the month of May 2018. Goods that are on sale fall
into two categories, A and B.
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Calculate for each category:
(a) cost of goods sold
(b) gross profit
(c) total expenses
(d) net profit
(e) average inventory at cost, assuming that sales are
distributed evenly over the year, and that there are 12 equal
months in the year.
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15 Capital and revenue
expenditure
Specific objectives
After you have studied this chapter you should be able to:
• distinguish between expenditure that is capital in nature and that
which is revenue
• understand that some expenditure is part capital expenditure and
part revenue expenditure
• understand that if revenue expenditure is incorrectly treated as
capital expenditure, or vice versa, both the final accounts and profit
will be affected.
15.1 Introduction
This chapter will deal with the distinction between capital and revenue
expenditure and show the importance of careful classification, which can
ultimately affect the recorded profits and the statement of financial position
valuations of a business.
15.2 Capital expenditure
Capital expenditure is incurred when a business spends money to either:
• buy non-current assets; or
• add to the value of an existing non-current asset.
Included in such amounts should be the costs of:
• acquiring non-current assets
• bringing them into the business
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• legal costs of buying buildings
• carriage inwards on machinery bought
• any other cost needed to get the non-current asset ready for use.
15.3 Revenue expenditure
Revenue expenditure is expenditure that does not increase the value of
non-current assets but is incurred in the day-to-day running expenses of the
business.
The difference from capital expenditure can be seen when considering the
cost of running a motor vehicle for a business. The expenditure incurred in
acquiring the motor vehicle is classed as capital expenditure, while the cost of
the petrol used to run the vehicle is revenue expenditure. This is because the
revenue expenditure is used up in a few days and does not add to the value of
the non-current asset.
15.4 Differences between capital and
revenue expenditure
The difference between capital and revenue expenditure can be seen more
generally in the following table (Exhibit 15.1). Revenue expenditure is the
day-to-day running expense of the business and, as such, is chargeable to the
trading and profit and loss account. Capital expenditure, in contrast, results in
an increase in the non-current assets shown in the statement of financial
position.
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Exhibit 15.1
Helpful Hint!
Practice tip:
Which type of expenditure are the following: installing mouldings
around the windows in a building, repairing a broken window pane,
routine cleaning of office? From observing organisations around you,
can you suggest at least two more examples for each type of
expenditure?
15.5 Joint expenditure
In certain cases, an item of expenditure will need dividing between capital
and revenue expenditure. Suppose a builder was engaged to build an
extension and carry out some repairs to your premises, the total bill being
$500,000. If one-fifth of this was for repair work and four-fifths the cost of
building the extension, then $100,000 should be charged to the profit and loss
account as revenue expenditure, and $400,000 should be identified as capital
expenditure and added to the value of the firm’s premises and shown as such
in the statement of financial position.
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Exhibit 15.2
15.6 Incorrect treatment of expenditure
If one of the following occurs:
• capital expenditure is incorrectly treated as revenue expenditure, or
• revenue expenditure is incorrectly treated as capital expenditure
then both the statement of financial position figures and trading and profit
and loss account (income statement) figures will be incorrect. This means that
the net profit figure will also be incorrect.
If capital expenditure is incorrectly posted to revenue expenditure – for
example, if the purchase of a photocopier is posted in error to the stationery
account instead of the office equipment account – then:
Net profit would be understated, and the statement of financial position
values would not include the value of the asset.
If revenue expenditure is incorrectly posted to capital expenditure – for
example, if stationery is posted to office equipment instead of the stationery
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account – then:
Net profit would be overstated, and the statement of financial position
values would be over-valued.
If the expenditure affects items in the trading account, then the gross profit
figure will also be incorrect.
15.7 Treatment of loan interest
If money is borrowed to finance the purchase of a non-current asset, then
interest will have to be paid on the loan. The loan interest, however, is not a
cost of acquiring the asset but is simply a cost of financing its acquisition.
This means that loan interest is revenue expenditure and not capital
expenditure, and should be charged to the profit and loss account.
15.8 Capital and revenue receipts
When an item of capital expenditure is sold, the receipt is called a capital
receipt. Suppose a motor van is bought for $5,000, and sold five years later
for $750. The $5,000 was treated as capital expenditure. The $750 received is
treated as a capital receipt.
Revenue receipts are sales and other revenue items, such as rent receivable
or commissions receivable.
Summary
• The distinction between capital and revenue expenditure is
explained, and the importance of classifying items carefully, since
this can ultimately affect the recording of profits and the statement
of financial position valuations of a business.
• Capital expenditure is money spent on the purchase of non-current
assets or additions to existing assets. They are usually purchased
to be retained in the business to enable it to generate profits.
• Revenue expenditure is money spent on day-to-day running
expenses of the business.
• Some items are both capital and revenue expenditure and the
costs involved need to be apportioned carefully.
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• If capital expenditure or revenue expenditure is mistaken one for
the other, then either gross or net profit (or both) will be incorrectly
stated. The value of the assets in the statement of financial position
will also be affected.
• It is also important to classify capital receipts, that is, the sale of a
non-current asset, from revenue receipts which are accounted for
from sales or other revenue items.
Chapter 15 Exercises
15.1 For the business of J. James, wholesale chemist, classify the
following between capital and revenue expenditure:
(a) Purchase of extra motor van
(b) Cost of rebuilding warehouse wall which had fallen down
(c) Building extension to warehouse
(d) Painting extension to warehouse when it is first built
(e) Repainting extension to warehouse three years after (d)
(f) Carriage costs on material for new warehouse extension
(g) Carriage costs on purchases
(h) Carriage costs on sales
(i) Legal costs of collecting debts
(j) Legal charges on acquiring new premises for office
(k) Fire insurance premium
(l) Costs of erecting new machine.
15.2X Newton Data Systems specialises in providing computer
services to small commercial businesses. You are required to
state whether the following transactions should be classified as
capital or revenue expenditure, giving reasons for your choice:
(a) Salaries of the computer operators
(b) Purchase of new computer for use in the office
(c) Purchase of computer printout paper
(d) Insurance of all the company’s computer hardware
(e) Cost of adding additional storage capacity to the company’s
computer network system
(f) Cost of providing additional security to the company’s
offices.
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15.3 Explain clearly the difference between capital expenditure and
revenue expenditure. State which of the following you would
classify as capital expenditure, giving your reasons.
(a) Cost of building extension to factory
(b) Purchases of filing cabinets for sales office
(c) Cost of repairs to accounting machine
(d) Cost of installing reconditioned engine in delivery van
(e) Legal fees paid in connection with factory extension.
15.4X The following data were extracted from the book of account of
H. E. Worth, a building contractor, on 31 March 2017, his
financial year end.
Allocate each of the items listed above to either capital or
revenue expenditure.
15.5X Star Fashions Ltd, which manufactures children’s clothing, is
planning to purchase a new cutting machine costing $20,000.
(a) Would the following items of expenditure be classed as
capital or revenue expenditure?
(i) The purchase price of the cutting machine
(ii) The cost of installing the machine
(iii) The significant cost of initial training for the staff to
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operate the new machine
(iv) The cost of future repairs and maintenance of the
machine.
(b) If capital expenditure is treated as revenue expenditure,
then:
(i) How would the total expenses and the net profit for the
period be affected?
(ii) What effect would the error have on the value of the
non-current assets in the statement of financial
position?
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Multiple-choice questions – Set 2 (21 to 40)
Each multiple-choice question has four suggested answers: (A), (B),
(C) or (D). You should read each question and then decide which
choice is best: (A), (B), (C) or (D). Write down your answers on a
separate piece of paper. You will then be able to repeat the set of
questions later without the distraction of previously written attempts.
When you have completed a set of questions, check your answers
against those given in Appendix C.
21 Gross profit is calculated in the:
(A) profit and loss account
(B) statement of financial position
(C) trading account
(D) trial balance.
22 Net profit is:
(A) sales less purchases add opening inventory less closing
inventory
(B) gross profit add expenses of the period
(C) capital plus all expenses
(D) gross profit less expenses of the period.
23 The debit entry for net loss is on the debit side of:
(A) the capital account
(B) the trading account
(C) the statement of financial position
(D) the profit and loss account.
24 We calculate the value of closing inventory at the end of a period
by:
(A) looking at the balance in the inventory account
(B) deducting opening inventory from purchases
(C) deducting purchases and opening inventory from sales
(D) conducting an inventory check.
25 What is the correct order for current assets in the statement of
financial position?
(A) Cash, bank, accounts receivable, inventory
(B) Inventory, accounts receivable, bank, cash
(C) Inventory, bank, cash, accounts receivable
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26
27
28
29
30
31
(D) Accounts receivable, inventory, bank, cash
Select the correct definition of a statement of financial position:
(A) A double entry account
(B) A list of balances after the profit and loss account has been
drawn up
(C) A statement of all the assets
(D) An account proving the books balance
Which of the following are not part of the double entry system?
(i) Trading account
(ii) Statement of financial position
(iii) Trial balance
(iv) Profit and loss account
(A) (i) and (ii)
(B) (i) and (iii)
(C) (ii) and (iii)
(D) (ii) and (iv)
Carriage inwards is charged to the trading account because:
(A) it is not a statement of financial position item
(B) it is not part of the motor expenses
(C) returns inwards also goes in the trading account
(D) it is basically part of the cost of buying goods.
Given figures showing: sales of $28,500, opening inventory of
$4,690, closing inventory of $7,240, carriage inwards of $570 and
purchases of $21,360, the cost of goods sold figure is:
(A) $19,830
(B) $19,380
(C) $18,810
(D) another figure.
In the trading account the returns inwards should be:
(A) added to cost of goods sold
(B) deducted from purchases
(C) deducted from sales
(D) added to sales.
The purchases day book (journal) is best described as:
(A) a list of purchases bought on credit
(B) containing suppliers’ accounts
(C) a list of purchases bought for cash
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32
33
34
35
(D) part of the double entry system.
Customers’ personal accounts are found in the:
(A) private ledger
(B) general ledger
(C) purchases ledger
(D) sales ledger.
Which of the following are not personal accounts?
(i) Accounts receivable
(ii) Drawings
(iii) Rent
(iv) Accounts payable
(A) (iii) only
(B) (i) and (ii) only
(C) (i) and (iv) only
(D) (ii) and (iii) only
The total of the sales day book (journal) is entered on:
(A) the debit side of the sales day book
(B) the credit side of the sales account in the general ledger
(C) the debit side of the sales account in the general ledger
(D) the debit side of the profit and loss account.
What is the rate of inventory turnover if:
(A) 3.75 times per annum
(B) 5.5 times per annum
(C) 4.25 times per annum
(D) 4.67 times per annum
36 A deficit balance in the trading account indicates a:
(A) gross profit
(B) gross loss
(C) net profit
(D) net loss.
37 The statement of financial position equation indicates that the
assets of the business were provided by:
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(i) accounts receivable
(ii) the owner
(iii) accounts payable
(iv) customers paying cash.
(A) (i) and (ii)
(B) (ii) and (iii)
(C) (ii) and (iv)
(D) (iii) and (iv)
38 Examples of only current assets can be found in:
(A) Inventory, Cash, Accounts receivable, Bank
(B) Cash, Equipment, Accounts receivable, Bank overdraft
(C) Accounts receivable, Bank, Inventory, Equipment
(D) Bank overdraft, Accounts receivable, Inventory, Accounts
payable.
39 Liabilities classified as non-current are:
(A) bonds, long-term notes payable, accounts payable
(B) mortgage, bonds, furniture
(C) bonds, mortgage, long-term notes payable
(D) accounts payable, furniture, equipment bought on credit.
40 Financial statements are prepared:
(A) to identify business resources, who owns them and owner
equity
(B) to provide information to enable investment and credit
decision-making
(C) to provide information to assess the sources of future cash
flows
(D) based on all of the above.
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16 Business documentation
Specific objectives
After you have studied this chapter you should be able to:
• identify source documents related to books of original entry
• prepare source documents for use in transaction descriptions
• use source documents to make entries into books of original entry.
16.1 Introduction
The aim of any business is to make a profit and this is achieved by the trading
of goods or services. When a business makes a sale of goods or provides a
service to its customers then it will use a number of different documents
which are then used to enter the sale into the books of account. Since any
transaction involves both the seller and buyer, the documents are used by
both parties, for example the invoice is a regarded as a ‘sales invoice’ for the
seller but a ‘purchase invoice’ for the buyer.
Let us consider the documents used in the selling and buying process:
• Purchase requisition – In a large organisation, this is sent by the
department manager to the Purchasing department requesting the items to
be purchased.
• Purchase order – A customer or the Purchasing department of a large
organisation will decide what goods or services they require and issue a
‘purchase order’ to the supplier.
• Delivery note – The supplier subsequently delivers the goods
accompanied by a ‘delivery note’. This document contains details of the
goods being delivered upon which the customer will sign for their receipt.
• Invoice – The supplier then sends an ‘invoice’ to the buyer detailing the
goods or services supplied and the amount due for payment.
• Debit note or Returns note – Should any goods be faulty or unsatisfactory
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•
•
•
•
the buyer will return them to the supplier together with a ‘debit note’
requesting an allowance in respect of the goods returned.
Credit note – Upon receipt of the faulty goods and ‘debit note’ the supplier
issues a ‘credit note’ indicating the amount of refund/allowance due to the
buyer.
Statement of account – At the end of the month the supplier issues a
‘statement’ to the buyer showing the opening balance then listing the
invoices and credit notes issued and any payment received and the amount
due.
Remittance advice – Any payment made should be accompanied by a
‘remittance advice’ detailing the invoices, credit notes making up the
payment.
Receipt – When goods are purchased and paid for immediately by cash
then a receipt is issued, usually via a cash-till-generated document. A handwritten receipt may also be given.
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Purchasing system
Sales system
In a typical sales system, the flow of documents is as follows:
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16.2 Case study: Zest Wooden Toys
Limited
Zest Wooden Toys Limited is a small manufacturing company that
specialises in making wooden toys which it sells to retailers and department
stores throughout the Caribbean. One of their customers is Rainbow Toys
which places an order for 20 wooden train sets at a cost price of $30 each.
Unfortunately, on checking the delivery, the proprietor of Rainbow Toys
discovers that five of the train sets are faulty and will have to be returned.
The case study will now show the process of the sale from Zest Wooden
Toys Limited to Rainbow Toys using the document shown in the diagram on
page 133.
Purchase Requisition – order for train sets submitted to buying department
at Rainbow Toys.
Rainbow Toys accounting department receives a Purchase requisition from
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one of its departments detailing the items for purchasing from Zest Wooden
Toys. This form contains the following information:
• Supplier name and address
• Date
• Item description
• Quantity
• Purpose
• Department
• Authorised signature of department head
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Purchase order – train sets ordered by
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Rainbow Toys
Rainbow Toys uses the Requisition form, which details the items the
department would like to purchase, to place an order with Zest Wooden Toys
Ltd. This document contains the following information:
• Name and address of the supplier (Zest Wooden Toys Ltd)
• Name and address of the buyer (Rainbow Toys)
• Purchase order number
• Date of order
• Full details of goods required, i.e. catalogue number
• Quantity ordered
• Delivery date
• Authorised signature of the buyer
• The price may also be included
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Delivery note – train sets delivered
When the goods are ready to be delivered, a delivery note is prepared and
sent with the goods. It contains the following details:
• Name and address of buyer – Rainbow Toys
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• Customer’s order number and date
• Details of goods being despatched
– Train set catalogue reference number
– Quantity supplied
– Description of the goods supplied
• Method of delivery
• The delivery note should be signed by the person receiving the goods as
proof of delivery. Many companies nowadays use portable electronic
machines which the customer is asked to sign as proof of delivery.
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Invoice – Zest Wooden Toys Ltd sends invoice
to Rainbow Toys
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Helpful Hint!
Practice tip:
Draw a table showing the differences between a delivery note and an
invoice. Can both source documents be combined into one source
document? Why do you say so?
The invoice is prepared by the seller, in this case Zest Wooden Toys Ltd,
who sends it to the buyer, Rainbow Toys, stating the goods purchased and the
amount due for payment. Invoices can be prepared manually or produced by
a computer and contain the following information:
• Name and address of the seller – Zest Wooden Toys Ltd
• Name and address of the buyer – Rainbow Toys
• Buyer’s order number and date
• Delivery date
• Invoice date
• Details of the goods
– Catalogue code/reference number
– Quantity
– Description
– Unit price
– Total amount due
– Terms of payment
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Debit note – return of faulty train sets to Zest
Wooden Toys Ltd
On checking the delivery of the train sets, the proprietor of Rainbow Toys
discovers five sets are faulty and returns them to Zest Wooden Toys Ltd.
Rainbow Toys then sends a debit note to Zest Wooden Toys requesting an
allowance for return of the faulty goods. The debit note contains the
following details:
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•
•
•
•
•
•
Name and address of the supplier (Zest Wooden Toys Ltd)
Name and address of the purchaser (Rainbow Toys)
Buyer’s order number and date
Details of the faulty goods
Unit and total price
Debit note date and reference numbers
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Credit note – refund now due to Rainbow Toys
On receiving the faulty train sets, Zest Wooden Toys Ltd issues a credit note
to Rainbow Toys indicating the amount of refund due. The buyer is then able
to deduct this amount from the total of the original invoice.
A credit note contains the same information as that of the invoice with the
additional details included:
• The original invoice number and date
• Reason for returning the faulty goods, i.e. goods damaged, not to
specification, not all the goods have been delivered
• Often printed in red to distinguish it from an invoice
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Statement of account – Zest Wooden Toys Ltd
request payment
At the end of the month it is usual for businesses to send a statement of
account to each of their customers stating the transactions of the month and
the amount due. The statement contains the following:
• Name and address of seller – Zest Wooden Toys Ltd
• Name and address of buyer – Rainbow Toys
• Date of statement
• Any outstanding balance from the previous month
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•
•
•
•
Any payments received from the buyer
A list of the invoices issued during the month for goods supplied
Credit notes showing amounts to be refunded
Amount due at the end of the month
Note: Balance b/f’ indicates that $130.00 due for payment has been bought
forward from the previous month. It is then paid on 14 November 2018. At
the end of this Statement $450.00 is outstanding and is shown as ‘Balance
c/f’ which stands for ‘Balance carried forward’. This balance will now be
carried forward to the beginning of the next monthly statement and shown as
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‘Balance b/f’ i.e. ‘Balance bought forward’.
Remittance advice – Rainbow Toys pays
outstanding invoice
Rainbow Toys pays the amount owed to Zest Wooden Toys by cheque on 7
December 2018. To ensure that the payment is correctly allocated to the
relevant invoices/credit notes, the business making the payment usually
prepares and sends a remittance advice to the supplier. This document is
rather like the statement since it contains details of the business transactions
for the month and the amount due for payment.
If payment had been made by BACS, then Rainbow Toys would still
prepare a remittance advice showing details of the payment and the date the
payment will be made.
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16.3 Book-keeping entries into the
books of original entry
We will now look at the entry of the source documents into Zest Wooden
Toys Limited books of original entry, followed by posting the invoice from
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the day book to the ledger. The two source documents that require entry are:
(a) Zest Wooden Toys Limited
1 Invoice – enter into the sales day book
– post entry into the sales ledger
2 Credit note – enter in the returns inwards day book
– post entry into the sales ledger
The book-keeping entries are now shown below:
1 Entering the invoice
Helpful Hint!
Practice and examination tip:
Ensure that you know the format of all source documents. Practise
with a friend by writing up a document and asking them to explain
what it is used for in business. Then let your friend write up a
document and you explain its use to your friend. Ensure that all of
your source documents are completely filled in. They must also be
signed if this is a requirement stated on the respective documents.
2 Entering the credit note
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(b) Rainbow Toys
On the sale of goods or services, a business prepares an invoice stating the
goods/services supplied and the amount due to be paid. As mentioned in the
introduction, the invoice is regarded as a sales invoice in the seller’s books
and a purchase invoice in the buyer’s books.
The invoice was previously entered into the books of Zest Wooden Toys
Limited as a sales invoice. However, in the books of Rainbow Toys the
invoice is a purchase invoice and the entries would be shown as follows:
1 Entering the invoice
2 Entering the credit note
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Note: The entry into the books of original entry shown above is to illustrate
the entries of the source documents used in the case study. In Chapters 17–19
this topic is covered fully.
16.4 Receipts from cash transactions
The transactions shown in the above case study are for sales made on credit,
however, transactions also occur when the goods are paid for immediately in
cash and a receipt issued. There is no need to enter the sale of goods into the
sales day book or sales ledger since the customer is not in debt to the
business.
Example: Let us assume that on 12.11.2018 Rainbow Toys, which is a
retail store, sells the following goods to a customer who pays for them
immediately in cash.
Funtime Colouring Book $5.00
Crayons
$2.00
Rainbow Toys will then provide the customer with a receipt, which will
have been produced via the cash till when the sale was made, see opposite:
Helpful Hint!
Practice and Examination Tip:
Ensure that you know the format of all source documents. Practise
with a friend by writing up a document and asking them to explain
what it is used for in business. Then let your friend write up a
document and you explain its use to your friend. Ensure that all of
your source documents are completely filled in. They must also be
signed if this is a requirement stated on the respective documents.
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Summary
• When a business sells goods or services on credit, various
financial documents are used:
– purchase requisition
– purchase order
– delivery note
– invoice
– debit note
– credit note
– statement
– remittance advice
• A customer will decide what goods or services they require and
issue a ‘purchase order’ to the supplier.
• The supplier subsequently delivers the goods accompanied by a
‘delivery note’. This document contains details of the goods being
delivered upon which the customer will sign for their receipt.
• The supplier then sends an ‘invoice’ to the buyer detailing the
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•
•
•
•
•
goods or services supplied and the amount due for payment.
Should any goods be faulty or unsatisfactory the buyer will return
them to the supplier together with a ‘debit note’ requesting an
allowance in respect of the goods returned.
Upon receipt of the faulty goods and ‘debit note’ the supplier issues
a ‘credit note’ indicating the amount of refund/allowance due to the
buyer.
At the end of the month the supplier issues a ‘statement’ to the
buyer showing the opening balance then listing the invoices and
credit notes issued and any payment received and the amount due.
Any payment made should be accompanied by a ‘remittance
advice’ detailing the invoices, credit notes making up the payment.
When goods are purchased and paid for immediately by cash then
a receipt is issued, usually via a cash till.
Chapter 16 Exercises
16.1 Explain the functions of the following documents used in the
selling of goods or services:
(a) Invoice
(b) Purchase order
(c) Remittance advice
(d) Statement
16.2X Explain the difference between a ‘debit note’ and a ‘credit
note’ stating clearly who prepares each of the documents.
16.3 In the following sentences complete the missing words:
(a) Elite Sports Limited wishes to order goods from Ace
Warehouses and sends them a …………………… detailing
their requirements.
(b) Ace Warehouses despatches the goods and sends them to
Elite Sports Limited together with a ……………………….
showing details of the delivery.
(c) On inspection, Elite Sports Limited discovers some of the
goods are faulty and duly returns them to Ace Warehouses
together with a ……………………………….
(d) Ace Warehouses sends an ………………………. to Elite
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Sports Limited detailing the amount owed for the goods
supplied together with a ………………………. in respect of
the faulty goods returned.
(e) At the end of the month Elite Sports Limited receives a
…………………. from Ace Warehouses stating the amount
due for payment.
(f) Elite Sports Limited sends a cheque to Ace Warehouses
together with a………………………. showing details of the
payment.
16.4X As Accounts Assistant for Blake Packaging Co, who
manufacture packing materials, one of your tasks is to prepare
statements to be sent out to your customers at the end of the
month showing the amount due for payment.
From the following information, draft a statement showing details
of how much your customer, Clark & Co, has outstanding at the
end of June.
The amount outstanding on June 1 amounted to $253.75
16.5X Using the information shown above in exercise 16.4X, prepare
a remittance advice to be sent by Clark & Co to accompany their
payment.
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17 Accounting for sales,
discounts and internal controls
Specific objectives
After you have studied this chapter you should be able to:
• appreciate how the books of original entry are used alongside the
ledgers
• distinguish between a cash sale and a credit sale and the way
each are recorded in the books of account
• prepare a sales invoice and appreciate the need for copy invoices
• enter invoices into the sales day book and post transactions to the
appropriate accounts in the sales ledger and general ledger
• explain the difference between trade discounts and cash discounts
and understand the treatment of each in the books of account
• appreciate documentation used in the sale of goods
• understand the importance of internal control
• understand terms and abbreviations used in trading activity
• appreciate the need for credit control over accounts receivable
(debtors).
17.1 Introduction
In Chapter 3, we discussed the accounting cycle within which a business
operates during its financial year. This included recording all the trading
activities from the source documents in the day books, posting to the various
ledgers and the preparation of the financial statements at the end of the
accounting period.
As a business expands, additional accounting record books are required to
enable the system of recording transactions to be made easier and more
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efficient. You may remember that a ‘book of original entry’ is where a
transaction is first recorded. All transactions that are entered into the bookkeeping system originate from a ‘source document’ such as an invoice, credit
note, cheque book stub, paying-in slip and so on. In the next two chapters, we
will be looking at invoices and credit notes that are raised when goods or
services are sold to customers and perhaps returned if a problem arises with
the goods when a credit note would be issued. Chapters 20 and 41 cover the
banking system and cash books which illustrate how cash and cheques are
recorded in the accounting records.
17.2 Diagram of the books commonly
used
The various books used in accounting are shown in linked diagram form, see
Exhibit 17.1.
Exhibit 17.1
17.3 Cash sales
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When goods are purchased by a customer, who pays for them immediately by
cash, then there is no necessity to enter the sale of these goods into the sales
day book or the sales ledger since the customer is not in debt to the business.
Keeping details of these customers’ names and addresses is, therefore, not
needed.
17.4 Credit sales
In many businesses, however, most of the sales will be made on credit rather
than in cash. In fact, the sales of some businesses or organisations will consist
entirely of credit sales.
For each credit sale, the supplier will send a document to the buyer
showing details and the prices of the goods sold. This document is known as
a sales invoice to the supplier and a purchase invoice to the buyer, as
explained in Chapter 16.
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Exhibit 17.2
Most businesses have individually designed invoices but inevitably they
follow a generally accepted accounting format. All invoices will be numbered
and contain the names and addresses of both the supplier and the customer. In
Exhibit 17.2 the supplier is J. Blake and the customer is D. Prendergast.
17.5 Copies of sales invoices
Once the goods have been despatched to the buyer, a sales invoice is made
out by the supplier. The top copy of the sales invoice is sent to the buyer and
further copies are retained by the supplier for use within the organisation. For
example, one copy is usually sent to the accounts department to enable the
sale of goods on credit to be recorded in the sales day book and sales ledger
and another copy may be passed to the sales department and so on.
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17.6 Entering into the sales day book
As mentioned above, a copy of the sales invoice is passed to the accounts
department where the supplier enters this into the sales day book. This book
is merely a list, showing the following:
• date of sale
• name of customer to whom the goods have been sold
• invoice number
• folio column
• final amount of invoice.
There is no need to give details of the goods sold in the sales day book. This
can be found by looking at the copy invoices. The folio column will be
completed when the items are entered in the sales ledger.
Exhibit 17.3 shows a sales day book, which illustrates how the invoices are
entered starting with the entry of the invoice shown in Exhibit 17.2. Assume
that the entries are on page 26 of the day book.
Exhibit 17.3
17.7 Posting credit sales to the sales
ledger
Instead of having one ledger for all accounts, a sales ledger is used for
recording credit sale transactions.
1 The credit sales are now posted, one by one, to the debit side of each
customer’s account in the sales ledger.
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2 At the end of each period, the total of the credit sales is posted to the credit
side of the sales account in the general ledger.
It may be easier to use ‘IN’ and ‘OUT’, as shown in Chapter 7, to post these
transactions; that is, the goods sold go ‘into’ each individual customer’s
account and they come ‘out’ of the sales account. This is now illustrated in
Exhibit 17.4.
You will have noticed the use of the word ‘posting’. This is where the
book-keeper or accountant enters information from the books of original
entry into the general ledger and subsidiary ledgers, that is, sales ledger and
purchases ledger, by means of double entry book-keeping.
Exhibit 17.4
17.8 An example of posting credit sales
The sales day book in Exhibit 17.3 is now shown again. This time posting is
made to the sales ledger (abbreviated SL) and the general ledger (abbreviated
GL). Notice the completion of the folio columns with the ledger reference, as
stated above, and the page number of the ledger (see Exhibit 17.5).
In the individual debtor’s accounts in the sales ledger, the folio columns
have also been completed. This time they show the reference ‘SDB’ for
‘Sales Day Book’ followed by the page number of the day book, in this case
page 26.
The use of folio columns is also discussed in Chapter 20, Sections 20.5 and
20.6
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Exhibit 17.5
Helpful Hint!
Practice tip:
Draw and label a line diagram illustrating where four copies of the
invoice from J Blake to D Pendergast (shown earlier in the chapter)
would be used within J Blake’s organisation if it is being efficiently
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run.
Alternative names for the sales day book are the ‘sales book’ and the ‘sales
journal’. Before you continue, you should attempt Exercise 17.1.
17.9 Trade discounts
A trade discount is a percentage reduction given by a business to a ‘trade’
customer on the list price of goods. A trade discount is only shown in the
calculations on the invoice and is not recorded anywhere. It represents a
profit for the ‘trade’ customer. These trade customers have to sell goods to
the general public in their own areas. Those who buy in large quantities will
not want to pay as much as those who buy in small quantities. You want to
attract such customers so you are happy to sell to them at a lower price.
This means that your selling prices are at three levels:
1 to trade customers buying large quantities
2 to trade customers buying small quantities
3 to the general public.
So that your staff do not need three different price lists, all goods are shown
on your price lists at the same price.
Exhibit 17.6
17.10 Sales invoice with trade discount
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Exhibit 17.7
Exhibit 17.7 is an invoice for goods supplied by R. Grant (Catering Supplies)
to D. Prendergast. The items supplied by R. Grant (Catering Supplies) are the
same as supplied by J. Blake – see Exhibit 17.2; however, you will notice that
R. Grant (Catering Supplies) uses trade discounts to encourage customers to
buy from him.
By comparing Exhibits 17.2 and 17.7, you can see that the prices paid by
D. Prendergast were the same. It is simply the method of calculating the price
that is different.
17.11 No double entry for trade
discounts
As trade discount is simply a way of calculating sales prices, no entry for
trade discount should be made in the double entry records or in the sales day
book.
The recording of Exhibit 17.7 in Grant’s (Catering Supplies) sales day
book and Prendergast’s personal account will appear as follows:
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To compare with cash discounts:
• trade discounts are not shown in double entry accounts
• cash discounts are shown in double entry accounts.
Cash discount is dealt with in Chapter 20, Cash book and cash discount.
17.12 Other documentation
Each business will have its own system of making out documents. All but the
very smallest organisations will have their documents prepared via computer.
The sales invoice is the document from which the book-keeping records
are prepared. There will usually be several other documents prepared at the
same time, so that the business may properly organise the sending of the
goods and ensuring that they are safely received. These are listed below.
Advice note
Advice notes will be sent to the customer before the goods are despatched.
This means that the customer will know that the goods are on the way and
when they should arrive. If the goods do not arrive within a reasonable time,
the customer will notify the seller so that enquiries may be made with the
carrier to establish what has happened to the goods.
Delivery note
When goods are sent out, they usually have a delivery note to accompany
them. This means that the customer can check immediately, and easily, what
goods are being received. Often the carrier will ask the customer to sign a
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copy of the delivery note confirming the receipt of the goods. The carrier will
then retain this copy for their own records.
Other documents
Each firm may vary in the type and number of documents used. Some of
these other documents may be:
• Despatch notes – these will resemble delivery notes, and are used by the
despatch department.
• Acknowledgement letters – these may be sent to customers to show that
their orders have been received, and whether delivery will be made as per
the order.
You will recall that other source documents were covered fully in Chapter 16.
17.13 Credit control
Any organisation that sells goods on credit should keep a close check to
ensure that customers pay their accounts on time. If this is not done properly,
the amount of accounts receivable can grow to a level that will make the
business short of cash. Businesses that grow too short of cash will fail, no
matter how profitable they may be.
The following four procedures should be carried out:
1 For each customer, a credit limit should be set and the accounts receivable
should not be allowed to owe more than this limit. The amount of the limit
will depend on the circumstances. Such things as the size of the customer’s
firm and the amount of business done with it, as well as its past record of
payments, will help in choosing the limit figure. Credit rating agencies
may be used to assess the credit worthiness of customers before credit is
granted.
2 As soon as the payment date has been reached, check to see whether
payment has been made or not. Failure to pay on time may mean you
refuse to supply any more goods unless payment is made quickly.
3 Where payment is not forthcoming, after investigation it may be necessary
to take legal action to sue the customer for the debt. This will depend on
the circumstances.
4 It is important that customers are made aware of what will happen if they
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do not pay their account by the due date.
17.14 Internal checks
Sales invoices
When sales invoices are prepared they should be checked very carefully. It is
important to ensure that the correct quantity of goods supplied is invoiced at
the correct price. This also applies to services. They also need to be invoiced
at the correct amount. To avoid the possibility of errors being made or indeed
fraud occurring it is prudent to have different members of staff involved at
the various stages of invoice preparation. One member of staff may prepare
the invoice, which is then passed to another senior member for checking and
approving, before the invoice is sent to the customer.
Purchase invoices
It is equally important for purchase invoices to be checked. The purchaser
needs to ensure that the goods or services to which the purchase invoice
refers have been received and are as per the order and specification. They
then need to check that the goods or services are charged at the correct
amount and calculations on the invoice are correct.
As will be also mentioned in Chapter 18, Section 18.5, many businesses
will stamp the invoice with an appropriate rubber stamp that contains boxes
to be signed by different members of staff. Each member of staff is then held
responsible for ensuring that, for example, the goods have been received, the
invoice calculations and total are correct, before it is passed for payment. The
person paying the invoice should again be different from the person checking
the incoming invoices.
In small businesses there may not be enough members of staff to carry out
the checking process as outlined above. In such circumstances it is important
to ensure that the person carrying out the checks is different from the member
of staff paying the invoices. Often the owner of the business will then pay the
invoices.
17.15 Factoring
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One of the problems that faces many businesses is the time taken by
customers to pay their accounts. Few businesses have so much cash available
to them that they do not mind how long the customer takes to pay. It is a fact
that many businesses that become bankrupt do so not because the business is
not making profits, but because the business has run out of cash funds. Once
that happens, the confidence factor in business evaporates, and the business
then finds that very few people will supply it with goods, and it also cannot
pay its employees. Closure of the firm then generally happens fairly quickly.
In the case of accounts receivable, the cash problem may be alleviated by
using the services of a financial intermediary called a ‘factor’. Factoring is
a financial service designed to improve the cash flow of healthy, growing
companies, enabling them to make better use of management time and the
money tied up in trade credit to customers. In essence, factors provide their
clients with three closely integrated services, covering sales accounting and
collection, credit management (which can include protection against bad
debts), and the availability of finance against sales invoices.
17.16 Abbreviations
Helpful Hint!
Student Tip:
Remember that a trade discount is a discount given to a customer
when calculating the selling price of goods.
Business documents frequently contain abbreviations and terms of trade, the
most common of which are:
Carriage paid – another word for carriage is transport costs. Thus
‘carriage paid’ indicates that the cost of transport has been included in the
cost of the goods.
COD – this stands for ‘cash on delivery’ and means that the goods must be
paid for on delivery.
E & OE – on some invoices and other documents you will see the initials
‘E & OE’ printed at the bottom of the invoice. This abbreviation stands for
‘errors and omissions excepted’. Basically, this is a warning that there may
possibly be errors or omissions, which could mean that the figures shown are
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incorrect, and that the recipient should check the figures carefully before
taking any action concerning them.
Ex works – an indication that the price of the goods does not include
delivery costs.
Net monthly – this frequently appears at the foot of an invoice and means
that the full amount of the invoice is due for payment within one month of the
date of the invoice.
Summary
• When goods/services are sold for cash it is not necessary to enter
the details into the sales day book and sales ledger since the
customer is not in debt to the business.
• When goods/services are sold on credit then an invoice will need to
be prepared and sent to the buyer. This document is known as a
sales invoice to the supplier and a purchase invoice to the buyer.
Several copies of the invoice are usually made to enable the
accounts staff to record the sale in the books of account; other
copies may be required for internal use.
• Sales invoices are ‘source documents’ and are entered into the
sales day book which is a book of original entry. They are then
posted to each individual customer’s account in the sales ledger. At
the end of the period total sales will be posted to the sales account
in the general ledger.
• Trade discount is a discount or reduction given to a customer when
calculating the price of goods. No entry is made of trade discount in
the accounting records.
• Other documentation involved in the selling process include an
advice note, delivery note, despatch note and acknowledgement
letters.
• The importance of credit control to ensure that the business
maintains a healthy cash flow.
• Other areas that are important include the checking of invoices
prior to entry into the books of account and before payment is
made.
• Factoring is offered to businesses to help improve their cash flow.
This involves ‘selling’ its accounts receivable to a factoring
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company who then becomes responsible for collecting debts as
they become due. The company retains a percentage of the
amount collected for their services.
Chapter 17 Exercises
17.1 You are to enter up the sales day book from the following
details. Post the items to the relevant accounts in the sales
ledger and then show the transfer to the sales account in the
general ledger.
Show folio numbers against all items to complete the posting
process using the following page reference numbers: the sales
day book page 54, the sales account in the general ledger page
98. The page numbers of the various ledger accounts in the
sales ledger are shown in brackets.
17.2X Enter up the sales day book from the following, then post the
items to the relevant accounts in the sales ledger. Show the
transfer to the sales account in the general ledger.
Show folio numbers against all items to complete the posting
process using the following page reference numbers: the sales
day book page 209, the sales account in the general ledger page
115. The page numbers of the various ledger accounts in the
sales ledger are shown in brackets.
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17.3 F. Benjamin of 10 Lower Street, San Fernando, is selling the
following items, the recommended retail prices as shown: white
tape at $10 per roll, green baize at $4 per metre, blue cotton at
$6 per sheet, black silk at $20 per dress length. He makes the
following sales during May 2017.
You are required to:
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(a) draw up a sales invoice for each of the above sales
(b) enter the invoices in the sales day book (page 163) and
then post them to the personal accounts
(c) transfer the total to the sales account (page 66) in the
general ledger
(d) show all folio numbers.
17.4X J. Fisher, White House, Bridgetown, is selling the following
items, the retail prices as shown: plastic tubing at $1 per metre,
polythene sheeting at $2 per length, vinyl padding at $5 per box,
foam rubber at $3 per sheet. She makes the following sales
during June 2017.
You are required to:
(a) prepare a sales invoice for each of the above sales
(b) enter the invoices on page 312 of the sales day book, then
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post them to the individual personal accounts in the sales
ledger
(c) transfer the total to the sales account (page 54) in the
general ledger
(d) show all folio numbers.
17.5 Why is it important to ensure that sales invoices are thoroughly
checked before being sent out to customers?
17.6 What is meant by the term ‘factoring’?
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18 Accounting for purchases
Specific objectives
After you have studied this chapter you should be able to:
• enter purchase invoices into the purchases day book
• post the purchases day book to the purchase ledger
• authorise and code invoices for payment.
18.1 Purchase invoices
When organisations purchase goods or services from suppliers on credit they
are sent a purchase invoice detailing the goods or services and their price.
In the previous chapter, Exhibit 17.2 showed an invoice raised by J. Blake,
the supplier, and sent to D. Prendergast, the buyer. The invoice is common to
both parties since it details the goods supplied and the amount outstanding.
1 In the books of D. Prendergast it is a purchase invoice.
2 In the books of J. Blake it is a sales invoice.
18.2 Entering into the purchases day
book
Upon receipt of the purchase invoice for goods and services supplied on
credit, the purchaser enters the details in their purchases day book. This book
is merely a list showing the following:
• date of purchase
• name of supplier from whom the goods were purchased
• reference number of the invoice
• folio column
• final amount of invoice.
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There is no need to show details of the goods bought in the purchases day
book; this can be found by looking at the invoices themselves. Exhibit 18.1 is
an example of a purchases day book.
Exhibit 18.1
In the same way that sales invoices are used as the source for entering up the
sales day book, the purchases invoices are used as the source for entering up
the purchases day book. These are also known as source documents. The
purchases day book is often known as the purchases book or the purchases
journal.
18.3 Posting credit purchases to the
purchases ledger
We now have a separate purchases ledger. The double entry is as follows:
• The credit purchases are posted one by one to the credit of each supplier’s
account in the purchases ledger.
• At the end of each period, the total of the credit purchases is posted to the
debit of the purchases account in the general ledger.
Again, you may find it easier to use ‘IN’ and ‘OUT’, as discussed in Chapters
6 and 17; that is, the goods purchased come from each supplier and therefore
their accounts are entered on the ‘OUT’ side. The total purchases for the
period are then entered on the ‘IN’ side of the purchases account since the
goods are coming ‘IN’ to us. This is illustrated in Exhibit 18.2.
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Exhibit 18.2
18.4 A worked example of posting
credit purchases
The purchases day book in Exhibit 18.1 is now shown again below (see
Exhibit 18.3). Note the completion of the folio columns. This time the
individual invoices are posted from the purchases day book (abbreviated
PDB) to the individual supplier’s accounts in the purchase ledger
(abbreviated PL) and to the general ledger (abbreviated GL). The reference
details, that is, the abbreviated initials of the specific ledger or day book, are
recorded followed by the page reference number.
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Exhibit 18.3
Helpful Hint!
Question:
How is a sales invoice similar to a purchase invoice? How is it
different?
18.5 Authorisation and coding of
invoices
Authorisation of purchase invoices
When purchase invoices are received from various suppliers of goods or
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services, it is important to check the invoices for accuracy in the calculations
and to ensure that the goods invoiced have been received and agree with the
relevant purchase order and specifications.
On receipt, each purchase invoice should be numbered, recorded and
stamped with an appropriate rubber stamp (see Exhibit 18.4), to enable the
invoice to be checked and coded.
Exhibit 18.4
Coding of invoices
After the invoices have been stamped, they must be coded. Each invoice
should be sent to the department responsible for ordering the goods, the
invoice should be checked and, if everything is satisfactory, it is coded,
passed for payment by a department head and returned to the accounts
department for entry into the books of account and, ultimately, payment.
Organisations using computer accounting systems need to give unique
numbers to all their various accounts so that the computer can recognise them
instantly.
Purchases ledger – Suppliers are given account numbers – for example:
Sales ledger – Customers’ account numbers may have a different series of
numbers:
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General ledger – Examples of account codes are:
A register of code numbers allocated to specific accounts must be maintained
and updated as necessary. This register may be a manual one or held on the
computer system.
Helpful Hint!
Examination tip:
Remember to write the correct name for the Purchases Day Book. It
is also called the Purchases Journal. It is not a ledger.
Summary
• When organisations purchase goods or services from suppliers,
they are sent a purchase invoice detailing the goods or services
and their price. The invoice is used by both buyer and seller; to the
buyer it is a purchase invoice and to the seller a sales invoice.
• Only invoices relating to goods bought on credit are entered into
the purchases day book which is merely a list showing details of
each credit purchase, that is, the date of purchase, name of
supplier, reference number and amount due.
• Each purchase invoice is then posted to the individual customer’s
account in the purchases ledger.
• At the end of the period, usually a month, the total purchases are
posted to the purchases account in the general ledger.
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• Many organisations have a system of coding the invoices prior to
entry into the books of account. Part of this process involves
authorising the invoice for payment.
Chapter 18 Exercises
18.1 B. Mann has the following purchases for the month of May
2017.
Required:
(a) Enter up the purchases day book for the month on page
177.
(b) Post the transactions to the suppliers’ accounts. Their
reference numbers are shown in brackets after each
transaction.
(c) Transfer the total to the purchases account on page 99 of
the general ledger.
(d) Show all folio numbers.
18.2X A. Rowland has the following purchases for the month of June
2018.
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Required:
(a) Enter up page 207 of the purchases day book for the month.
(b) Post the items to the suppliers’ accounts.
(c) Transfer the total to the purchases account, page 33, of the
general ledger.
(d) Show all folio numbers.
18.3 C. Phillips, a sole trader, has the following purchases and sales
for March 2017.
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Required:
(a) Enter up the purchases day book (page 55) and sales day
book (page 62).
(b) Post the items to the personal accounts.
(c) Post the totals of the day books to the sales and purchases
accounts, on pages 88 and 146 of the general ledger.
(d) Show all folio numbers.
18.4X A. Henriques has the following purchases and sales for May
2017.
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Required:
(a) Write up the sales and purchases day books using the
following reference numbers: Sales day book page 216 and
purchases day book page 119.
(b) Post the items to the personal accounts.
(c) Post the totals of the day books to the sales accounts, on
page 322 of the general ledger and the purchases account
on page 166 of the general ledger.
(d) Show all folio numbers.
18.5 You are employed as accounts assistant for a catering
company, Surprise Desserts, that specialises in making desserts
for sale to local restaurants, hotels and shops. During July 2017
the following purchases invoices are received.
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Required:
(a) Draw up a purchases day book, enter the invoices and total
it up at the end of the month.
(b) Open accounts for each of the suppliers, use your own folio
numbers and post the invoices to the suppliers’ accounts in
the purchase ledger.
(c) Post the totals to the purchases account in the general
ledger.
18.6X (a) As accounts assistant for a builders’ merchants, you are
responsible for approving invoices prior to payment at the
end of each month. List the steps you would take in
authorising an invoice for payment.
(b) The company has recently purchased four concrete mixers
which are shown in the catalogue at $260 less 25 per cent
trade discount and a further 2.5 per cent cash discount if the
invoice is settled within 7 days. Assuming the invoice is paid
within 7 days, what is the total amount the firm would have
to pay for the concrete mixers?
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19 Accounting for returns
Specific objectives
After you have studied this chapter you should be able to:
• enter credit notes in the returns inwards day book
• post entries from the returns inwards day book to the appropriate
customers’ accounts in the sales ledger and the returns inwards
account in the general ledger
• enter debit notes in the returns outwards day book
• post entries from the returns outwards day book to the appropriate
suppliers’ accounts in the purchase ledger and the returns
outwards account in the general ledger
• understand the reason for keeping the returns inwards and returns
outwards day books
• understand the use of statements.
19.1 Returns inwards (sales returns)
and returns outwards (purchase
returns)
When goods are bought and sold it is inevitable that occasionally they are not
suitable to the buyer for various reasons, such as when the goods were:
• faulty or damaged
• not suitable for the particular requirement, that is, wrong type, size, colour,
etc.
• the consignment was incomplete
• there was an overcharge on the invoice.
When this happens, the supplier will need to make an allowance to the
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customer to correct the situation.
19.2 Returns inwards (sales returns)
and credit notes
As mentioned above, if the goods supplied are unsuitable then the supplier
will need to rectify the situation. Since the customer (debtor) will have
already been sent an invoice at the time the goods were delivered they will be
in debt to the supplier (creditor) for the value of the goods. Therefore, when
the supplier makes an allowance for goods that have been returned, or a
reduction in price has been agreed, the supplier will issue a credit note to the
customer (debtor) showing the amount of the agreed reduction.
Exhibit 19.1 shows an example of a credit note – note that credit notes are
usually printed in red to distinguish them from invoices.
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Exhibit 19.1
19.3 Book-keeping entries for credit
notes
Credit notes are source documents and are listed in a separate day book called
the returns inwards day book. The book-keeping entries are:
Sales ledger: Credit the individual customer accounts (debtor’s) with the
amount of each credit note.
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General ledger: Debit the Returns Inwards Account with the total of the
returns day book at the end of the period.
Again, you may find it easier to use ‘IN’ and ‘OUT’ as discussed
previously; that is, goods returned to us are entered on the ‘IN’ side of the
returns inwards account since the goods are coming ‘IN’ to us, and on the
‘OUT’ side of the individual customers’ accounts.
Alternative names in use for the returns inwards day book are the returns
inwards journal or the sales returns day book.
19.4 Example of a returns inwards day
book
An example of a returns inwards day book, showing the items posted from
the returns inwards day book (abbreviated RIDB) to the sales ledger (SL) and
the general ledger (GL), is shown in Exhibit 19.2.
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Exhibit 19.2
19.5 Returns outwards (purchases
returns) and debit notes
When a business buys goods for resale but then has to return some of the
goods for any of the reasons already discussed, they are known as ‘returns
outwards’. When this happens, a document known as a debit note is sent by
the business to the supplier giving details of a claim for an allowance in
respect of goods returned.
Exhibit 19.3 shows an example of a debit note.
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Exhibit 19.3
19.6 Book-keeping entries for debit
notes
Debit notes are source documents and are listed in a returns outwards day
book. This is then used for posting the items, as follows:
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Purchases ledger: Debit the individual supplier (creditor) accounts with
the amount of each debit note.
General ledger: Credit the Returns Outwards Account with the total of the
returns day book at the end of the period.
Using ‘IN’ and ‘OUT’, the entries would be as follows: the goods returned
by us to the supplier go ‘IN’ to the suppliers’ accounts and come ‘OUT’ of
the returns outwards account.
Other names in use for the returns outwards day book are the returns
outwards journal or the purchases returns day book.
Helpful Hint!
Question:
How is the returns inwards day book different from the returns
outwards day book? How are they similar?
19.7 A worked example of a returns
outwards day book
An example of a returns outwards day book, showing the items posted from
the returns outwards day book (abbreviated RODB) to purchases ledger (PL)
and the general ledger (GL), is shown in Exhibit 19.4.
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Exhibit 19.4
19.8 Double entry and returns
Exhibit 19.5 shows how double entry is made for both returns inwards and
returns outwards.
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Exhibit 19.5
19.9 Reasons for keeping separate
returns accounts
It is important for the owners of a business to monitor the amount of goods
being returned and the reasons for the returns. Separate returns accounts, that
is, a Returns inwards account and a Returns outward account, are therefore
kept so that recording returns in these accounts would indicate any excessive
amounts which management would then need to investigate. For example, are
too many faulty goods being sold or bought? This can result in unnecessary
costs, such as carriage outwards, packing expenses and so on.
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19.10 Statements
At the end of each month, a statement of account should be sent to each
customer (debtor) who owes money on the last day of that month. It is really
a copy of the customer’s account in the seller’s books. It should show:
1 amount owing at start of month
2 amount of each sales invoice sent to them during the month
3 credit notes sent during the month
4 cash and cheques received from customer during the month
5 amount due from customer at the end of the month.
Customers will use these statements to see if the accounts in their own
accounting records agree with their accounts in our records. If a customer is
shown in our books as owing $798, then, depending on items in transit
between us, his books should show us as a supplier for $798.
The statement also acts as a reminder to the customer that money is owed,
and will show the date by which payment should be made.
An example of a statement might be as shown in Exhibit 19.6.
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Exhibit 19.6
19.11 Sales and purchases via credit
cards
Nowadays, consumers are increasingly using credit cards to purchase
goods and services. In effect, the sales are ‘cash sales’, for as far as the
purchasers are concerned: they have seen and received goods or obtained
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services and in their eyes they have paid for them by using their credit card.
Such sales are very rarely sales to anyone other than the general public, as
compared with sales to professionals in a specific trade.
Helpful Hint!
Examination tip:
Label your Return Inwards Day Book and Returns Outwards Day
Book correctly. No marks will be given for correct calculations in an
incorrectly labelled Day Book.
Once a customer has received the goods or services from the seller, he or
she does not need to be entered in the sales ledger as an account receivable.
All the selling company is then interested in, from a recording point of view,
is collecting the money from the credit card company.
The book-keeping entries are as follows.
Credit cards are discussed in more detail in Chapter 41, Section 41.5.
Summary
• A credit note is a document issued by a supplier and sent to a
purchaser showing details of an allowance made in respect of
unsatisfactory goods or services.
• Credit notes are entered into a returns inwards day book. The total
returns for the month are posted to the debit side of the returns
inwards account in the general ledger. Each transaction is also
posted to the credit side of the individual customer’s accounts
(debtors) in the sales ledger.
• A useful hint: goods returned to us are entered on the ‘IN’ side of
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•
•
•
•
•
•
the returns inwards account and on the ‘OUT’ side of the individual
customers’ accounts (debtors).
A debit note is a document prepared by a business and sent to a
supplier giving details of a claim for an allowance in respect of
goods returned or unsatisfactory.
Debit notes are entered into a returns outwards day book. Each
transaction is then posted to the debit side of the individual
suppliers’ (creditors) accounts in the purchase ledger. The total
returns for the month are posted to the credit side of the returns
outwards account in the general ledger.
A useful hint: the goods returned by us to the supplier go ‘IN’ to the
individual suppliers’ accounts and come ‘OUT’ of the returns
outwards account.
To keep a note of the number of returns being made it is important
to have separate accounts for returns inwards and returns
outwards.
Statements are issued by suppliers and sent to their customers,
that is, their debtors, requesting payment of amounts due. The
customer uses the statement to check the suppliers’ records
against their own and if correct will make payment against the
statement.
Many consumers now use credit cards to pay for goods and
services.
Chapter 19 Exercises
19.1 You are to enter up the purchases day book and the returns
outwards day book from the following details, then post the items
to the relevant accounts in the purchases ledger and show the
transfers to the general ledger at the end of the month. Make up
your own folio numbers and show against every item.
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19.2X Enter up the sales day book and the returns inwards day book
from the following details. Then post to the customers’ accounts
and show the transfers to the general ledger. Make up your own
folio numbers and record against each item.
19.3 You are to enter up the sales, purchases and the returns
inwards and returns outwards day books from the following
details, then post the items to the relevant accounts in the sales
and purchases ledgers. The totals of the day books are then to
be transferred to the accounts in the general ledger. Make up
your own folio numbers and record against each item.
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19.4 Write up the day books for June 2017 from the following credit
transactions.
You are also required to:
(a) Post the transactions to the sales and purchases ledgers
and to the general ledger.
(b) Balance the personal accounts.
(c) Use the accounts to draw up a trial balance as on 30 June
2017.
19.5X You are to enter the following items in the day books, post to
personal accounts, and show transfers to the general ledger.
Make up your own folio numbers and record against each item.
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19.6 In which book of original entry would you enter the following?
(a) Sales invoice
(b) Debit note
(c) Cash sale
(d) Purchase invoice
(e) Credit note.
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20 Cash book and cash discount
Specific objectives
After you have studied this chapter you should be able to:
• enter data into two- and three-column cash books
• balance off the cash book at the end of a period
• use folio columns for cross-referencing purposes
• enter ‘contra’ items in the cash book
• understand and complete entries for discounts allowed and
discounts received both in the cash book, and at the end of a
period, in the discount accounts in the general ledger.
20.1 Introduction
The cash book consists of the cash account and the bank account put together
in one book. Initially, we showed these two accounts on different pages of the
ledger; now it is easier to put the two sets of account columns together. This
means that we can record all money received and paid out on a particular date
on the same page.
In the cash book, the debit column for cash is put next to the debit column
for bank. The credit column for cash is put next to the credit column for bank.
20.2 Drawing up a cash book
We can now look at a cash account and bank account in Exhibit 20.1 as they
would appear if they had been kept separately. Then in Exhibit 20.2, they are
shown as if the transactions had, instead, been kept in a cash book.
The bank column contains details of the payments made by cheque and
direct transfer from the bank account and of the money received and paid into
the bank account. The bank will have a copy of the account in its own books.
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Periodically the bank sends a copy of the account in its books to the
business.
This document is known as a bank statement. When the business
receives the bank statement, it will check it against the bank column in its
own cash book to ensure that there are no errors.
Exhibit 20.1
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Exhibit 20.2
20.3 Monies paid into the bank and
cash withdrawn from the bank
Cheques deposited
In Exhibit 20.2 the payments into the bank were cheques received by the
business which were banked on receipt.
Cash deposited
Businesses who receive large amounts of cash need to transfer this to the
bank as soon as possible for security purposes. The money is deposited
straight into the bank account. Therefore, it is entered into the bank column in
the cash book.
Some businesses bank cash received on a weekly basis. Cash accumulated
during the week will be counted and checked against sales. The business may
decide to retain a float (cash in hand) and bank the remaining cash. The
double entry for banking the remaining cash is as follows:
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Effect
Asset of cash
is decreased
Asset of bank
is increased
Action
Credit the cash account (the money comes ‘OUT’),
that is, the cash column in the cash book.
Debit the bank account (the money goes ‘IN’), that is,
the bank column in the cash book.
In the following example you will see how cash received from a customer
is recorded in the cash book, then a couple of days later part of that cash is
banked.
Example: A cash receipt of $100 from John Ash on 1 August 2017, later
followed by the banking of $80 of this amount on 3 August, would appear in
the cash book as follows:
Notice that against the entry on the credit side of the cash book the word
‘bank’ is shown indicating that the cash has been paid into the bank account.
On the debit side the word ‘cash’ is shown which means that the money
being banked has come from the cash account.
Also, if you look at the cash book above you will see ‘C’ in the folio
column. This stands for contra and is the reference used to show that both
parts of the double entry have been entered and completed in one book, the
cash book.
Cash withdrawn
When a business requires cash for business purposes it will make a cheque
out to itself for the amount of cash required. The cheque is taken to the bank
and the money withdrawn.
The double entry for such a transaction is as follows:
Effect
Action
Asset of bank Credit the bank account (the money comes ‘OUT’),
is decreased that is, the bank column in the cash book.
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Asset of cash
is increased
Debit the cash account (the money comes ‘IN’), that
is, the cash column in the cash book.
An example of cash being withdrawn from the bank for business use is now
shown:
Example: A withdrawal of $75 cash on 1 June 2017 from the bank would
appear in the cash book as follows:
20.4 The use of folio columns
In Chapter 17, Exhibit 17.8, an example was shown posting invoices from the
sales day book to the personal ledger accounts using folio columns and
references. We will now consider this further by posting items entered in the
cash book to the various ledger accounts.
The ‘details column’ in an account contains the name of the account in
which the other part of the double entry has been entered. Anyone looking
through the books should, therefore, be able to find the other half of the
double entry in the ledgers. However, when many books are being used, just
to mention the name of the other account may not be enough information to
find the other account quickly. More information is needed, and this is given
by using folio columns. In this column the initials of the ledger where the
other entry has been recorded is shown, that is, GL (General Ledger) together
with the page number. For example:
An entry for receipt of cash from C. Kelly whose account was on page 45
of the sales ledger, and the cash recorded on page 37 of the cash book, would
have the following folio column entries:
• in the cash book, the folio column entry would be SL 45
• in the sales ledger, the folio column entry would be CB 37.
Note how each of the titles of the books is abbreviated so that it can fit into
the space available in the folio column. Entering transactions into the
accounts, in order to complete the double entry, is known as posting.
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20.5 Advantages of folio columns
The advantages of using folio columns are as follows:
• Folio references are essential to help locate where entries have been posted
(see Section 20.4).
• Entering references in the folio columns confirms the transaction has been
posted. Therefore, any item without a reference can easily be identified and
subsequently posted.
20.6 Example of a cash book with folio
columns
The following transactions are written up in the form of a cash book. The
folio columns are filled in as though double entry had been completed to
other accounts.
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The abbreviations used in the folio column are as follows: GL – General
Ledger; SL – Sales Ledger; C – Contra; PL – Purchases Ledger.
20.7 Cash discounts
Businesses prefer it if customers pay their accounts quickly. A firm may
accept a smaller sum in full settlement if payment is made within a certain
period of time. The amount of the reduction of the sum to be paid is known as
a cash discount. The term ‘cash discount’ thus refers to the allowance given
for quick payment. It is still called a cash discount even if the account is paid
by cheque or by direct transfer into the bank account.
The rate of cash discount is usually stated as a percentage. Full details of
the percentage allowed, and the period within which payment is to be made,
are quoted on all sales documents by the selling company. A typical period
during which a discount may be allowed is one month from the date of the
original transaction.
20.8 Discounts allowed and discounts
received
A business may have two types of cash discounts in its books. These are:
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1 Discounts allowed – cash discounts allowed by a business to its
customers when they pay their accounts quickly.
2 Discounts received – cash discounts received by a business from its
suppliers when it pays their accounts quickly.
We can now see the effect of discounts by looking at two examples.
Example 1: W. Charles owed us $100. He pays on 2 September 2017 by
cash within the time limit laid down, and the business allows him 5% cash
discount. So he will pay $100 less $5 cash discount = $95 in full settlement
of his account.
Effect
1 Of cash:
Cash is increased by $95
Action
Debit: Cash account, that is,
enter $95 in debit column of cash
book.
Credit: W. Charles $95.
Asset of accounts receivable is
decreased by $95.
2 Of discounts:
Asset of accounts receivable is
Credit: W. Charles $5.
decreased by $5.
(After the cash was paid there
remained a balance of $5. As the
account has been paid this asset
must now be cancelled.)
Expenses of discounts allowed
Debit: Discounts allowed account
increased by $5.
$5.
This means that W. Charles’ debt of $100 has now been shown as fully
settled, and exactly how the settlement took place has also been shown.
Example 2: The business owed Ms Sue Smith $400 and pays her by
cheque on 3 September 2017. Since they pay within the specified 30 days
they can claim 2.5% cash discount. So the business will pay her $400 less
$10 cash discount = $390 in full settlement of the account.
Effect
Action
1 Of cheque
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Asset of bank is reduced by $390. Credit: Bank, that is, enter in
credit bank column, $390.
Liability of accounts payable is
Debit: S. Smith’s account $390.
reduced by $390.
2 Of discounts:
Liability of accounts payable is
Debit: S. Smith’s account $10.
reduced by $10.
(After the cheque was paid, the
balance of $10 remained. As the
account has been paid, the
liability must now be cancelled.)
Revenue of discounts received
Credit: Discounts received
increased by $10.
account $10.
The accounts in the business’s books for both W. Charles and S. Smith would
appear thus:
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Helpful Hint!
Practice tip:
Write out the full names for the abbreviations in the Folio columns of
the business books related to Examples 1 and 2. Check with a friend.
Did you get these correct?
It is accounting custom to enter the word ‘Discount’ in the personal accounts,
not stating whether it is a discount received or a discount allowed.
20.9 Discount columns in the cash
book
The discounts allowed account and the discounts received account are in the
general ledger, along with all the other revenue and expense accounts. It has
already been stated that every effort should be made to avoid too much
reference to the general ledger.
In the case of discounts, this is done by adding an extra column on each
side of the cash book in which the amounts of discounts are entered.
Discounts received are entered in the discounts column on the credit side of
the cash book, and discounts allowed in the discounts column on the debit
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side of the cash book.
The cash book, if completed for the two examples so far dealt with, would
appear thus:
There is no alteration to the method of showing discounts in the personal
accounts.
To make entries in the discount accounts:
20.10 A worked example
The following is an example of a three-column cash book for the whole of a
month, showing the ultimate transfer of the totals of the discounts columns to
the discount accounts.
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Is the above method of entering discounts correct? You can easily check. See
the following:
You can see that the double entry has been carried out correctly. Equal
amounts, in total, have been entered on each side of the accounts.
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20.11 Bank overdrafts and the cash
book
A business may borrow money from a bank by means of a bank overdraft.
This means that the business is allowed to pay more out of the bank account,
by writing out cheques, than the total amount available in the account.
Up to this point the bank balances have all been money at the bank, and so
they have all been assets, that is, debit balances. When the account is
overdrawn, the firm owes money to the bank and so the account is a liability
and the balance becomes a credit one.
Taking the cash book shown, suppose that the amount payable to A. Azar
was $1,429 instead of $429. Thus the amount in the bank account, $1,044, is
exceeded by the amount withdrawn. The cash book would appear as follows:
Helpful Hint!
Examination tip:
Remember to properly identify the folio of the ledger to which you are
posting information from the respective day books, for example SL
10, CB 5.
On a statement of financial position, a bank overdraft will be shown as an
item included under the heading Current Liabilities.
Summary
• A cash book is made up of a cash account and a bank account put
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•
•
•
•
•
•
•
•
together into one book.
Entries made on the debit side of the cash book are in respect of
monies received via cash, cheque or bank transfer. The money
comes ‘into’ the business and is, therefore, entered on the debit ‘in’
side of the cash book.
Entries made on the credit side of the cash book are in respect of
monies paid out via cash, cheque or bank transfer. Money is paid
‘out’ of the business so entries are made on the ‘out’ side of the
account.
Folio columns are used in the cash book so that items may easily
be traced to other accounts in the ledgers and to provide
assurance that the double entries have been completed.
Cash discounts are given to encourage prompt payment of
outstanding accounts. The discount is referred to as cash discount
irrespective of whether the account is settled by cash, cheque or
bank transfer.
Discount allowed is the amount of discount allowed by a business
to its customers when their accounts are settled promptly and
within the time limit.
Discount received is when the business’s suppliers allow them to
deduct a discount if they pay the account within the stated terms of
trade.
Discounts allowed and received are entered into the appropriate
column in the cash book, totalled at the end of the period, and the
amount transferred to the discount accounts in the general ledger.
Should the balance at the bank go into an overdraft position then
the balance brought down will appear on the credit side of the cash
book.
Chapter 20 Exercises
20.1 Write up a two-column cash book from the following details,
and balance off as at the end of the month.
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20.2X A two-column cash book is to be written up from the following,
carrying the balances down to the following month.
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20.3X Write up a two-column cash book from the following:
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20.4X Roger Groves runs a small store. The records he keeps are of
cash received and paid plus cheques received. His bank
statement and cheque counterfoils act as his bank record. All
cheques received are banked immediately. During May 2017
Groves did not sell or buy anything on credit. The following
information for May 2017 is also available:
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On 1 May 2017 both the bank statement and the cash book
showed a balance of $3,725. Cheques drawn for the month were
as follows.
You are to:
(a) write up a two-column cash book for the month and bring
the balance down
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(b) write up purchases and sales accounts and show totals
(c) calculate the total expenses for the month.
20.5 Enter up a three-column cash book from the details following.
Balance off at the end of the month, and post to the relevant
discount accounts in the general ledger.
20.6 A three-column cash book is to be written up from the following
details, balanced off and posted to the relevant discount
accounts in the general ledger.
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20.7 From the following details write up a three-column cash book,
balance off at the end of the month, and post to the relevant
discount accounts in the general ledger:
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20.8X Enter the following in a three-column cash book. Balance off
the cash book at the end of the month and post to the discount
accounts in the general ledger.
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21 Petty cash and the imprest
system
Specific objectives
After you have studied this chapter you should be able to:
• understand why organisations use a petty cash book
• recognise the need for a petty cash voucher
• understand the imprest system
• make entries in a petty cash book
• post the appropriate amounts from the petty cash book to the
various accounts in the general ledger at the end of the period.
21.1 Introduction to petty cash
All types of organisation from very small ones to large businesses usually
incur small amounts of expenditure. The type of expenditure incurred would
be such items as the purchase of postage stamps or perhaps the posting of a
parcel to a customer, travel expenses, cleaning materials and stationery. The
items purchased are usually paid for in cash by a member of staff on behalf of
the organisation who then seeks reimbursement of the amount spent. A petty
cash book is used to record these transactions. Larger amounts of expenditure
will be paid for by cheque and recorded in the cash book as discussed in the
previous chapter.
The petty cash book is a book of original entry since items are entered here
first and it also acts as a ledger account for the cash in hand at any point of
time.
21.2 Petty cash voucher
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Helpful Hint!
Question:
Name two source documents which can be used in drawing up a
petty cash book.
When a person incurs expenditure on behalf of the organization, they need to
complete a petty cash voucher in order to reclaim the amount of money spent.
This will show details of the expense incurred together with a receipt (if
possible), the amount spent and signed by the person making the claim. The
petty cash voucher will then need to be authorised for payment. Often the
petty cashier is able to authorise payments up to a specific limit, for example
$25.00, with any amount above that usually being authorised by a manager or
accountant.
When the petty cash voucher is entered into the petty cash book it will be
numbered for future reference purposes and then filed. Two examples of
petty cash vouchers are shown in Exhibit 21.1.
Exhibit 21.1
21.3 The imprest system
The imprest system is where the cashier gives the petty cashier enough cash
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to meet the needs for the next period. At the end of the period, the cashier
finds out the amounts spent by the petty cashier, and tops up the petty
cashier’s cash by an amount equal to that spent. The petty cash in hand
should then be equal to the original amount with which the period was
started. Exhibit 21.2 shows an example of this method.
Exhibit 21.2
It may be necessary to increase the fixed sum, often called the cash float, to
be held at the start of each period. In the above case, if we had wanted to
increase the float at the end of the second period to $120, then the cashier
would have given the petty cashier an extra $20, that is, $84 + $20 = $104.
Advantages of using the petty cash imprest
system
• A junior member of the accounts department, usually called the petty
cashier, can be given the task of operating the system thus allowing the
cashier to concentrate on other areas of work.
• Small items of expenditure incurred by the organisation are entered into the
petty cash book and only the totals at the end of the period are posted to the
appropriate accounts in the general ledger. This eliminates numerous
transactions from the main cash book and ledger accounts.
• The imprest system enables the cash to be checked at any time since the
amount paid out, represented by the petty cash vouchers, and the cash in
hand should equal the float at the beginning of the period.
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21.4 A worked example of an analytical
cash book
An analytical petty cash book is often used to record petty cash transactions.
One of these is shown in Exhibit 21.3 recording the following transactions:
Each of the above items will have had a petty cash voucher completed by the
person who had incurred the expenditure on behalf of the business. For
illustration purposes two petty vouchers are shown, petty cash vouchers nos.
9 and 16 (see Exhibit 21.1).
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Exhibit 21.3
Entering the petty cash book
On 1 September the petty cashier received $600.00 cash from the main
cashier. This is the amount of the float for the period of September.
The cashier would enter this item on the credit side of the cash book, the
money comes ‘OUT’ of the bank. The debit entry is now shown on the
Receipts side of the petty cash book, the money comes ‘INTO’ the petty cash.
Note that the folio reference ‘CB 19’ (Cash Book page 19) is also entered to
cross-reference the entry.
Each petty cash voucher is then entered in date order as follows:
• Enter the date.
• Enter the details of each payment.
• A voucher number is then given to each petty cash voucher and entered on
the voucher itself and in the ‘voucher number’ column.
• The total amount of the expenditure incurred is then entered in the ‘total’
column.
• The expenditure is then analysed into an appropriate expense column.
• The petty cash book now requires balancing off at the end of the month as
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follows:
• Add up the ‘total’ column.
• Add up each of the expense columns. The total of all the expense columns
added together should now equal the amount shown in the ‘total’ column.
In Exhibit 21.3 this would be:
The petty cashier now needs to calculate the amount of money needed to
restore the imprest to $600.00 for the beginning of the next period. This is as
follows:
• The balance of cash in hand at 30 September 2017 $95 is now entered into
the petty cash book and shown as Balance c/d, $95 (see Exhibit 21.3).
• The Receipts and Total columns are now added up and should equal each
other, that is, $600. These totals should be shown on the same line and both
double underlined.
• The Balance b/d on 1 October, $95, is now entered in the Receipts column
and underneath that entry the amount received from the cashier to restore
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the imprest $505 is also entered.
• The double entry for each of the expense columns is now carried out.
• The total of each expense column is debited to the expense account in the
general ledger.
• The folio number of each general ledger account is entered under each of
the expense columns in the petty cash book. This enables cross-referencing
and also means that the double entry to the ledger account had been
completed.
The double entry for all the items in Exhibit 21.3 appears as Exhibit 21.4.
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Exhibit 21.4
In a business with both a cash book and a petty cash book, the cash book is
often known as a bank cash book. This means that all cash payments are
entered in the petty cash book, and the bank cash book will contain only bank
columns and discount columns. In this type of business any cash sales will be
paid directly into the bank.
Helpful Hint!
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Examination tip:
Write the steps you would take to ensure that the imprest system is
restored correctly at each month end.
Summary
• The petty cash book is used to record transactions involving small
items of expenditure incurred by a member of staff on behalf of the
organisation.
• Claims for reimbursement of monies paid out are usually made on
a petty cash voucher. The voucher should be completed with all the
relevant details together with receipt (if possible), duly signed and
authorised.
• The imprest system is used by many organisations to operate the
petty cash system. Here an amount of money called a ‘cash float’ is
given to the petty cashier at the start of a period. At the end of the
period, the amount spent by the petty cashier is reimbursed by the
cashier to restore the imprest to its original amount.
• The advantages of using a petty cash system is that it enables a
junior member of staff to be appointed petty cashier so allowing the
cashier or accountant to concentrate on other areas of work.
• Using the petty cash book saves both the cash book and the ledger
account from containing many small items of expenditure.
• The imprest system enables the cash to be checked at any time.
• The petty cash book is totalled, balanced off and the double entry
completed with postings to the ledger accounts in the general
ledger.
• Some organisations use a petty cash book and a bank cash book
instead of a cash book.
Chapter 21 Exercises
21.1 Enter the following transactions in a petty cash book that has
analysis columns for motor expenses, postage and stationery,
cleaning, sundry expenses, and a ledger column. This is to be
kept on the imprest system, the amount spent to be reimbursed
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on the last day of the month. The opening petty cash float is
$1,000.
21.2 Write up a petty cash book with analysis columns for office
expenses, motor expenses, cleaning expenses and casual
labour. The cash float brought down is $500 and the amount
spent is reimbursed on 30 June. Show the balance carried down
to 1 July 2017. Also show how the items for motor expenses and
office expenses would appear in the general ledger.
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21.3X From the following details you are required to:
(a) record in a petty cash book, with headings for school bus
expenses, staff travelling expenses, postage, cleaning and
ledger accounts
(b) show the balance carried down to 1 October 2018
(c) show how the items would be entered in the general ledger,
use your own folio references.
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21.4X C. Chester keeps a cash book with bank columns and
discount columns only. All petty cash paid out is entered in a
petty cash book. All payments above $50 are by cheque, below
that figure by cash.
You are required to:
(a) write up and balance the cash book
(b) write up the petty cash book, balancing down at the end of
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the month.
Analysis columns to be for: motor expenses; postage and
stationery; general expenses; ledger accounts. The petty cash
reimbursement takes place on 1 September.
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22 The general journal
Specific objectives
After you have studied this chapter you should be able to:
• identify the journal as an original book of entry
• explain the purpose of having a journal
• use the journal for entering a range of different transactions
• post items from the journal to the ledgers.
22.1 Main books of original entry
We have seen in earlier chapters that most transactions are entered in one of
the following books of original entry:
• cash book
• sales day book (or journal)
• purchases day book (or journal)
• returns inwards day book (or journal)
• returns outwards day book (or journal).
Each of the above books contains particular forms of transactions; for
example, the sales day book contains details of all credit sales. To trace any
of the transactions entered in the above five books would be relatively easy
since it is known which book of original entry contains which item.
22.2 The journal: a book of original
entry
Other items that are not entered into one of the above books of original entry
are much less common and sometimes more complicated. It is easy for a
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book-keeper to forget the details of these transactions or perhaps the bookkeeper may leave the company making it impossible at a later date to
understand such book-keeping entries.
It is, therefore, important to record such transactions in a form of diary to
relate to entries being made in the double entry accounts. The book used to
record these transactions is called the general journal (or simply referred to as
the journal) and contains the following details for each transaction:
• the date
• the name of account(s) to be debited and the amount(s)
• the name of the account(s) to be credited and the amount(s)
• a description and explanation of the transaction (this is called a narrative)
• a reference number for the source documents giving proof of the
transaction.
Helpful Hint!
Discussion:
Write five entries that should go into the general journal. Support your
answer with information from this chapter.
By recording the transaction in the journal there is less chance of further
errors occurring by ensuring that the item is recorded properly and posted in
the appropriate double entry accounts. Without such a record in the journal,
fraudulent transactions could occur more easily. Despite these advantages,
many businesses do not use a journal.
22.3 Typical uses of the journal
Some of the main uses of the journal are listed below (this list is not
comprehensive):
• the purchase and sale of non-current assets on credit
• the writing off of bad debts
• other items: adjustments to any of the entries in the ledgers
• opening entries – the entries needed to open a new set of books
• the correction of errors.
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The layout of the journal can now be shown as follows.
It can be seen that the name of the account to be debited is entered on the first
line while the second line gives the account to be credited. The name of the
account to be credited is indented slightly and not shown directly under the
name of the account to be debited, because this makes it easier to distinguish
between the debit and credit item.
It should remembered that the journal is not a double entry account; it is a
form of diary, and entering an item in the journal is not the same as recording
an item in an account. Once the journal entry is made, the entry in the double
entry accounts can then be made.
22.4 Journal entries and examination
questions
If you were to ask examiners about what types of book-keeping and
accounting questions are most often answered badly, they would certainly
include ‘Questions involving journal entries’. This is not because questions
about journal entries are actually more difficult than other types, but rather
that many students seem to get some sort of a mental block when dealing
with them.
It appears that this difficulty arises because students often think in terms of
the debits and credits in accounts. Instead, they should think of the journal
simply as a form of written instruction stating which account is to be debited
and which account is to be credited, with a description of the transaction
involved.
To try to help you avoid this sort of problem with journal entries, we will
first show what the entries are in the accounts, and then write up the journal
for those entries. We will now look at a few examples, which include folio
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numbers.
22.5 Purchase and sale on credit of
non-current assets
Example 1: A machine is bought on credit from Toolmakers for $550 on 1
July 2017.
From what you have learned in earlier chapters, you will know that the
double entry accounts would be as follows:
Now we have to record those entries in the journal. Remember, the journal is
simply a kind of diary, not in account form, but in ordinary written form. It
says which account has been debited, which account has been credited, and
then gives a narrative that simply describes the nature of the transaction.
For the transaction above, the journal entry will appear as follows:
Example 2: Sale of stationery no longer required, for $300 on credit to K.
King on 2 July 2017.
Here again, it is not difficult to work out what entries are needed in the
double entry accounts. They are as follows:
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These are shown in journal form as follows:
22.6 Writing off bad debts
Example 3: A debt of $78 owing to us from H. Marshall is written off as a
bad debt on 31 August 2017. This means that we will credit H. Marshall’s
account to cancel the amount out of his account. A bad debt is an expense,
and so we will debit the amount to a bad debts account.
In double entry form this is shown as follows:
The journal entry showing the same transaction would be as follows:
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22.7 Other items
These can be of many kinds and it is impossible to write out a complete list.
Several examples are as follows.
1 S. Blake, a debtor, owed $2,000 on 1 July 2017. He was unable to pay his
account in cash, but offers a motor car in full settlement of the debt. The
offer is accepted on 5 July 2017.
The personal account is now no longer owed and therefore needs to be
credited. On the other hand, the firm now has an extra asset, a motor car, and
therefore the motor car account needs to be debited.
The double entry records are as follows:
This is shown in the journal as follows:
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2 G. Grant is a creditor. On 10 July 2017, his business is taken over by A.
Lee, to whom a debt of $150 is to be paid.
Here, one creditor is being exchanged for another. The action needed is to
cancel the amount owing to G. Grant by debiting his account, and to show it
owing to A. Lee by opening an account for A. Lee and crediting it.
The double entry records are as follows:
This is shown in the journal as follows:
3 An office photocopier, previously bought on credit from RS Ltd, for
$1,310, is found to be faulty and returned to the supplier on 12 July 2017.
The supplier, RS Ltd, agreed to make an allowance for the full amount
outstanding, $1,310, which the business accepted.
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The double entry records are as follows:
This is shown in the journal as follows:
Helpful Hint!
Practice tip:
Remember to use the correct names ‘journal’ or ‘day book’ as
applicable to head the respective book account before inserting the
relevant transactions.
22.8 Opening entries
J. Brown, after being in business for some years without keeping proper
records, now decides to keep a double entry set of books. On 1 July 2017, he
establishes that his assets and liabilities are as follows:
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The assets, therefore, total $4,840 + $700 + $390 + $95 + $45 + $5,080 + $20
= $11,170: and the liabilities total $129 + $41 = £170.
The capital consists of Assets – Liabilities, which in J. Brown’s case is
$11,170 – $170 = $11,000.
We must start the writing up of the books on 1 July 2017 (see Exhibit
22.1). To do this:
1 Open asset accounts, one for each asset. Each opening asset is shown as a
debit balance.
2 Open liability accounts, one for each liability. Each opening liability is
shown as a credit balance.
3 Open an account for the capital, showing it as a credit balance.
The journal records the details of the above transactions. Exhibit 22.1
shows:
• the journal
• the opening entries in the double entry accounts.
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Exhibit 22.1
Once the opening balances have been recorded in the books, the day-to-day
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transactions are entered in the normal way. Opening entries are needed only
once in the life of the business.
22.9 Correction of errors
Further journal entries for correction of errors are dealt with in Chapters 31
and 32.
22.10 Examination guidance
Later in your studies, you may find that some of the journal entries become
rather more complicated than those you have seen so far. The best plan for
nearly all students would be to follow this advice during examinations:
• On your examination answer paper, write a heading entitled ‘Workings’.
Then under that show the double entry accounts.
• Now write a heading entitled ‘Answer’, and show the answer in the form of
the journal, as shown in this chapter.
Helpful Hint!
Examination tip:
When answering an examination question prepare a ‘Workings
Sheet’ and work out the double entry entries prior to preparing the
journal entry.
If you are already confident about dealing with these questions and you feel
that you can manage them without showing your workings, then you may
wish to leave out your workings from your answer.
If the question asks for ‘journal entries’ you must not fall into the trap of
just showing the double entry accounts, as you could get no marks at all even
though your double entry records are correct. The examiner wants to see the
journal entries, and you must show them as your answer.
Summary
• The general journal is an original book of entry and is used to
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record rare or exceptional transactions that do not appear in the
other books of original entry.
• Typical uses of the journal include the purchase and sale of noncurrent assets, writing off bad debts, correction of errors and
opening entries.
• When preparing a journal entry, the date is entered first followed by
the name of the account to be debited and the amount; this is
followed by entering the name of the account to be credited, slightly
indented, and the amount. Finally, a narrative is written, giving a
brief description of the transaction.
• Since many students have problems answering examination
questions involving journal entries, it is recommended that they
prepare a working section to show the double entry aspect prior to
preparing the journal entry, which usually forms the answer to the
question.
Chapter 22 Exercises
22.1 Show the journal entries to record the following: 2017
(i) Jan 1 Bought computer system on credit from Data Systems
Ltd for $4,000.
(ii) Jan 5 Goods taken from the business for own use, $120.
The goods were not paid for by the proprietor.
(iii) Jan 8 A debt of $220 owing to us by J. Oddy is written off as
a bad debt.
(iv) Jan 15 Bought a motor vehicle from Nasrad Garage Ltd
paying by cheque, $15,500.
(iv) Jan 29 J. Spencer owes us $250. She is unable to pay her
debt and we agree to take some filing cabinets valued at
$250 from her to cancel the debt.
Narratives are not required.
22.2 You are to show the journal entries necessary to record the
following items. 2017
(i) May 1 Bought a motor vehicle on credit from Kingston
Garage for $6,790.
(ii) May 2 Bought machinery $980 on credit from Systems
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Accelerated.
(iii) May 8 Office furniture bought by us for $490 was found to
be unsuitable and was returned to the supplier Unique
Offices who gave us full allowance.
(iv) May 12 We are owed $150 by W. Charles. He is unable to
pay in cash: we receive office equipment to the value of
$150 in full settlement of the debt.
(v) May 14 We take $45 goods out of the business stock for
private use without paying for them.
(vi) May 28 Some time ago we paid an insurance bill thinking
that it was all in respect of the business. We now discover
that $76 of the amount paid was in fact insurance of our
private house.
22.3X Show the journal entries necessary to record the following
items.
(i) Apr 1 Bought fixtures on credit from J. Harper, $1,809.
(ii) Apr 4 Goods taken from the business for own use, $500.
The goods were not paid for by the proprietor.
(ii) Apr 9 $28 of the goods taken by us on 4 April are now
returned back into stock by us. We do not take any money
for the return of the goods.
(iv) Apr 12 K. Lamb owes us $500. He is unable to pay his debt.
We agree to take some fixtures and fittings from him at that
value and so cancel the debt.
(v) Apr 18 Some of the fixtures bought from J. Harper, $65
worth, are found to be unsuitable and are returned to him
for full allowance.
(vi) Apr 30 Office equipment is bought on credit from Super
Offices for $2,190.
22.4X (a) J. Green’s financial position at 1 May 2018 was as
follows.
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(i) Show the opening entries needed to open a double
entry set of books for Mr Green as at 1 May 2018.
(ii) Open up the necessary accounts in J. Green’s ledger to
record the above as well as the succeeding
transactions.
(b) During May 2018 J. Green’s transactions were as follows.
You are required to post all accounts and to extract a trial
balance as at 31 May 2018, but only the cash book needs
balancing down.
Note: Sales, purchases and returns day books (journals)
are not needed.
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22.5X (a) Prepare journal entries to record each of the following:
(i) The opening entries of T. Lee who commenced his
business on 1 April 2017.
(ii) The purchase of a new computer system on credit from
Computex Data Services for $20,000 on 23 November
2017.
(iii) K. Bond owed the company $780 but unfortunately was
unable to pay the debt so you decide to write it off as
bad on 30 November 2017.
(iv) The sale of some office equipment no longer required
for $3,000 to Ms Chandler who pays by cheque on 30
November 2017.
(b) Name three books of original entry apart from the journal.
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23 Control accounts
Specific objectives
After you have studied this chapter you should be able to:
• understand the need for control accounts
• prepare a sales ledger control account
• prepare a purchase ledger control account
• know the sources of information for control accounts
• understand the double entry aspect of control accounts
• appreciate the advantages of control accounts.
23.1 The need for control accounts
Where a business is small, all the accounts may be contained in one ledger
and at the end of the accounting period a trial balance could easily be drawn
up as a test of the arithmetical accuracy of the accounts. However, it must be
remembered that certain errors may not be revealed by the trial balance (refer
to Chapter 10). If the trial balance totals disagree, the books could easily and
quickly be checked to find the errors.
However, as the business grows, the accounting requirements also expand
and the work has to be divided up into various separate ledgers and,
consequently, errors are not as easily identifiable. The error (or errors) could
be very difficult to find and it may be necessary to check every item in every
ledger. Therefore, what is required is a type of trial balance for each ledger,
and this requirement is met by the control account. Thus it is only the
ledgers where the control accounts do not balance that need detailed checking
to locate any errors.
If the trial balance or control accounts do not balance, the difference is
posted to a suspense account (see Chapter 32, where this topic is fully
explained). Another process in accounting procedures is the preparation of
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bank reconciliation statements which ensures that the balance at the bank
agrees with businesses’ balances (this is dealt with fully in Chapter 24).
23.2 The principle of control accounts
The principle on which control accounts are based is simple. If the opening
balance of an account is known, together with the information of the
additions and deductions entered in the account, the closing balance can be
calculated.
This idea can be applied to a complete ledger. Suppose that there were
only four accounts in the sales ledger, and for the month of May 2017, the
accounts were as follows:
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A control account, in this case the sales ledger control account, would
consist only of the totals of each of the items in the sales ledger.
Let us therefore first list the totals for each type of item.
Now, looking at the totals only, it is possible to draw up a sales ledger control
account.
Debits are shown as usual on the left-hand side, and credits on the righthand side.
Thus:
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From your studies of double entry so far, you should be able to see that the
Balance c/d (A) is the figure needed to balance the account, that is, the
difference between the two sides. It works out to be $3,270.
We can now look at the ledger and see if that is correct. The balances are
$1,250 + $780 + $1,240 = $3,270. As this has now been proved to be correct,
the figure of $3,270 can be shown in the Sales Ledger Control Account as the
Balance carried down (A) and the Balance brought down (B).
In the above, very simple, example, there were only four ledger accounts.
Suppose instead that there were 400 or 4,000 or 40,000 ledger accounts. In
these cases, the information concerning the totals of each type of item cannot
be obtained so easily.
Remember that the main purpose of a control account is to act as a check
on the accuracy of the entries in the ledgers. The total of a list of all the
balances extracted from the ledger should equal the balance on the control
account. If not, a mistake, or even many mistakes, may have been made and
will have to be found.
23.3 Information for control accounts
Exhibits 23.1 and 23.2 show where information is obtained from in order to
draw up control accounts.
Helpful Hint!
Discussion:
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Write brief descriptions of three control systems used in the
accounting process. Discuss with your friend the situations each of
these should be used in, supporting your answer with information
from this chapter.
Exhibit 23.1
Exhibit 23.2
23.4 Form of control accounts
Control accounts are normally prepared in the same form as an account, with
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the totals of the debit entries in the ledger on the left-hand side of the control
account, and the totals of the various credit entries in the ledger on the righthand side.
Exhibit 23.3 shows an example of a sales ledger control account for a sales
ledger in which all the entries are arithmetically correct. We have proved the
ledger to be arithmetically correct because the totals of the control account
equal each other. If the totals are not equal, then this proves there is an error
somewhere.
Exhibit 23.3
Exhibit 23.4 shows an example where an error is found to exist in a purchases
ledger. The ledger will have to be checked in detail, the error found, and the
control account then corrected. There is a $40 error in this ledger. We will
have to check the ledger in detail to find the error.
Notice that a double line does not appear under the totals figures. We will
not ‘rule off’ the account until the error is traced and corrected.
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Exhibit 23.4
*As can be seen from the totals at the bottom of the control account, there is a
$40 ($8,866 – $8,826) error in the purchases ledger. We will have to check
that ledger in detail to find the error.
23.5 Other transfers
Transfers to bad debts accounts will have to be recorded in the sales ledger
control account as they involve entries in the sales ledgers.
Similarly, a contra account, whereby the same firm is both a supplier and a
customer and inter-indebtedness is set off, will also need entering in the
control accounts. An example of this is as follows:
(i) The firm has sold A. Hope $600 goods on 1 May.
(ii) Hope has supplied the firm with $880 goods on 12 May.
(iii) The $600 owing by Hope is set off against $600 owing to him on 30
May.
(iv) This leaves $280 owing to Hope on 31 May.
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The set-off now takes place:
Helpful Hint!
Examination tip:
Students often find it difficult to work out which side of each control
account contra items (set-offs) are shown. Consider set-offs as
money received or paid. These entries are then entered in the control
accounts on the same side you would normally enter money received
or paid. Thus a set-off or contra item appears on the credit side of the
sales ledger control account (the same side as money received from
accounts receivable) and on the debit side of the purchases ledger
control account (the same side as money paid to accounts payable).
Remember this and you will not get it wrong.
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The transfer of the $600 will appear on the credit side of the sales ledger
control account and on the debit side of the purchases ledger control account.
Relevant entries must be made in the journal.
23.6 A more complicated example
Exhibit 23.5 shows a worked example of a more complicated control account.
You will see that there are sometimes credit balances in the sales ledger as
well as debit balances. Suppose for instance we sold $500 goods to W.
Young; he paid in full for them, and then afterwards he returned $40 goods to
us. This would leave a credit balance of $40 on the account, whereas usually
the balances in the sales ledger are debit balances.
There may also be reason to write off a debt as bad where a business finds
it impossible to collect the debt. If this happens, the double entry would be as
follows:
Debit: bad debts account
Credit: individual account receivable
Ultimately, the bad debts account would be credited and the profit and loss
account would be debited (see Chapter 27). If the business uses control
accounts, then the sales ledger control account would also be credited, as
shown in Exhibit 23.5.
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Exhibit 23.5
23.7 Control accounts and double entry
Most organisations maintain the control accounts in the general ledger as an
integral part of the double entry system, with the balances on both the sales
ledger and purchases ledger control accounts being extracted for inclusion in
the trial balance at the end of specific periods as required. When the control
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accounts are kept in the general ledger, the personal accounts, that is, the
individual accounts of the accounts receivable and accounts payable in the
respective sales ledger and purchases ledger, are used as subsidiary records
and referred to as memorandum accounts which lie outside the double
entry system.
The following exhibits demonstrate the control accounts, maintained in the
general ledger, as part of the double entry system.
Exhibit 23.6 The sales ledger control account as part of the double entry system
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Exhibit 23.7 The purchase ledger control account as part of the double entry system
Note: The entries in the control accounts go on the same side as respective
entries in the personal accounts.
23.8 Control accounts and
computerised accounting systems
Control accounts are used by many organisations, especially those using
manual accounting systems. For organisations using computerised accounting
systems, the control accounts are an integral part of the accounting package
and are prepared automatically. This is because computerised systems ensure
that all double entry transactions are completed upon entry thereby ensuring
that the ledgers all balance. However, even businesses with computerised
accounting packages often prepare their own manual control accounts to
ensure that the ledgers balance and to detect any errors.
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23.9 Advantages of control accounts
There are several advantages an organisation can benefit from by using
control accounts:
• Location of error – By preparing control accounts, any arithmetical errors
that may have occurred are identified. Also, if a clerk has inadvertently
omitted entering an invoice or payment in the personal accounts, these too
would be identified since the control account acts as a mini trial balance.
However, it must be pointed out that there are other errors that may still be
contained in the ledgers such as mispostings or compensating errors.
• Prevention of fraud – Normally the control accounts are under the
supervision of a senior member of the accounting team or accounts
manager. This makes fraud more difficult since any transaction entered into
a ledger account must also be included in the control account, and since a
different member of staff would be responsible for maintaining the ledgers
from the member supervising the control account, it would be more
difficult to carry out fraudulent transactions. Therefore the supervisor or
manager provides an internal check on the procedures.
• Information for management – For management purposes, the balances
on the control accounts can always be taken to equal accounts receivable
and accounts payable without waiting for an extraction of individual
balances. Management control is thereby aided because the speed at which
information is obtained is one of the prerequisites of efficient control.
23.10 Other sources of information for
control accounts
With a large organisation there may well be more than one sales ledger or
purchase ledger. The accounts in the sales ledger may be divided up in ways
such as:
• Alphabetically – thus we may have three sales ledgers, split: A–F, G–O
and P–Z.
• Geographically – this could be split: Caribbean, North and South America.
Helpful Hint!
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Examination tip:
Remember to use information from the cash account to prepare the
control account. Double-check that you have entered the relevant
information in the correct side of the account.
For each ledger we must therefore have a separate control account.
Note that many students become confused when making postings to
control accounts. You might find it useful to remember that when posting
entries to control accounts the entry goes on the same side as it would in the
respective personal account. Another useful hint can also be applied when
entering contra or set-off items: here, think of the contra or set-off as cash
and enter the item where you would normally enter cash in the respective
control account (as mentioned previously in Section 23.5).
Summary
• As a business expands, it becomes increasingly difficult to trace
any error(s) that may have occurred. Tracing an error may involve
checking every item in every ledger, which is very time consuming.
Therefore, what is needed is a type of trial balance for each ledger
and this requirement is met by the control account.
• Control accounts are usually prepared at the end of each month or
period. The account contains the total of the various individual
personal account balances which are held in subsidiary ledgers
such as the sales ledger or purchase ledger. By comparing the
balance on the control account with the total outstanding balances
in a subsidiary ledger, the arithmetical accuracy can be checked.
Errors can be located and rectified more easily.
• Control accounts contain information gathered from the various
accounting books, including sales and purchase day books, returns
inwards and returns outwards day books and cash books. These
items are entered into the control accounts in ‘total’, that is, total
credit sales for the month, total monies received from the accounts
receivable for the month, and so on.
• Transfers from one ledger to another may be called ‘contra entries’
or sometimes ‘set-offs’. Remember to enter these on the same side
in the control account as you would normally enter cash either
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received or paid.
• Control accounts as part of the double entry system is explained.
• The advantages of using control accounts is explained.
• Finally, remember that when making entries into the control
accounts the entry goes on exactly the same side as it would in the
personal accounts. Think of ‘contra items’ or ‘set-offs’ as cash and
enter them on the same side you would normally enter cash on the
respective control account.
Chapter 23 Exercises
23.1 You are required to prepare a sales ledger control account from
the following.
23.2 You are to prepare a sales ledger control account from the
following. Deduce the closing figure of sales ledger balances as
at 31 March 2018.
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23.3X Draw up a purchases ledger control account from the
following.
23.4X You are to prepare a purchases ledger control account from
the following. As the final figure of purchases ledger balances at
30 November is missing, you will have to deduce that figure.
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23.5 Prepare a sales ledger control account from the following.
23.6X Draw up a sales ledger control account from the following.
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23.7X Carl Barber runs a small business selling electrical
components to wholesalers. Since he has numerous accounts
receivable and accounts payable, he keeps sales and purchase
ledgers and maintains both sales and purchases control
accounts.
The following information is available from Carl’s books for the
year ended 31 December 2017.
Note: The credit balance of $71 in the Sales Ledger brought
forward on 1 January 2017 is to be carried forward as at 31
December 2017.
Required:
(a) Prepare Carl’s Sales Ledger Control Account as at 31
December 2017.
(b) Prepare Carl’s Purchases Ledger Control Account as at 31
December 2017.
(c) Why is it important to maintain control accounts? Discuss
the advantages.
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24 Bank reconciliation
statements
Specific objectives
After you have studied this chapter you should be able to:
• understand the reason for preparing bank reconciliation statements
• reconcile cash book balances with bank statement balances
• understand how bank overdrafts affect the reconciliation process
• make necessary entries in the account for dishonoured cheques.
24.1 Completing entries in the cash
book
In Chapter 20, we saw how businesses record monies coming into and out of
the business in their cash book, with cash items being entered in the cash
columns and cheques and other bank items being entered in the bank
columns.
In the business bank account, the bank will also be recording monies paid
into and out of the account in the bank’s own records. If all the items entered
in the cash book were the same as those entered in our account with the bank,
then obviously the bank balance per our books and the bank balance per the
bank’s books would equal each other.
However, this is not usually the case. There may be items paid into or out
of the business bank account which have not been recorded by us in the cash
book. There may also be items that we have entered in the cash book which
have not yet been entered in the bank’s records of our account. To see if any
differences have occurred, the business will need to obtain a bank statement
from the bank and use this to compare our records with those of the bank.
Banks usually issue bank statements to their customers on a regular basis but
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one can easily be obtained from the bank on request.
Let us look at an example of a cash book and a bank statement in Exhibit
24.1. We will tick off the items that are the same in both sets of records.
Exhibit 24.1
It is now possible to see that the two items not shown in our cash book are:
• Bank Giro credit: P. Smith $70
• Bank charges $50
P. Smith had paid us $70, but instead of sending us a cheque, he had paid
the money by bank giro credit transfer direct into our bank account. The
business was not aware of this until we received the bank statement.
The other item was in respect of bank charges. The bank had charged us
$50 for keeping our bank account and all the work connected with it. Instead
of sending us an invoice, they have simply taken the money out of our bank
account.
As we have now identified the items missing from the cash book, we can
now complete writing it up by entering the two items that we identified:
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Both closing balances are now shown as being $320.
24.2 Where closing balances differ
Although a cash book may be kept up to date by a business, we obviously
cannot alter the bank’s own records. Even after writing up entries in the cash
book there may still be a difference between the cash book balance and the
bank statement balance. Exhibit 24.2 shows such a case.
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Exhibit 24.2
You can see that two items ((1) and (2)) are in the cash book but are not
shown on the bank statement.
1 A cheque had been paid to M. Peck on January 30. He banked it at his
bank on January 31 but it was not presented to our bank until February 2.
This is known as an unpresented cheque.
2 Although we had received a cheque for $470 from J. Soames on January
31, the business did not bank it until February 1. This will be known as a
bank lodgement not yet credited to the business bank account.
The balance per our cash book on January 31 was $600, whereas the bank
statement shows a balance of $330. Although the balances are different they
can be ‘reconciled’ (that is, made to agree) with each other, by preparing a
bank reconciliation statement. It may start either with the cash book
balance and be reconciled to the bank statement balance, or alternatively, it
can start with the bank statement balance and be reconciled to the cash book
balance.
In this first example we will start with the ‘Balance as per the cash book’:
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The following example is a bank reconciliation statement, starting with the
balance shown in the bank statement:
If the two balances cannot be reconciled, then there will be an error
somewhere. This will have to be located and then corrected.
24.3 The bank balance in the statement
of financial position
The balance to be shown in the statement of financial position is that per the
cash book after it has been written up to date. In Exhibit 24.2 the statement of
financial position figure would be $600.
24.4 Bank overdrafts
When there is a bank overdraft (shown by a credit balance in the cash book),
the adjustments needed for reconciliation work are opposite to those needed
for a debit balance.
Exhibit 24.3 shows a cash book, and a bank statement, showing an
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overdraft. Only the cheque for G. Cumberbatch (A) $106 and the cheque paid
to J. Kelly (B) $63 need adjusting. Work through the reconciliation statement
in Exhibit 24.3 and then compare the reconciliation statements in Exhibits
24.2 and 24.3.
Exhibit 24.3
Note: On a bank statement an overdraft is often shown with the letters O/D
following the amount; or else it is shown as a debit balance, indicated by the
letters ‘Dr’ after the amount.
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Now compare the reconciliation statements in Exhibits 24.2 and 24.3. This
comparison reveals the following:
Adjustments are, therefore, made in the opposite way when there is an
overdraft.
24.5 Dishonoured cheques
When a cheque is received from a customer and paid into the bank, it is
recorded on the debit side of the cash book. It is also shown on the bank
statement as a deposit to the bank. However, at a later date it may be found
that the customer’s bank will not pay us the amount due on the cheque. The
cheque is therefore worthless. It is known as a dishonoured cheque.
There are several possible reasons for this. As an example, let us suppose
that K. King gave us a cheque for $5,000 on 20 May 2017. We banked it, but
a few days later our bank returned the cheque to us. Typical reasons are:
1 King had put $5,000 in figures on the cheque, but had written it in words
as five thousand five hundred dollars. You will have to give the cheque
back to King for amendment.
2 Normally, cheques are considered stale six months after the date on the
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cheque. In other words, the banks will not pay cheques over six months
old. If King had put the year 2016 on the cheque instead of 2017, then the
cheque would be returned to us by our bank.
3 King simply did not have sufficient funds in his bank account. Suppose he
had previously a balance of only $2,000 and yet he has given us a cheque
for $5,000. His bank has not allowed him to have an overdraft. In such a
case, the cheque would be dishonoured. The bank would write on the
cheque ‘refer to drawer’, and we would have to get in touch with King to
see what he was going to do to settle his bill.
In all of these cases the bank would show the original banking as being
cancelled by showing the cheque paid out of our bank account. As soon as
this happens they will notify us. We will then also show the cheque as being
cancelled by a credit in the cash book. We will then debit that amount to
King’s account.
When King originally paid his account, our records would have appeared as
shown below.
After our recording the dishonoured cheque, the records will appear as:
In other words, King is once again shown as owing us $5,000.
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24.6 Terms used in banking
There are many terms used in the banking system with which a student of
accountancy needs to be familiar. In our chapter on the banking system most
of these will be discussed in detail (see Chapter 41, Sections 41.2, 41.7, 41.9,
41.10). The terms used in this chapter are listed below for your ease of
reference:
• Bank charges and interest – charges made by the bank for providing the
services of a bank account, while interest is charged for making funds
available to a business when it is overdrawn.
• Bank giro credits (credit transfer) – a method used by businesses to pay
accounts payable (creditors), wages and salaries.
• Bank lodgement – money deposited by a business into their account at the
bank.
• Bank overdraft – a facility provided by the bank where they will continue
to make payments from a current account even though there are insufficient
funds to cover the payment. This is a short-term loan, on which the bank
charges daily interest.
• Bank reconciliation statement – a calculation comparing the cash book
balance with the bank statement balance.
• Bankers’ automated clearing service (BACS) – computerised payment
transfer system which is, a very popular way of paying accounts payable
(creditors), wages and salaries.
• Direct debits – where the business gives permission for an organisation
to collect amounts owing direct from their bank account. This method is
often used to pay mortgages, insurance premiums, etc.
• Dishonoured cheques – when a bank dishonours a cheque, it will not pay
up on the cheque because there are insufficient funds in the drawer’s (the
person making the payment) account.
• Out-of-date cheques – a cheque becomes ‘stale’ six months after the date
on the cheque. Banks will not pay cheques over six months old.
• Standing order – instructions given by a business to a bank to pay
specified amounts at given dates.
• Unpresented cheques – cheques that have been sent but have not yet gone
through the recipient’s bank account.
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Helpful Hint!
Examination tip:
When attempting an examination question on bank reconciliation, be
sure to read the question carefully to ascertain which method is to be
used in preparing the bank reconciliation statement.
Summary
• The purpose of preparing a bank reconciliation statement is to find
the reasons for the differences in the balance as shown in the cash
book with that shown on the bank statement.
• By preparing a bank reconciliation statement, errors may be
identified in either the cash book or the bank statement and be
corrected.
• The differences in balances may be caused by quite valid reasons
and are usually due to the varying dates that the business and the
bank record monies paid into and out of their particular account.
• It is easier to write up the cash book first before preparing a bank
reconciliation statement since the only differences will be items in
the cash book but not on the bank statement.
• If the account is showing a bank overdraft, then preparing a bank
reconciliation statement is the opposite to when there is a balance
in the account.
• If a business receives a cheque from a customer which ultimately
‘bounces’, that is, there are insufficient funds in the account for the
cheque to be paid, then it is known as a ‘dishonoured cheque’.
• How to make the appropriate entries in the account to record a
dishonoured cheque.
• Typical terms used in banking are shown.
Chapter 24 Exercises
24.1 The following are extracts from the cash book and the bank
statement of J. Roche. You are required to:
(a) write the cash book up to date, and state the new balance
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as on 31 December 2017
(b) draw up a bank reconciliation statement as on 31 December
2017.
24.2X William Kelly’s cash book on 28 February 2017 showed a
balance at bank of $456.48. On attempting a reconciliation with
his bank statement, the following matters were discovered.
(i) A payment from B. Green to W. Kelly of $40 by direct bank
transfer had not been recorded in the cash book.
(ii) Cheques drawn but not presented to the bank were: A. Roe,
$21.62; C. Mills, $36.55.
(iii) A paying-in slip dated 27 February 2017 totalling $372.31
was not credited by the bank until 1 March 2017.
(iv) A standing order for $21.58 payable on 20 February 2017
for fire insurance had been paid by the bank but not entered
in the cash book.
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(v) Bank charges $15 had not been entered in the cash book.
(a) Open the cash book and make such additional entries as
you consider necessary.
(b) Prepare a statement reconciling your revised cash book
balance with the balance shown by the bank statement.
24.3 The bank columns in the cash book for June 2017 and the bank
statement for that month for C. Grant are as follows.
You are required to:
(a) write the cash book up to date taking the above into account
(b) draw up a bank reconciliation statement as on 30 June
2017, reconciling the corrected cash book balance with the
bank statement balance.
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24.4X On 31 October 2017 the cash book of N. Orange showed a
balance at bank of $570. An examination of his records located
the following errors.
(i) Orange paid to R. Jones $175 by cheque on 15 October.
This cheque was entered in the cash book as $195.
(ii) Bank charges not recorded in the cash book amounted to
$25.
(iii) A cheque dated 19 October, value $150, payable to T. Jack
was not paid by the bank until 5 November.
(iv) Orange on 23 October received from W. Green a cheque,
value $125. This cheque was dishonoured on 29 October.
No entry for the dishonour has been made in the cash book.
(v) On 31 October a cheque, value $200, received from F.
Brown was banked; however, the bank statement was not
credited until 1 November.
You are required to:
(a) make the necessary entries in the cash book in order to
show the revised cash book balance at 31 October 2017;
(b) prepare a statement reconciling the corrected cash book
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balance with the bank statement at 31 October 2017;
(c) state the balance at bank at 31 October 2017 as shown by
the bank statement.
24.5 (a) You have the task of writing up B. Mills’ cash book. From
the following, write up the cash book for May 2017. All the
details concern the bank columns only.
(b) The bank statement of B. Mills on 31 May 2017 shows a
balance of $1,995. The following information was
discovered.
• Bank charges of $110 have been entered in the bank
statement but not in the cash book.
• Dividends received from J. G. Ltd of $280 and banked in
the month have not been recorded in the cash book.
• The cheque banked on 29 May for $555 has not yet been
entered on the bank statement.
• Standing orders of $920 for insurance have been entered
on the bank statement but not in the cash book.
• A cheque of $75, received as cash sales on 7 May and
banked, has been returned marked ‘insufficient funds’. No
entry has been made in the books.
• The cheque paid to Marple $237 has not yet been
presented by them.
You are required to:
(i) enter up all relevant information up to date in Mills’ cash
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book for May 2017 and balance down
(ii) draw up a bank reconciliation statement as on 31 May
2017, reconciling the corrected cash book balance with
the bank statement balance
(iii) explain why bank reconciliation statements are drawn
up.
24.6X The bank statement for G. Greene for the month of March
2017 is as follows.
The cash book for March 2017 is as follows.
You are to:
(a) write the cash book up to date
(b) draw up a bank reconciliation statement as on 31 March
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2017, reconciling the corrected cash book balance with the
bank statement balance.
24.7X (a) R. Rogers had a $3,470 balance in a bank current
account. Show whether each of the following increases or
reduces the balance.
(i) Bank charges $70.
(ii) Standing order paid of $250.
(iii) Dividends received and banked $400.
(iv) Payment to supplier $140.
(v) Item previously written off as bad debt, cheque received
and banked $90.
(vi) Account receivable (Debtor) paid direct into Rogers’
bank account $470.
(vii) Drawings in form of cheque $150.
(viii) Cheque previously banked, $279, now dishonoured.
(b) A summary of D. Plant’s bank account in his cash book for
July 2017 was as follows.
You are told the following.
(i) A cheque banked for $200 from K. Stevens has been
treated as a payment in the cash book.
(ii) A cheque from T. Cooper for $180 banked in the month was
dishonoured two days later, but no entry was made of the
dishonour.
(iii) The unpresented cheques on 31 July 2017 were in the
sums of $154 and $378.
(iv) Bank charges for July not yet entered, $10.
(v) $477 banked and entered in the cash book on 29 July had
not been entered on the bank statement.
(vi) Standing order for rent $175 paid in July has not been
entered.
(vii) A customer, R. Salt, deposited $760 direct into Plant’s
account on 29 July but this has not been entered in the
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cash book.
You are to:
(a) write up Plant’s cash book to bring it up to date, balance off
and bring the balance down on 1 August 2017
(b) by means of a bank reconciliation statement, calculate the
balance per the bank statement as on 31 July 2017.
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Multiple-choice questions – Set 3 (41 to 60)
Each multiple-choice question has four suggested answers: (A), (B),
(C) or (D). You should read each question and then decide which
choice is best: (A), (B), (C) or (D). Write down your answers on a
separate piece of paper. You will then be able to repeat the set of
questions later without the distraction of previously written attempts.
When you have completed a set of questions, check your answers
against those given in Appendix C.
41 When Fisher makes out a cheque for $100 and sends it to
Hamilton, then Hamilton is known as:
(A) the payee
(B) the drawer
(C) the accounts receivable
(D) the banker.
42 A business starts each month with a petty cash float of $700. If
$541 is spent during the month, how much will be reimbursed at
the end of the period?
(A) $541
(B) $700
(C) $159
(D) None of the above.
43 A trade discount is best described as:
(A) a discount given if the invoice is paid
(B) a discount given for cash payment
(C) a discount given to suppliers
(D) a discount given to traders.
44 A credit balance of $500 in the cash columns of the cash book
would mean:
(A) the book-keeper has made a mistake
(B) we have $500 cash in hand
(C) we have spent $500 cash more than we have received
(D) someone has stolen $500 cash.
45 $200 withdrawn from the bank and placed in the cash till is
entered:
(A) debit bank column $200, credit bank column $200
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46
47
48
49
50
51
(B) debit cash column $200, credit bank column $200
(C) debit bank column $200, credit cash column $200
(D) debit cash column $400, credit cash column $400.
A contra item is where:
(A) cash is banked before it has been paid out
(B) double entry is completed within the cash book
(C) the proprietor has repaid his capital in cash
(D) sales have been paid by cash.
An invoice shows a total of $3,200 less 2.5% cash discount if
paid within 30 days. If the invoice was paid within the time
allowed, what amount would be shown on the cheque?
(A) $2,960
(B) $3,040
(C) $3,120
(D) $2,800
The total of the discount received column in the cash book is
posted to the:
(A) credit of the discounts received account
(B) credit of the discounts allowed account
(C) debit of the discounts allowed account
(D) debit of the discounts received account.
A bank overdraft is best described as:
(A) a business wasting its money
(B) having more receipts than payments
(C) a business having bought too many goods
(D) a business having paid more out of its bank account than it
has put in it.
Of the following, which should not be entered in the journal?
(i) Cash payments for wages
(ii) Bad debts written off
(iii) Credit purchases of goods
(iv) Sale of non-current assets
(A) (i) and (ii)
(B) (i) and (iii)
(C) (ii) and (iii)
(D) (iii) and (iv)
A sales invoice shows 12 items of $250 each, less trade discount
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52
53
54
55
56
57
of 20% and cash discount of 5%. If the payment is made within
the credit period what will be the amount paid?
(A) $2,440
(B) $2,360
(C) $2,280
(D) $2,500
The purchases day book (journal) consists of:
(A) cash purchases
(B) suppliers’ ledger accounts
(C) a list of purchase invoices
(D) payment for goods.
80 items are bought at $60 each, less trade discount of 25%. Five
items are subsequently returned. What will be the amount of the
debit note?
(A) $270
(B) $240
(C) $225
(D) $220
The total of the purchases day book (journal) is transferred to the:
(A) debit side of the purchases account
(B) credit side of the purchases journal
(C) debit side of the purchases day book
(D) debit side of the purchases ledger.
Depreciation is:
(A) the cost of a current asset wearing away
(B) the cost of a replacement for a non-current asset
(C) the salvage value of a non-current asset plus its original cost
(D) the part of the cost of the non-current asset consumed during
its period of use by the business.
A machine is bought for $50,000. It is expected to be used for six
years and then sold for $5,000. What is the annual amount of
depreciation if the straight line method is used?
(A) $7,000
(B) $8,000
(C) $7,500
(D) $6,750
When a separate provision for depreciation account is in use,
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then the book-keeping entries for the year’s depreciation are:
(A) debit profit and loss, credit the statement of financial position
(B) debit profit and loss, credit asset account
(C) debit asset account, credit provision for depreciation account
(D) debit profit and loss, credit provision for depreciation
account.
58 A bank reconciliation statement is:
(A) drawn up by the bank regularly and kept by them
(B) sent by the bank to us monthly
(C) drawn up by us to verify our cash book balance with the bank
statement balance
(D) sent to the bank when we have made an error.
59 The balances in the purchases ledger are usually:
(A) credit balances
(B) contras
(C) nominal account balances
(D) debit balances.
60 Debit notes sent out by us are entered in our:
(A) returns outwards day book
(B) returns inwards day book
(C) purchases account
(D) returns outwards account.
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25 The nature of depreciation
and calculations
Specific objectives
After you have studied this chapter you should be able to:
• define depreciation
• explain why depreciation is charged
• calculate depreciation using both the straight line method and the
reducing balance method
• calculate depreciation on assets bought or sold within an
accounting period.
25.1 Introduction
In Chapter 15 we considered the distinction between capital and revenue
expenditure. Capital expenditure involves the purchase of non-current assets.
This chapter covers the need for charging depreciation on these assets and the
causes of depreciation.
The methods of calculating depreciation usually involve either the straight
line or reducing balance method.
The double entry aspect of recording transactions showing the purchase of
non-current assets, charges for depreciation and the disposal of assets will be
shown in Chapter 26.
25.2 Nature of non-current assets
Non-current assets are those assets that are:
• of long life, and
• to be used in the business, and
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• not bought with the main purpose of resale.
25.3 Depreciation of non-current assets
However, non-current assets such as machinery, motor vans, fixtures and
even buildings do not last indefinitely: therefore, when the non-current asset
is finally disposed of the difference between the cost price and the amount
received on disposal is called depreciation.
The only time that depreciation can be calculated accurately is when the
non-current asset is finally disposed of, and the difference between the cost to
its owner and the amount received on disposal is then calculated. For
example, if a motor van was bought for $l0,000 and sold five years later for
$2,000, then the amount of depreciation is $10,000 – $2,000 = $8,000.
25.4 Depreciation is an expense
Depreciation is the part of the original purchase cost of a non-current asset
consumed during its period of use by the business. It is an expense for
services consumed, in the same way as expenses for items such as wages,
rent or electricity. Since depreciation is an expense, it will have to be charged
to the profit and loss account and will, therefore, reduce net profit.
You can see that the only real difference between the cost of depreciation
for a motor vehicle and the cost of petrol for the motor vehicle is that the
petrol cost is used up in a day or two, whereas the cost of depreciation for the
motor vehicle is spread over several years. Both are expenses to the business.
25.5 Causes of depreciation
The principal causes of depreciation are:
• physical deterioration
• economic factors
• the time factor
• depletion.
These are described in greater detail below.
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Physical deterioration
Physical depreciation can come in two basic forms:
• Wear and tear. When a motor vehicle, machinery or fixtures and fittings
are used they eventually wear out. Some last many years, others only a few
years. This is even true of buildings, although some may last for a very
long time.
• Erosion, rust, rot and decay. Land may be eroded or wasted away by the
action of wind, rain, sun and other elements of nature. Similarly, the metals
in motor vehicles or machinery will rust or corrode. Wood will rot
eventually. Decay is another process that will occur due to the elements of
nature and a lack of proper attention.
Economic factors
Economic factors may be said to be the reasons for an asset being put out of
use even though it is in good physical condition. The two main factors are
usually obsolescence and inadequacy, described further as follows:
• Obsolescence. This is the process of becoming out of date due to advanced
technology or a change in processes. A typical example is in the car
industry where the majority of the assembly work is now carried out by
robots.
• Inadequacy. This arises when an asset is no longer used because of growth
and changes in the size of the business. For instance, a small ferryboat that
is operated by a business at a coastal resort will become entirely inadequate
when the resort becomes more popular. Then it will be found that it would
be more efficient and economical to operate a large ferryboat, and so the
smaller boat will be put out of use by the business. In this case also, it does
not mean that the ferryboat is no longer in good working order. It may be
sold to a business at a smaller resort.
The time factor
Obviously, time is needed for wear and tear, erosion, obsolescence and
inadequacy to occur. However, there are non-current assets to which the time
factor is connected in a different way. These are assets that have a legal life
non-current in terms of years.
For instance, you may agree to rent some buildings for 10 years. This is
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normally called a lease. When a lease expires, it is worth nothing to you as it
has finished; whatever you paid for the lease is now of no value.
A similar asset is a patent purchased with complete rights, so that only you
are able to produce something using the patent. When the patent’s time has
expired, it no longer has any value. The usual life of a patent is 16 years.
Instead of using the term depreciation, the term amortisation is often
used for these assets.
Depletion
Other assets are of wasting character, perhaps as a result of the extraction of
raw materials from them. These materials are then either used by the business
to make something else, or are sold in their raw state to other firms. Natural
resources such as mines, quarries and oil wells come under this heading.
Providing for the consumption of an asset of a wasting character is called
providing for depletion.
25.6 Provision for depreciation as an
allocation of cost
Depreciation in total over the life of an asset can be calculated quite simply as
cost less amount receivable when the asset is put out of use by the business.
If the item is bought and sold within one accounting period, then the
depreciation for that period is charged as a revenue expense in arriving at that
period’s net profit. The difficulties start when the asset is used for more than
one accounting period, and an attempt has to be made to charge each period
with the depreciation for that period.
Even though depreciation provisions are now regarded as allocating cost to
each accounting period (except for accounting for inflation), it does not
follow that there is any ‘true’ method of performing even this task. All that
can be said is that the cost should be allocated over the life of the asset in
such a way as to charge it as equitably as possible to the periods in which the
asset is used.
The difficulties involved are considerable, and some of them are now
listed.
• Apart from a few assets, such as a lease, how accurately can a business
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measure an asset’s useful life? Even a lease may be put out of use if the
premises leased have become inadequate.
• How is ‘use’ measured? A car owned by a business for two years may have
been driven for one year by a very careful driver and another year by a
reckless driver. The standard of driving will affect the car and also the
amount of cash receivable on its disposal. How should such a business
apportion the car’s depreciation costs?
• There are other expenses beside depreciation, such as repairs and
maintenance of the non-current asset. As both of these affect the rate and
amount of depreciation, should they not also affect the depreciation
provision calculations?
• How can a business possibly know the amount receivable in a number of
years’ time when the asset is put out of use?
These are only some of the difficulties. Therefore, the methods of calculating
provisions for depreciation are mainly accounting customs, and are shown
below.
25.7 Methods of calculating
depreciation charges
The two main methods in use are the straight line method and the reducing
balance method. Most accountants think that, although other methods may be
needed in certain cases, the straight line method is the one that is generally
most suitable.
Straight line method
This method involves the cost price of an asset, the estimated years of its use
and the expected disposal value. The depreciation charge each year can be
calculated thus:
For instance, if a car was bought for $22,000 and the business decided to
keep it for four years and then sell it for an estimated price of $2,000, the
depreciation to be charged would be:
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If, after four years, the car had no disposal value, the charge for depreciation
would be:
This method may sometimes be referred to as the ‘non-current instalment
method’.
Reducing balance method
Depreciation to be charged involves deciding on a percentage amount to be
used each year. This percentage is then deducted from the cost price for the
first year and in subsequent years from the reducing balances. This is
illustrated in the following example:
Example: If a machine is bought for $10,000, and depreciation is to be
charged at 20%, the calculations for the first three years would be as follows:
Note that net book value means the cost of a non-current asset with
depreciation deducted. It is sometimes simply known as ‘book value’.
This method may sometimes be referred to as the ‘diminishing balance
method’.
Using this method means that much larger amounts are charged in the
earlier years of use compared with the final years of use. It is often said that
repairs and upkeep in the early years will not cost as much as when the asset
becomes old. This means that:
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The worked example in Section 25.8 gives a comparison of the calculations
using the two methods, if the same cost applies for the two methods.
25.8 A worked example
A business has just bought a machine for $8,000. It will be kept in use for
four years, and then it will be disposed of for an estimated amount of $500.
The firm asks for a comparison of the amounts charged as depreciation using
both methods.
For the straight line method, the depreciation is calculated as follows:
For the reducing balance method, a percentage figure of 50% will be used.
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This illustrates the fact that using the reducing balance method there is a
much higher charge for depreciation in the early years, and lower charges in
the later years.
You will see that the straight line method involves depreciation per year
being charged by the same amount. In the above example, the figure is
$1,875. However, you could be asked to charge depreciation per year at a
percentage figure.
For example, office furniture is purchased for $5,500 and depreciation per
year is to be charged at 25%. It would have no disposal value after four years.
Using the straight line method, the amount to be charged to depreciation per
year would be:
Percentage of cost price = 25% of $5,500 = $1,375
The figure of $1,375 remains the same each year. Thus,
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25.9 Depreciation provisions and
assets bought or sold
There are two main methods of calculating depreciation provisions for assets
bought or sold during an accounting period.
1 Ignore the dates during the year that the assets were bought or sold and
merely calculate a full period’s depreciation on the assets in use at the end
of the period. Thus, assets sold during the accounting period will have no
provision made for depreciation for that last period irrespective of how
many months they were in use. Conversely, assets bought during the
period will have a full period of depreciation provision charged even
though they may not have been owned throughout the whole period.
2 Provide for depreciation made on the basis of one month’s ownership
equals one month’s depreciation. Fractions of months are usually ignored.
This is obviously a more precise method than method 1.
The first method is the one normally used in practice. However, for
examination purposes, where the dates on which the assets are bought and
sold are shown, you should use method 2. If no such dates are given then,
obviously, method 1 is the one to use. Often the question will indicate which
method to use so it is important to read the instructions carefully before
attempting your answer.
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25.10 Other methods of calculating
depreciation
There are many more methods of calculating depreciation, but they are
outside the scope of this book. Special methods are often used in particular
industries, where there are circumstances that are peculiar to that industry.
Summary
• Depreciation is charged on non-current assets in use during an
accounting period.
• Non-current assets are defined as those assets of material value
that are intended to be used in the business over a period of time
and have not been bought with the intention of resale.
• Depreciation is an expense of the business and as such is charged
to the profit and loss account.
• The main causes of depreciation are physical deterioration,
economic factors, the time factor and depletion.
• The straight line method is where an equal amount of depreciation
is charged each year.
• The reducing balance method is where a fixed percentage for
depreciation is taken from the cost of the asset in the first year. In
the second and later years, the same percentage is taken from the
reduced balance (that is, cost less depreciation already charged).
• There are two methods of calculating depreciation provisions for
assets bought or sold during an accounting period.
• If an asset is bought or sold during an accounting period the
depreciation calculation is shown.
Chapter 25 Exercises
25.1 D. Jones, a manufacturer, purchases a drilling machine for the
sum of $4,000. It has an estimated life of five years and a scrap
value of $500.
Jones is not certain whether she should use the ‘straight line’ or
‘reducing balance’ basis for the purpose of calculating
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depreciation on the machine.
You are required to calculate the depreciation on the machine
using both methods, showing clearly the balance remaining in
the machine account at the end of each of the five years for each
method. (Assume that 40% per annum is to be used for the
reducing balance method.)
(Calculations to nearest $.)
25.2 A machine costs $12,500. It will be kept for four years, and then
sold for an estimated figure of $5,120. Show the calculations of
the figures for depreciation for each of the four years using (a)
the straight line method, (b) the reducing balance method, for
this method using a depreciation rate of 20%.
25.3 A car costs $6,400. It will be kept for five years, and then sold
for scrap for $200. Calculate the depreciation for each year using
(a) the reducing balance method, using a depreciation rate of
50%; (b) the straight line method.
25.4X A machine costs $5,120. It will be kept for five years, and then
sold at an estimated figure of $1,215. Show the calculations of
the figures for depreciation each year using (a) the straight line
method, (b) the reducing balance method using a depreciation
rate of 25%.
25.5X A photocopier costs $12,150. It will be kept in use for five
years. At the end of that time agreement has already been made
that it will be sold for $1,600. Show your calculation of the
amount of depreciation each year if (a) the reducing balance
method, at a rate of 33.3% was used, and (b) the straight line
method was used.
25.6X A concrete mixer is bought for $6,000. It will be used for three
years, and then sold back to the supplier for $3,072. Show the
depreciation calculations for each year using (a) the reducing
balance method with a rate of 20%, and (b) the straight line
method.
25.7X From the following information, which shows the depreciation
for the first two years of use for two assets, you are required to
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answer the questions set out below.
(a) Which type of depreciation method is used for each asset?
(b) What will be the book value of each of the assets after four
years of use?
(c) If, instead of the method used, the machinery had been
depreciated by the alternative method but using the same
percentage rate, what would have been the book value after
four years? (Calculate your answer to the nearest $.)
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26 Double entry records for
depreciation and the disposal of
assets
Specific objectives
After you have studied this chapter you should be able to:
• record depreciation charges into the accounting records
• record the book-keeping entries for the disposal of non-current
assets
• incorporate depreciation calculations into the accounting records
• record the disposal of non-current asset and the adjustments
needed to the provision for depreciation accounts.
26.1 Recording depreciation
When a business purchases non-current assets, the cost price is recorded in
the respective asset account and the depreciation charge is shown separately
in an ‘Accumulated provision for depreciation account’. This account shows
the depreciation charges accumulating each year.
The following example illustrates the accounting records.
Example: A business purchases machinery for use in the business’s
workshop for $2,000 on 1 January 2015. The company uses the reducing
balance method of depreciation using a rate of 20% per annum and their
financial year end is 31 December. The accounting records for the first three
years are illustrated in Exhibit 26.1.
1 The machinery is purchased on 1 January 2015 and paid for by cheque:
• Debit the machinery account
• Credit the bank account
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2 At the end of the financial year, the asset is depreciated at 20% per annum
using the reducing balance method. First of all, we need to calculate the
amount of depreciation to be charged each year:
3 To record the depreciation:
• Debit the profit and loss account with the amount of the depreciation
each year
• Credit the provision for depreciation of machinery account with the
amount of the depreciation each year.
4 Show how the items would appear in the statement of financial position:
• the balance of the machinery account is shown at cost price
• the balance on the provision for depreciation of machinery account is
shown
• the net book value is shown, that is, the cost price less the balance on
the provision for depreciation account.
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Exhibit 26.1
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Now, the balance on the machinery account is shown on the statement of
financial position at the end of each year, less the balance on the provision for
depreciation account.
Another example is now given. This is of a business with the financial year
ending 30 June. A motor car is bought on 1 July 2015 for $8,000. Another car
is bought on 1 July 2016 for $11,000. Each car is expected to be in use for
five years, and the disposal value of the first car is expected to be $500 and of
the second car $1,000. The method of depreciation to be used is the straight
line method. The first two years’ accounts are shown in Exhibit 26.2.
Depreciation per year – straight line method:
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Note: The entries in the cash book have not been shown in this example.
Helpful Hint!
Practice Tip:
Write a definition for depreciation. List five types of assets in a
business which depreciate in value over a number of years.
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Exhibit 26.2
26.2 The sale of an asset
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Reason for accounting entries
Upon the sale of an asset, we will want to delete it from our records. This
means that the cost of that asset needs to be taken out of the asset account. In
addition, the depreciation of the asset that has been sold will have to be taken
out of the depreciation provision. Finally, the profit or loss on sale, if any,
will have to be calculated.
When we charge depreciation on a non-current asset, we have to make
estimates. We cannot be absolutely certain how long we will keep the asset in
use, nor can we be certain at the date of purchase how much the asset will be
sold for on disposal. Nor will we always estimate correctly. This means that
when the asset is disposed of, the cash received for it is usually different from
our original estimate.
Accounting entries needed
On the sale of a non-current asset, for instance machinery, the following
entries are needed.
1 Transfer the cost price of the asset sold to an assets disposal account (in
this case a machinery disposals account):
• Debit machinery disposals account
• Credit machinery account.
2 Transfer the depreciation already charged to the assets disposal account:
• Debit provision for depreciation of machinery account
• Credit machinery disposals account.
3 For remittance received on disposal:
• Debit cash book
• Credit machinery disposal account.
4 Transfer the difference (that is, the amount to balance the machinery
disposal account) to the profit and loss account.
(i) If the machinery disposals account shows a difference on the debit side
of the account, it is a profit on sale:
• Debit machinery disposals account
• Credit profit and loss account.
(ii) If the machinery disposals account shows a difference on the credit
side of the account, it is a loss on sale:
• Debit profit and loss account
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• Credit machinery disposals account.
These entries can be illustrated by looking at those needed if the machinery
already shown in Exhibit 26.1 was sold. The records to 31 December 2017
show that the cost of the machine was $2,000 and a total of $976 had been
written as depreciation, leaving a net book value of ($2,000 – $976) = $1,024.
If, therefore, the machinery is sold on 2 January 2018 for more than $1,024, a
profit on sale will be made; if, on the other hand, the machinery is sold for
less than $1,024, then a loss on disposal will be incurred.
The machinery sold for $1,070, therefore a profit is made.
Exhibit 26.3
Exhibit 26.4 now shows the entries if, instead of the machine being sold at a
profit, the same asset had been sold for only $950, which would mean that a
loss was incurred on sale.
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Exhibit 26.4
Helpful Hint!
Examination Tip:
To record the purchase of an asset in the books of account:
Debit – the Asset account
Credit – the Bank account (if paid)
To record the depreciation charges:
Debit – Profit and Loss Account
Credit – Provision for depreciation account
26.3 Depreciation provisions and the
replacement of assets
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Making a provision for depreciation does not mean that money is invested
somewhere to finance the replacement of the asset when it is put out of use. It
is simply a book-keeping entry, and the end result is that lower net profits are
shown because the provisions have been charged to the profit and loss
account.
It is not surprising to find that people who have not studied accounting
misunderstand the situation. They often think that a provision is the same as
money kept somewhere with which to replace the asset eventually.
On the other hand, lower net profits may also mean lower drawings by the
owner(s) of the business. If this is the case, then there will be more money in
the bank with which to replace the asset. However, there is no guarantee that
lower profits mean lower drawings.
Note: A step-by-step guide dealing with depreciation in final accounts is
shown in Chapter 28 Section 28.14.
Summary
• Non-current assets are shown at cost price in the appropriate asset
account. Any depreciation charge is shown separately and
accumulating in a ‘provision for depreciation account’.
• The depreciation charge for the period is then debited to the profit
and loss account.
• In the statement of financial position, the asset is shown at cost
price, less the accumulated depreciation so giving the ‘net book
value’ of the asset.
• On disposal of a non-current asset the book-keeping entries will
involve a new account, that is, ‘asset disposal account’. It is then
necessary to transfer the cost price of the asset, the accumulated
depreciation and the cash received to this account when the asset
is sold. The balancing figure in the asset disposal account may be
either a profit or loss on disposal.
• If there is a profit on disposal of a non-current asset the profit will
be credited to the profit and loss account.
• If there is a loss on disposal this will be charged as an expense in
the profit and loss account.
• Providing for depreciation does not mean that money is invested
elsewhere for financing the replacement of the asset.
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Chapter 26 Exercises
26.1 A. White, an exporter, bought a new car for his business on 1
January 2015 for $12,500. He decided to write off depreciation at
the rate of 20%, using the reducing balance method.
Show the following for each of the financial years ended 31
December 2015, 2016 and 2017:
(a) motor cars account
(b) provision for depreciation account
(c) extracts from the profit and loss accounts
(d) extracts from the statement of financial position.
26.2 The Boyd Delivery Service started in business on 1 January
2015 and on that date purchased two motor vans at a cost of
$12,000 each; a further motor van was also purchased for
$14,000 on 1 July 2015.
You are required to write up the motor vans account and the
provision for depreciation account for the years ended 31
December 2015 and 2016. The straight line method of
depreciation is used at a rate of 20% per annum; ignore disposal
value in this case, and depreciation should be apportioned on
the basis of one month’s ownership needing one month’s
depreciation.
26.3X Harvey DaCosta, a sole trader, purchases on 1 November
2015 a new machine for $18,000. His business year end is 31
October but he cannot decide which method of depreciation he
should use in respect of the machine – the straight line method
or the reducing balance method.
Required:
In order to assist him in making his decision, draw up the
machine account, and provision for depreciation account, for the
three years from 1 November 2015, using:
(a) the straight line method
(b) the reducing balance method.
Each account must indicate which method is being used and
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must be balanced at the end of each of the three years.
Notes:
(i) In both cases the rate of depreciation is to be 10%.
(ii) Calculations should be made to the nearest $.
26.4X (a) What is meant by depreciation, and why is it important that
a business person should provide for depreciation in his
accounts?
(b) On 1 January 2015, A. Simpson, a building contractor,
purchased three dumpers for $48,000 each. Mr Simpson
estimated that his dumpers would have an effective working
life of five years with a disposal value of $3,000 each. The
straight line method of depreciation is to be used. The
financial year ends on 31 December. One of the dumpers
kept breaking down and was sold on 1 January 2016 for
$25,000.
You are required to show the relevant entries for the years 2015,
2016 and 2017 in the following ledger accounts:
(i) dumper
(ii) dumper disposal
(iii) provision for depreciation – dumpers.
All workings are to be shown.
26.5X On 1 January 2015, which was the first day of a financial year,
T. Young bought computer equipment for $9,500. It is to be
depreciated by the straight line method at the rate of 20%,
ignoring salvage value. On 1 January 2018 the equipment was
sold for $4,250.
Show the following for the complete period of ownership.
(a) The computer equipment account.
(b) The provision for depreciation – computer equipment
account.
(c) The computer equipment disposal account.
(d) The extracts from profit and loss accounts for three years.
(e) The extracts from three years’ statements of financial
position – 2015, 2016 and 2017.
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26.6 A business buys a non-current asset for $10,000. The business
estimates that the asset will be used for five years, and will then
have no scrap value. After exactly two and a half years,
however, the asset is suddenly sold for $5,000. The business
always provides a full year’s depreciation in the year of purchase
and no depreciation in the year of disposal.
Required:
(a) Write up the relevant accounts (including disposal account
but not profit and loss account) for each of years 1, 2 and 3:
(i) using the straight line depreciation method (assume
20% p.a.)
(ii) using the reducing balance depreciation method
(assume 40% p.a.).
(b) (i) What is the purpose of depreciation? In what
circumstances would each of the two methods you have
used be preferable?
(ii) What is the meaning of the net figure for the non-current
asset in the statement of financial position at the end of
year 2?
26.7X Show the relevant disposal account for each of the following
cases, including the transfers to the profit and loss account.
(a) Motor vehicle: cost $12,000; depreciated $9,700 to date of
sale; sold for $1,850.
(b) Machinery: cost $27,900; depreciated $19,400 to date of
sale; sold for $11,270.
(c) Fixtures: cost $8,420; depreciated $7,135 to date of sale;
sold for $50.
(d) Buildings: cost $200,000; depreciated straight line 5% on
cost for 11 years to date of sale; sold for $149,000.
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27 Bad debts and provision for
doubtful debts
Specific objectives
After you have studied this chapter you should be able to:
• understand and show how bad debts are written off
• understand why provisions for doubtful debts are made
• make the accounting entries necessary for recording a provision for
doubtful debts
• make the accounting entries for increasing or reducing the
provision for doubtful debts
• make all the entries in respect of the provision for doubtful debts in
the profit and loss account and statement of financial position.
• make accounting entries in respect of bad debts recovered.
27.1 Bad debts
If a business finds that it is impossible to collect a debt, then that debt should
be written off as a bad debt. This could happen if the debtor is suffering a
loss in the business, or may even have gone bankrupt and is thus unable to
pay the debt. A bad debt is, therefore, an expense on the business that is owed
the money.
An example of debts being written off as bad is shown next.
We sold $50 goods to C. Baptiste on 5 January 2017, but that business
became bankrupt. On 16 February 2017 we sold $240 goods to R. Shaw.
Shaw managed to pay $200 on 17 May 2017, but it became obvious that he
would never be able to pay the final $40.
When drawing up our final accounts to 31 December 2017, we decided to
write these off as bad debts. The accounting entries are shown in the
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following table:
Exhibit 27.1
The accounts would appear as follows:
27.2 Provisions for doubtful debts
Let us look, as an example, at the accounts of K. Charles, who started in
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business on 1 January 2017 and has just completed his first year of trading on
31 December 2017.
Charles sold goods for $50,000 that cost him $36,000, giving him a gross
profit of $14,000 ($50,000 – $36,000). However, included in the $50,000
sales was a credit sale of $250 to C. Young who recently died, leaving no
money and the amount for the goods still outstanding. The $250 debt is,
therefore, a bad debt and should be written off and charged to the profit and
loss account as an expense.
Besides that debt, a credit sale of $550 on 1 December 2017 to Ms L. Hall,
is unlikely to be paid. Although Charles is not certain of this, he has been
informed that Hall has not paid debts owing to other businesses. As Charles
has given three months’ credit to Hall, the debt is not repayable until 28
February 2018.
However, Charles has been requested by his bank to provide them with his
financial statements for the year 2017. Unfortunately, Charles cannot wait
until after 28 February 2018 to see if the debt of $550 owing by Hall will be
paid or not.
If it is not paid then it will become a bad debt, but in the meantime it is a
doubtful debt.
What, therefore, can Charles do? When he presents the bank with his
financial statements he wants to achieve the following objectives:
(a) to charge as expenses in the profit and loss account for the year 2017 an
amount representing sales of that year for which he will never be paid
(b) to show in the statement of financial position as correct a figure as
possible of the true value of accounts receivable at the date of the
statement of financial position.
He can carry out (a) above by writing off Young’s debt of $250 and then
charging it as an expense in his profit and loss account.
For (b) he cannot yet write off Hall’s debt of $550 as a bad debt because he
is not certain about it being a bad debt. If he does nothing about it, then the
accounts receivable shown on the statement of financial position will include
a debt that is probably of no value. The accounts receivable on 31 December
2017, after deducting Young’s $250 bad debt, amounted to $10,000. The
answer to this is as follows:
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In the above examples we have shown how ‘bad debts’ and ‘provisions for
doubtful debts’ appear as expenses in the year in which the sales were
made, with the accounts receivable figure in the statement of financial
position representing their true value.
The double entry is explained in Section 27.4.
27.3 Provisions for doubtful debts:
estimating provisions
The estimates of provisions for doubtful debts can be made as follows:
• by looking into each debt, and estimating which ones will be bad debts
• by estimating, on the basis of experience, what percentage of the debts will
result in bad debts.
It is well known that the longer a debt is owing, the more likely it will
become a bad debt. Some businesses draw up an ageing schedule, showing
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how long debts have been owing. Older debtors need higher percentage
estimates of bad debts than newer debtors. Exhibit 27.2 gives an example of
such an ageing schedule.
Exhibit 27.2
Helpful Hint!
Question:
Is a bad debt the same as a doubtful debt? Support your answer with
evidence from this textbook.
In the above example the calculation of the provision for doubtful debts has
been specifically detailed. Many businesses do not go to this level of detail;
instead they apply a percentage based upon the experience that has been
established within the business over a number of years. For example, they
may decide to use 5% of the accounts receivable figure as a provision for
doubtful debts.
27.4 Accounting entries for provisions
for doubtful debts
When a decision has been taken as to the amount of the provision to be made,
then the accounting entries needed for the provision relate to the year in
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which provision is first made, as follows:
1 Debit: Profit and loss account with the amount of the provision (as an
expense)
2 Credit: Provision for doubtful debts account.
Let us look at an example that shows the entries needed for a provision for
doubtful debts.
Helpful Hint!
The provision for doubtful debts is deducted from the figure of
‘Accounts receivable’ in the Statement of financial position.
At 31 December 2017, the accounts receivable figure after deducting bad
debts amounted to $10,000. It is estimated that 2% of debts (that is, $200)
will eventually prove to be bad debts, and it is decided to make a provision
for these. The accounts would appear as follows:
Exhibit 27.3
In the statement of financial position, the balance on the provision for
doubtful debts will be deducted from the total of accounts receivable, thus:
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27.5 Increasing the provision
Let us suppose that for the same business as in Exhibit 27.3, at the end of the
following year, 31 December 2018, the doubtful debts provision needed to be
increased. This was because the provision was kept at 2%, but the accounts
receivable had risen to $12,000. A provision of $200 had been brought
forward from the previous year, but we now want a total provision of $240
(that is, 2% of $12,000). All that is needed is a provision for an extra $40.
The double entry will be:
1 Debit: Profit and loss account with the increase in the provision, that is,
$40
2 Credit: Provision for doubtful debts account.
The relevant accounts are shown below:
27.6 Reducing the provision
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Outstanding debtors can reduce as well as increase and if a business finds that
the amount outstanding has decreased, they may decide to reduce the
provision for doubtful debts. Reducing a provision is the opposite of
increasing a provision.
In the provision for doubtful debts account, a credit balance is shown,
therefore, to reduce it we would need a debit entry in the provision account.
The credit would be in the profit and loss account. Let us assume that at 31
December 2019, in the business already examined, the accounts receivable
figure had fallen to $10,500 but the provision remained at 2%, that is, $210
(2% of $10,500).
As the provision had previously been $240, it now needs a reduction of
$30. The double entry is the following:
• Debit: Provision for doubtful debts account, that is, $30
• Credit: Profit and loss account.
There are some things you have to remember about provisions for doubtful
debts.
Year 1 Provision first made:
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• Debit profit and loss account with the full provision.
• Show in Statement of financial position as a deduction from the accounts
receivable.
Later years: Only the increase, or the decrease, in the provision is shown in
the profit and loss account as follows:
• To increase: debit the profit and loss account and credit the provision for
doubtful debts account.
• To decrease: credit the profit and loss account and debit the provision for
doubtful debts account.
The Statement of financial position will show the amended figure of the
provision as a deduction from the accounts receivable.
27.7 A worked example
Let us now look at a comprehensive example (Exhibit 27.4).
A business owned by J. Gupta starts on 1 January 2017 and its financial
year end is 31 December annually. A table of the accounts receivable, the bad
debts written off and the estimated doubtful debts at the rate of 2% of
accounts receivable at the end of each year, as well as the double entry
accounts and the extracts from the final accounts follow.
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Exhibit 27.4
27.8 Bad debts recovered
It is not uncommon for a debt written off in previous years to be recovered in
later years. When this occurs, the book-keeping procedures are such that,
first, you should reinstate the debt by making the following entries:
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• Debit: the customer’s account
• Credit: bad debts recovered account.
Helpful Hint!
Examination Tip:
How does the provision for doubtful debts affect the statement of
financial position? Remember that the provision for doubtful debts is
not a current liability.
The reason for reinstating the debt in the ledger account of the customer is
to have a detailed history of the account as a guide for granting credit in the
future. By the time a debt is written off as bad, it will be recorded in the
customer’s ledger account. Thus, when such a debt is recovered, it must also
be shown in the customer’s ledger account.
When cash or a cheque is later received from the customer in settlement of
the account or part thereof, other book-keeping entries are necessary:
• Debit: cash/bank with the amount received
• Credit: customer’s account with the amount received.
At the end of the financial year, the credit balance on the bad debts recovered
account will be transferred to either the bad debts account or direct to the
credit side of the profit and loss account. The net effect of either of these
entries is the same, since the bad debts account will be transferred to the
profit and loss account at the end of the financial year. In other words, the net
profit will be the same no matter which method is used.
Note: A step-by-step guide for dealing with bad debts and provisions for
doubtful debts in the financial statements is shown in Chapter 28, Section
28.14.
Summary
• If a debt is unlikely to be paid, it is known as a bad debt.
• When the debt has been outstanding for a length of time, the
business usually decides to write it off. The debt is debited to the
bad debts account and the customer’s account is credited. The bad
debt account is later credited and the profit and loss account
debited where it is charged as an expense.
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• A provision for doubtful debts is created in case some of the
outstanding debts are not paid. The provision is charged to the
profit and loss account and then deducted from the accounts
receivable in the statement of financial position, thereby showing a
realistic figure of the debts owed and what payment the business
expects to receive.
• The provision for doubtful debts is calculated after any bad debts
have been written off and deducted from the outstanding accounts
receivable.
• The provision for doubtful debts can be adjusted if the accounts
receivable at the end of the financial year either increase or
decrease.
• To increase the provision, debit the profit and loss account and
credit the provision for doubtful debts account with the amount of
the increase.
• To reduce the provision, debit the provision for doubtful debts
account and credit the profit and loss account with the amount of
the reduction.
• A debt that has previously been written off but is subsequently paid
by the customer is known as a bad debt recovered.
Chapter 27 Exercises
27.1 On 1 January 2017, the balances below appeared in the sales
ledger of S. Henry.
During the year the following events took place:
Feb 1 After negotiation, Henry agreed to accept $150 cash from
D. Fung and regarded the outstanding balance as irrecoverable.
Mar 10 C. Manley was declared bankrupt. A payment of 30 cents
in the $ was received in full settlement.
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Show how these matters would be dealt with in Henry’s ledger
assuming that the financial year ends on 30 June.
27.2 On 30 September 2017 B. Fraser’s accounts receivable totalled
$12,000. The following debts were found to be bad and Fraser
decided to write them off:
He further decided to make a provision for doubtful debts of 10%
on the remaining accounts receivable.
On 30 September 2018, Fraser’s accounts receivable totalled
$10,000 and it was decided to maintain the provision at 10%.
You are required to show, for each of the years ended 30
September 2017 and 2018:
(a) provision for doubtful debts account
(b) appropriate entries in the profit and loss account
(c) the necessary entries on the statement of financial position
on each of the above dates.
27.3X A business started on 1 January 2017, and its financial year
end is 31 December.
The table below shows the figure for accounts receivable
appearing in the trader’s books on 31 December of each year
from 2017 to 2020. The provision for doubtful debts is to be 1%
of accounts receivable from 31 December 2017. Complete the
table below indicating the amount to be debited or credited to the
profit and loss account for the year ended on each 31 December,
and the amount for the final figure of accounts receivable to
appear in the statement of financial position on each date.
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27.4X A business started on 1 January 2015 and its financial year
end is 31 December annually. The table of the accounts
receivable, the bad debts written off and the estimated doubtful
debts at the end of the year is given below.
You are required to show the bad debts account and provision
for doubtful debts account, as well as the extracts from the profit
and loss account for each year and the statement of financial
position extracts.
27.5X F. Grant maintained his accounting books from January to
December. The accounts receivable balances and the rates for
the provision for doubtful debts at the end of each of the
following years are shown below.
(a) Write up the provision for doubtful debts account for the
year ending 31 December 2017 to 31 December 2019.
(b) On 2 January 2019, J.Brown, a customer, was declared
bankrupt and could pay only 25% of the $800 that he owed.
Show the effect of this in the books of F. Grant.
(c) What is the reason for creating a provision for doubtful debts
account?
(CSEC style)
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28 Accruals, prepayments and
other adjustments for financial
statements
Specific objectives
After you have studied this chapter you should be able to:
• understand why it is necessary to adjust expense accounts for
amounts owing or paid in advance
• adjust expense accounts for amounts owing (accruals) and paid in
advance (prepayments)
• adjust revenue accounts for amounts owing at the end of a period
• show accruals, prepayments and accounts receivable in the
statement of financial position
• ascertain the amounts of expenses and revenue that should be
shown in the profit and loss account after making adjustments for
accruals and prepayments
• enter up the necessary account for goods taken for own use
• prepare financial statements for service sector organisations
• distinguish between various kinds of capital
• enter discounts allowed and received in the financial statements
• prepare financial statements, incorporating the above-mentioned
adjustments, for a sole trader using the fully worked example and
step-by-step guide.
28.1 The final accounts so far
The trading and profit and loss account (income statement) that has been
considered until now has taken sales for a period and deducted all the
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expenses for that period, resulting in either a net profit or net loss.
So far, it has been assumed that the expenses incurred have belonged
exactly to the period of the trading and profit and loss account. If, for
example, the trading and profit and loss account (income statement) for the
year ended 31 December 2017 was being drawn up, then the rent paid as
shown in the trial balance was exactly that due for 2017. At the beginning of
2017 there was no rent owing, nor was any owing at the end of 2017 or been
paid in advance. It is easier to consider a simple example at first to
understand the principles of final accounts.
28.2 Adjustments needed for expenses
owing or paid in advance
Not all businesses pay their rent exactly on time and, indeed, some businesses
prefer to pay for their rent in advance. The following examples will illustrate
the adjustments necessary if expenses are either owing, or paid in advance, at
the end of a financial period.
Two firms rent their premises for $6,000 per year.
1 Firm A pays $5,000 during the year and owes $1,000 rent at the end of the
year:
Rent expense used up during the year = $6,000
Rent actually paid in the year = $5,000
2 Firm B pays $6,500 during the year, including $500 in advance for the
following year:
Rent expense used up during the year = $6,000
Rent actually paid for in the year = $6,500
The profit and loss account needs 12 months’ rent, that is, $6,000, charging
as an expense in that trading period. This means that in the above two
examples the double entry accounts will have to be adjusted.
In all the examples following in this chapter, the trading and profit and loss
accounts are for the period ended 31 December 2017.
28.3 Accrued expenses
Assume that rent of $12,000 per year is payable at $3,000 at the end of every
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three months. The rent was not always paid on time. Details were as follows.
The rent account to 31 December 2017 appeared as follows:
The rent paid on 5 January 2018 will appear in the books of the year 2018 as
part of the double entry.
The rent expense for 2017 is obviously $12,000, as that is the year’s rent,
and this is the amount that needs to be transferred to the profit and loss
account. But, if $12,000 is put on the credit side of the rent account (the debit
being in the profit and loss account), the account would not balance. We
would have $12,000 on the credit side of the account and only $9,000 on the
debit side.
To make the account balance, the $3,000 rent owing for 2017, but paid in
2018, must be carried down to 2018 as a credit balance because it is a
liability on 31 December 2017. Instead of rent owing, it could be called rent
accrued or just simply an accrual. The completed account can now be
shown in Exhibit 28.1.
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Exhibit 28.1
The balance c/d has been described as ‘accrued c/d’, rather than as a balance.
This is to explain what the balance is for; it is for an accrued expense, that is,
an expense owing.
28.4 Prepaid expenses
Insurance for a business is at the rate of $840 a year, starting from 1 January
2017. The business has agreed to pay this at the rate of $210 every three
months. However, payments were not made at the correct times. Details were
as follows.
The insurance account to the year ended 31 December 2017 will be shown in
the books as:
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The last payment of $420 is not just for 2017: it can be split as $210 for the
three months to 31 December 2017 and $210 for the three months ended 31
March 2018. For a period of 12 months, the cost of insurance is $840 and this
is, therefore, the figure needing to be transferred to the profit and loss
account.
If this figure of $840 is entered then the amount needed to balance the
account will be $210 and at 31 December 2017 there is a benefit of a further
$210 paid for but not used up – an asset that needs carrying forward as such
to 2018, that is, as a debit balance. It is a prepaid expense. The account
for the year can now be completed (Exhibit 28.2).
Exhibit 28.2
Prepayment happens when items other than purchases are bought for use in
the business and they are not fully used up in the period. For instance,
packing materials and stationery items are normally not entirely used up over
the period in which they are bought, there being a stock in hand at the end of
the accounting period. This stock is, therefore, a form of prepayment and
needs carrying down to the following period in which it will be used. This
can be seen in the following example:
Year ended 31 December 2017:
Stationery bought in the year $2,200
Stock of stationery (inventory) in hand as at 31 December 2017 amounts to
$200.
Looking at the example, it can be seen that in 2017 the stationery used up
will have been ($2,200 – $200) = $2,000. We will still have an inventory of
$200 stationery at 31 December 2017, to be carried forward to 2018 as an
asset balance (debit balance). Thus:
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Helpful Hint!
Discussion:
Remember that an accrued expense is one that has been incurred
but not yet paid. and a prepayment is an expense that has been paid
for in advance. How can these be beneficial to a business?
The stock of stationery (inventory) is not added to the stock of unsold goods
in hand in the statement of financial position but it is added to the other
prepayments of expenses.
28.5 Revenue owing at the end of
period
The revenue owing for sales is already shown in the books. These are the
debit balances on our customers’ accounts, that is, accounts receivable. There
may be other kinds of revenue, all of which has not been received at the end
of the period, that is, rent receivable. An example now follows.
A business’s warehouse is larger than it needs to be. The business rents
part of it to another organisation for $1,600 per annum. Details for the year
ended 31 December were as follows.
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The account for 2017 will appear as follows:
The rent received of $400 on 7 January 2018 will be entered in the books in
2018 (not shown).
Any rent paid by the business is charged as a debit to the profit and loss
account. Any rent received, being the opposite, is transferred to the credit of
the profit and loss account, since it is revenue/income.
The amount to be transferred to the profit and loss account for 2017 is the
revenue earned for the twelve months, that is, $1,600. The balance owed to
the business $400, is shown as a debit balance brought down in January 2018,
as it is an asset on 31 December 2017.
The rent receivable account can now be completed:
28.6 Expenses and revenue account
balances and the statement of financial
position
In all the cases listed, dealing with adjustments in the final accounts, there
will still be a balance on each account after the preparation of the trading and
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profit and loss account (income statement). All such balances remaining
should appear in the statement of financial position. The only question left is
where and how they shall be shown.
The amounts owing for expenses are usually added together and shown as
one figure. These could be called expense creditors, expenses owing, or
accrued expenses. The items appear under current liabilities as they are
expenses that have to be discharged in the near future.
The items prepaid are also added together and are called prepayments,
prepaid expenses, or payments in advance. They are shown next under the
accounts receivable. Amounts owing for rents receivable or other revenue
owing are usually added to accounts receivable.
The statement of financial position in respect of the accounts so far seen in
this chapter would appear as follows:
28.7 Some more examples
The following accounts for C. Holmes are shown entered up for transactions
during the year ended 31 December 2017, before balancing off as at 31
December 2017.
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Note: A telephone bill of $520 for the three months ended 31 December 2017
was not paid until January 2018.
Note: The payment for rent of $2,000 on 30 December 2017 covers the
period 1 January 2018 to 31 March 2018.
Note: Commission income of $1,360 earned for the four months from 1
September to 31 December 2017 will be received in 2018.
The accounts now balanced off as at 31 December 2017 can be shown as
follows:
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The items would appear in the profit and loss accounts as follows (extracts
only).
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Statement of financial position extracts will be as follows:
28.8 Expenses and revenue accounts
covering more than one period
Students are often asked to draw up an expense or revenue account for a full
year where there are amounts owing or prepaid at both the beginning and end
of the year. We can now see how this is done.
Example 1: The following details are available:
(a) On 31 December 2016, three months’ rent of $3,000 is owing.
(b) The rent chargeable per year is $12,000.
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(c) The following payments are made in the year 2017: 6 January $3,000; 4
April $3,000; 7 July $3,000; 18 October $3,000.
(d) The final three months’ rent for 2017 is still owing.
Now we can look at the completed rent account. The letters (a) to (d) give
reference to the details above.
Example 2: The following details are available:
(a) On 31 December 2016, stationery in hand amounted in value to $1,850.
(b) During the year to 31 December 2017, $27,480 is paid for stationery.
(c) There are no stocks of stationery (inventory) on 31 December 2017.
(d) On 31 December 2017, we still owed $2,750 for stationery already
received and used.
The stationery account will appear thus:
The figure of $32,080 is the difference on the account, and is transferred to
the profit and loss account. We can prove it is correct through the following:
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Example 3: Where different expenses are put together in one account, it can
get even more confusing. Let us look at where rent and rates are joined
together. Here are the details for the year ended 31 December 2017:
(a) Rent is payable of $6,000 per annum.
(b) Rates of $4,000 per annum are payable by instalments.
(c) At 1 January 2017, rent $1,000 has been prepaid in 2016.
(d) On 1 January 2017, rates are owed of $400.
(e) During 2017, rent of $4,500 is paid.
(f) During 2017, rates of $5,000 were paid.
(g) On 31 December 2017, rent $500 is owing.
(h) On 31 December 2017, rates of $600 have been prepaid.
A combined rent and rates account is to be drawn up for the year 2017
showing the transfer to the profit and loss account, and balances are to be
carried down to 2018.
Thus:
28.9 Goods for own use
Traders will often take items out of the business stocks for their own use,
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without paying for them. There is nothing wrong about this, but an entry
should be made to record the event. This is done as follows:
1 Credit the purchases account, to reduce cost of goods available for sale
2 Debit the drawings account, to show that the proprietor has taken the
goods for his or her private use.
Adjustments may also be needed for other private items. For instance, if a
trader’s private insurance had been incorrectly charged to the insurance
account, then the correction would be as follows:
1 Credit the insurance account
2 Debit the drawings account.
28.10 Distinctions between various
kinds of capital
The capital account represents the claim the owner has against the assets of a
business at a point in time, that is, the amount of the business that belongs to
the owner. The word ‘capital’ is, however, often used in a specific sense. The
main uses are listed below.
Capital invested
Capital invested means the actual amount of money, or money’s worth,
brought into a business by its owners from his or her outside interests. The
amount of capital invested is not disturbed by the amount of profits made by
the business or any losses incurred.
Capital employed
The term capital employed has many meanings but basically it means the
amount of money that is being used (or ‘employed’) in the business. If,
therefore, all the assets were added up in value and the liabilities of the
business deducted, the answer would be that the difference is the amount of
money employed in the business (that is, the net assets).
Another way of looking at the calculation of capital employed is to take the
balance of the capital account and add this to any long-term loan. The result
will be the same as the net assets, that is, the capital employed.
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Working capital (net current assets)
The difference between the current assets and current liabilities is often
referred to as working capital or net current assets. This amount
represents the money that is available to pay the running expenses of the
business and, ideally, the current assets should exceed the current liabilities
twice over, that is, in the ratio 2: 1. In simple terms it means that, for every $1
owed, the business should be able to raise $2.
Helpful Hint!
Examination Tip:
List the number of ways ‘capital’ is used in accounting. Write a brief
explanation of each term involving the use of the word ‘capital’. Write
an explanation for the term ‘favourable working capital’.
28.11 Financial statements in the
services sector
All the accounts considered so far have been accounts for businesses that
trade in some sort of goods. To enable the business to ascertain the amount of
gross profit made on selling the goods, a trading account has been drawn up.
There are, however, many organisations that do not deal in goods but instead
supply customers with a ‘service’. These will include professional firms such
as accountants, solicitors, doctors, estate agents, management consultants and
advertising agencies. Also businesses that provide such services as window
cleaning, gardening, hairdressing, repairs and maintenance, computer repairs,
leisure and health clubs and so on. Since they do not deal in ‘goods’, there is
no need for trading accounts to be drawn up; a profit and loss account
(income statement), together with a statement of financial position, is
prepared instead.
The first item in the profit and loss account (income statement) will be the
revenue which might be called ‘fees’, ‘charges’, ‘accounts rendered’,
‘takings’ etc., depending on the nature of the organisation. Any other item of
income will also be added, for example rent receivable. Following this, the
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expenses incurred in running the business will be deducted to arrive at the net
profit or loss.
An example of the profit and loss account (income statement) of a solicitor
is shown in Exhibit 28.3.
Exhibit 28.3
28.12 Treatment of discounts allowed
and discounts received in final
accounts
In Chapter 20, we dealt with recording cash discounts in the cash book and
ledgers and you will recall that such a discount could be either ‘discounts
allowed’, which represents a reduction given to our customers for prompt
payment of their account or ‘discounts received’ when the reduction is given
by a supplier to us when we pay their account within a specified period.
Using the example below of D. Marston (Exhibit 28.4), let us assume that
the discount allowed amounted to $310 and the discount received totalled
$510. These items would appear in the trading and profit and loss account
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(income statement) as follows:
Exhibit 28.4
28.13 Worked example of the financial
statements for a sole trader
We have now covered all the adjustments that may be necessary before
preparing the financial statements for a business. The adjustments covered
are depreciation, from Chapter 26, writing off bad debts and the provision for
doubtful debts from Chapter 27, and in this chapter, we have dealt with
accruals, prepayments, discounts allowed and received. You may also recall
that Chapter 13 dealt with closing inventory and returns inwards and
outwards and carriage inwards and outwards.
Shown in Exhibit 28.5 is a fully worked example that includes all the items
mentioned above and in Section 28.14 you will find another step-by-step
guide that deals with these rather tricky adjustments; remember there is also a
step-by-step guide to preparing financial statements, preliminary level, in
Chapter 13, Section 13.8.
G. Lea, a sole trader, extracted the following trial balance from his books
for the year ended 31 March 2016.
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Exhibit 28.5
Notes:
1 Inventory 31 March 2016 was valued at $42,900.
2 Wages and salaries accrued $2,100 and office expenses owing $200 at 31
March 2016.
3 Rent prepaid 31 March 2016 was $1,800.
4 Increase the provision for doubtful debts to $8,100.
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5 Provide for depreciation on the office equipment at 20% per annum using
the straight line method.
6 Provide for depreciation on the delivery vans at 20% per annum using the
reducing balance method.
You are required to prepare the trading and profit and loss account (income
statement) for the year ended 31 March 2016 together with a statement of
financial position as at that date.
Note: The letters shown in the worked answer below refers to the guidance
given in the ‘Step-by-step guide’ shown in Section 28.14.
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Helpful Hint!
Practice Tip:
Following the ‘Step-by-step guide’ is useful when preparing financial
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statements.
28.14 Step-by-step guide dealing with
further adjustments to financial
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statements
Note: In what follows, the letters (A) to (N) shown after each adjustment can
be cross-referenced to the trading and profit and loss account (income
statement) and statement of financial position of G. Lea.
1 Prepayments (amounts paid in advance)
(a) If a trial balance is provided in a question then ensure that you deduct the
amount of the prepayment from the appropriate expense account and put
the resultant figure in the profit and loss account. Ensure that only the
expenses incurred for that particular period are charged against the profits
for that period. Refer to the worked example, note (3) rent prepaid
$1,800. This amount should be deducted from the rent in the trial
balance, that is, $17,400 – $1,800 = $15,600; this figure should be
entered as an expense in the profit and loss account (A).
(b) In the statement of financial position show the amount of the prepayment
in the current assets section directly under accounts receivable, that is,
Prepaid expenses $1,800 (B).
2 Accruals (amount owing)
(a) If a trial balance is provided in a question then add the amount of the
accrual to the appropriate expense account and put this figure in the profit
and loss account (income statement). Refer to the worked example, note
(2) wages and salaries accrued $2,100 and office expenses owing $200.
These figures should be added as follows:
The amounts to be charged as expenses to the profit and loss account (income
statement) are thus, wages and salaries $91,100 (C) and general office
expenses $4,700 (D).
(b) In the statement of financial position show the amount of the accrual
under the heading current liabilities section directly under accounts
payable that is, Expenses owing $2,100 + $200 = $2,300 (E).
3 Discounts allowed and received
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Discount allowed
Charge as an expense in the profit and loss account (income statement). Refer
to the worked example where the discount allowed $14,400 has been charged
as an expense (F).
Discount received
Add as income in the profit and loss account directly underneath the gross
profit figure. Again, refer to the worked example where there is discount
received of $9,300 that has been added as income (G).
4 Depreciation
Straight line method
(Refer to the worked example, note 5)
(a) Find the cost price of the office equipment $20,000
(b) Using percentage given 20%
calculate 20% of $20,000= $4,000
then
(c) Charge $4,000 as an expense in the profit and loss account (income
statement) (H).
(d) In the statement of financial position, deduct total depreciation $4,000
from this year plus depreciation deducted in previous years $8,000* =
$12,000 from the cost price of the asset to give you the net book value of
the asset $20,000 – $12,000 = $8,000. Enter each of these figures in the
appropriate columns in the statement of financial position (I). (*See trial
balance credit side.)
Reducing balance method
(Refer to the worked example, note 6)
(a) Find the cost price of the delivery vans $27,000
(b) Find the total amount of depreciation to date (refer to trial balance credit
side) $5,400
(c) Find the difference ($27,000 – $5,400) = $21,600
(d) Using percentage given 20% calculate 20% of $21,600 = $4,320
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then
(e) Charge $4,320 as an expense in the profit and loss account (J).
(f) In the statement of financial position, deduct total depreciation $4,320
from this year plus depreciation deducted in previous years $5,400* =
$9,720 from the cost price of the asset to give you the net book value of
the asset $27,000 – $9,720 = $17,280. Enter these figures in the
appropriate columns in the statement of financial position (K). (*See trial
balance credit side.)
5 Provision for doubtful debts
Creating a provision:
(a) If a provision is to be created for the first time look in the question for
details of the amount to be set aside. Let us assume in our worked
example that a provision had been created in 2015 amounting to $6,600.
(b) The provision for doubtful debts $6,600 would have been charged to the
profit and loss account as an expense in 2015.
(c) In the statement of financial position, the provision for doubtful debts
$6,600 would have been deducted from the accounts receivable. The
accounts receivable are to be found under the heading of current assets.
Increasing the provision:
(a) Refer to your question and ascertain the new provision; in our example
the new provision is $8,100 for this year (see note 4).
(b) Find last year’s provision; using our example the figure is $6,600 (this
figure can be found in the trial balance, credit side).
(c) Charge the difference between the new and old provision, $8,100 –
$6,600 = $1,500 to the profit and loss account (L).
(d) In the statement of financial position, deduct the new provision $8,100
from the accounts receivable. (M).
Reducing the provision:
(a) Refer to your question and ascertain the new provision. Using our
worked example, we will assume that in 2017 it was decided to reduce
the provision to $5,000.
(b) Find the old provision, again using our example this would be $8,100.
(c) Take the difference between the old and the new provision, $8,100 –
$5,000 = $3,100 then add this amount as income in the profit and loss
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account.
(d) Deduct the new provision for doubtful debts $5,000 from the accounts
receivable in the statement of financial position.
6 Bad debts
Simply write them off as an expense in the profit and loss account. In our
example you will see that bad debts written off are $400; this is shown as an
expense in the profit and loss account (N).
Helpful Hint!
Examination Tip:
Is the term ‘provision for bad debts’ the same as ‘provision for
doubtful debts? Use the information in this chapter to give a reason
for your answer.
Note: A model layout of the financial statements of a sole trader is shown in
Appendix B and on the website.
Summary
• It is important to ensure that expenses incurred in a particular
period are charged against the profit for that period whether or not
they have been paid. In the same way, revenue earned in a period
should be included as income for that period irrespective of
whether the money has been received or is still owed.
• Items owing are called ‘accruals’; items paid in advance are called
‘prepayments’.
• Adjustments need to be made in the expense and revenue
accounts to ensure that expenses incurred or revenue due for the
period are included in that year’s financial statements.
• Expenses owing (accruals) are shown in the statement of financial
position under the heading of current liabilities while expenses
prepaid (prepayments) are shown under current assets. Amounts
owing for rents receivable or other revenue due is usually added to
the accounts receivable.
• If the owner of a business takes goods for his or her own use
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without paying for them then an adjustment is made by crediting
the purchases account and debiting the drawings account.
• Private expenses should not be charged as an expense in the
trading and profit and loss accounts, but should instead be charged
to the drawings account.
• There are various forms of ‘capital’ used in a business; capital
invested, capital employed and working capital.
• A fully worked example of the financial statements for a sole trader,
including all adjustments, is illustrated using the step-by-step guide.
Chapter 28 Exercises
28.1 K. Holding has just finished his first year of trading, which was
for the year ended 31 December 2017. He wants you to
complete the following expense accounts, showing the amounts
transferred to the profit and loss account. Also show any
balances of expenses owing or paid in advance carried down to
the next year.
(a) Rent paid for the 11 months to 30 November 2017 $3,300.
The rent for December 2017 of $300 was not paid until
2018.
(b) Telephone expenses paid in 2017 amounted to $589. The
telephone bill for November and December 2017 of $107
was not paid until 2018.
(c) Wages paid during 2017 amounted to $14,690. The total
pay of $330 for the last week of 2017 was not paid until
2018.
(d) Rates charged were $4,200 per year. During 2017 he paid
$5,250, which included rates for the three months ended 31
March 2018.
(e) Insurance costs were $800 per year. During 2017 he had
paid $1,200, which included insurance for the six months
ended 30 June 2018.
28.2X J. Lloyd has just finished his first year of trading, which was
for the year ended 31 December 2016. Write up the following
expenses, show the amounts transferred to the profit and loss
account and any balances to be carried down to the year 2017.
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(a) Motor expenses paid in 2016 amounted to $4,971. A bill for
motor repairs carried out in November 2016 for $410 was
not paid until 2017.
(b) Sundry expenses paid in 2016 amounted to $115. A bill for
a sundry expense of $12 was not paid until 2017.
(c) Electricity bills paid in 2016 totalled $885. The electricity bill
for the months of November and December 2016 of $216
was not paid until 2017.
(d) Computer hire rental of $1,200 was paid in 2016. Of this
figure, $300 was in respect of the first three months of 2017.
(e) Security expenses were $250 per month, but had to be paid
three months in advance. In 2016, $3,750 had been paid,
which included an amount for the first three months of 2017.
28.3 D. Weekes’ first year of business ended 31 December 2016.
Besides his main business, he earns extra money by sub-letting
part of his premises and earns commission etc., which is treated
as part of his business income. Write up the following revenue
accounts. Show the amount transferred to his profit and loss
account for the year ended 31 December 2016 and any
balances carried down to the year 2017.
(a) Insurance commission received during 2016 amounted to
$1,377. One item of $114, which should be been received in
2016, was not received until 2017.
(b) He sublets part of his premises for $4,800 per year. During
2016 he received payment for 14 months, which included
January and February 2017.
(c) His store windows are also used for local advertising by his
customers. During 2016 he received $248 for this, but was
also owed $22 which was not received until 2017.
(d) He hires deckchairs to tourists who pay in advance for their
use. During 2016, he received $3,122. Two tourists still
owed a total of $45 at 31 December 2016 and paid the
amounts owing in 2017.
28.4X G. Hamilton’s first year in business ended on 31 December
2015. Open revenue accounts for the following, showing the
amounts transferred to the profit and loss account for the year
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2015 and also the balances carried down to 2016.
(a) Part of the building is sublet to a tenant from 1 January 2015
for $4,200 per year. Rent for 15 months to 31 March 2016
was received in 2015.
(b) Commission received amounted to $3,820. Outstanding
commission of $270 for December 2015 was not received
until 2016.
(c) Bank interest is received on a business deposit account.
$489 was received in 2015, but the interest for November
and December 2015, a total of $114, was not received until
2016.
(d) Advertising revenue of $1,577 was received in 2015. Of this,
$248 was in respect of an advertisement to be displayed in
2016.
28.5 The financial year of J. Thomas ended on 31 December 2016.
Show the ledger accounts for the following items, including the
balance transferred to the necessary part of the final accounts,
as well as the balances carried down to 2017.
(a) Motor expenses: paid in 2016, $744; owing at 31 December
2016, $28.
(b) Insurance: paid in 2016, $420; prepaid as at 31 December
2016, $35.
(c) Rent: paid during 2016, $1,800; owing as at 31 December
2015, $250; owing as at 31 December 2016, $490.
(d) Rates: paid during 2016, $950; prepaid as at 31 December
2015, $220; prepaid as at 31 December 2016, $290.
(e) Thomas sublets part of the premises. He receives $550
during the year ended 31 December 2016. Tenant owed
Thomas $180 on 31 December 2015 and $210 on 31
December 2016.
28.6X J. Persad’s year ended on 30 June 2016. Write up the ledger
accounts, showing the transfers to the final accounts and the
balances carried down to the next year for the following:
(a) Stationery: paid for the year to 30 June 2016, $855; stocks
of stationery at 30 June 2015, $290; at 30 June 2016, $345.
(b) General expenses: paid for the year to 30 June 2016, $590;
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owing at 30 June 2015, $64; owing at 30 June 2016, $90.
(c) Rent and rates (combined account): paid in the year to 30
June 2016, $3,890; rent owing at 30 June 2015, $160; rent
paid in advance at 30 June 2016, $250; rates owing 30
June 2015, $205; rates owing 30 June 2016, $360.
(d) Motor expenses: paid in the year to 30 June 2016, $4,750;
owing as at 30 June 2015, $180; owing as at 30 June 2016,
$375.
(e) Persad earns commission from the sales of one item.
Received for the year to 30 June 2016, $850; owing at 30
June 2015, $80; owing at 30 June 2016, $145.
28.7X Draw up the trading and profit and loss account (income
statement) of J. Lester for the year ended 31 December 2017
from the following information.
The following information at 31 December 2017 is also available:
(a) Inventory at 31 December 2017, $27,540.
(b) Rent in arrears, $320.
(c) Included in general expenses is a figure of $2,000 for
equipment.
(d) Equipment to be depreciated by 20%.
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(e) Carriage outwards, $70 owing.
(f) There was one year’s loan interest of 8% owing to J. Rogers.
(CSEC style)
28.8 From the following trial balance of John Brown, grocery store
owner, prepare a trading account and profit and loss account
(income statement), for the year ended 31 December 2017, and
a statement of financial position as at 31 December 2017, taking
into consideration the adjustments shown below.
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Adjustments:
(a) Closing inventory at 31 December 2017, $12,000.
(b) Accrued wages, $500.
(c) Rates prepaid, $50.
(d) The provision for doubtful debts to be increased to 10% of
accounts receivable.
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(e) Telephone account outstanding, $22.
(f) Depreciate shop fittings at 10% per annum, and van at 20%
per annum, using the reducing balance method.
28.9 J. Graham drew up the following trial balance as at 30
September 2018. You are to draft a trading and profit and loss
account (income statement) for the year to 30 September 2018
and a statement of financial position as at that date.
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Notes: at 30 September 2018.
(a) Prepaid expenses: insurance, $105; rates, $405.
(b) Expenses owing: rent, $300; telephone, $85.
(c) Inventory, $27,475.
(d) Depreciate motor van and office equipment at the rate of
20% on original cost.
28.10 The trial balance now shown was extracted from the books of
J. Webster as at 31 December 2017.
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The following are to be taken into account as at 31 December
2017.
(a) Inventory, $36,530.
(b) Insurance prepaid, $44.
(c) Wages outstanding, $506.
(d) Provision for doubtful debts to be increased to $880.
(e) Provide for depreciation for the year: fixtures, $2,200; motor
vans, $1,620.
You are required to prepare a trading and profit and loss account
(income statement) for the year ended 31 December 2017 and a
statement of financial position as at that date.
28.11X The following trial balance was extracted from the records of
J. Jordan, a trader, as at 31 December 2018.
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The following matters are to be taken into account at 31
December 2018.
(a) Inventory, $36,420.
(b) Expenses owing: sundry expenses, $62; motor expenses,
$33.
(c) Prepayment: rates, $166.
(d) Provision for doubtful debts to be reduced to $580.
(e) Depreciation for motors to be $2,100 for the year.
(f) Part of the premises was let to a tenant who owed $250 at
31 December 2018.
(g) Loan interest owing to P. Holland, $4,000.
You are required to draw up a trading and profit and loss account
(income statement) for the year ended 31 December 2018 and a
statement of financial position as at that date.
28.12X Jane Jones is in business as a hairdresser. From the figures
below, prepare her profit and loss account for the year ended 31
December 2017 and a statement of financial position on that
date.
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The following should be taken into consideration:
(a) Rates prepaid 31 December 2017, $30.
(b) One-third of motor car expenses including depreciation for
the year is to be regarded as private use.
(c) Provide for cleaning costs, $50.
(d) Depreciate all equipment on hand at 31 December 2017 by
10% of cost.
(e) Motor car is to be depreciated by 20% using reduced
balance method.
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29 The extended trial balance
Specific objectives
After you have studied this chapter you should be able to:
• enter balances from the general ledger and other records on the
extended trial balance
• deal with adjustments, including accruals and prepayments, and
enter them correctly on the extended trial balance
• enter the closing inventory valuation on the extended trial balance
• deal with other adjustments such as depreciation and provision for
doubtful debts and enter them on the extended trial balance
• deal with any errors and discrepancies and enter them on the
extended trial balance
• extend the extended trial balance entries into appropriate columns
of adjustments, profit and loss account and statement of financial
position and total them correctly.
29.1 Introduction
As already mentioned in Chapter 10, a trial balance is a list of all balances on
the double entry (the ledgers) accounts and the cash book at a particular point
in time. The main purpose of the trial balance is to ensure that the books
‘balance’ and, if any errors are identified, to make the necessary corrections.
Another important function of the trial balance is to provide the balances to
be used in preparation of the financial statements of the business, the trading
and profit and loss account (income statement) and the statement of financial
position.
29.2 The extended trial balance
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The extended trial balance is often referred to as a ‘worksheet’ which
provides a useful aid where a large number of adjustments are needed prior to
the preparation of the financial statements. The extended trial balance is
drawn up on specially preprinted stationery on which suitable columns are
printed. Exhibit 29.1 shows an example of an extended trial balance. You
may wish to photocopy this format and use it when carrying out some of the
student activities at the end of the chapter.
Exhibit 29.1 Format for an extended trial balance
It should be noted, however, that some examining bodies may require a
slightly different format which needs more columns. It is advisable to find
out in which format the examining body, whose syllabus you are studying,
require the extended trial balance to be shown.
29.3 Preparing the extended trial
balance
Once the trial balance has been drawn up and balanced off correctly, the next
task is to implement the following adjustments:
• accruals and prepayments
• include the closing inventory valuation
• make provision for depreciation and provision for doubtful debts
• correct any errors.
29.4 A worked example
In Exhibit 29.2 you will find the trial balance which was extracted from the
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books of Sam Taylor, a retailer, at 31 December 2017.
Exhibit 29.2
Notes:
(a) Rent owing amounted to $1,000 as at 31 December 2017.
(b) Rates paid in advance amounted to $500.
(c) Closing inventory was valued at $12,042 as at 31 December 2017.
(d) Depreciate the motor vehicle at 20% using the straight line method. Note:
Fixtures and fittings are not to be depreciated in this example.
(e) Provide for the creation of a provision for doubtful debts amounting to
2% of accounts receivable.
You are required to:
1 Prepare an extended trial balance at 31 December 2017.
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2 Prepare a trading and profit and loss account (income statement) for the
year ended 31 December 2017 and a statement of financial position as at
that date.
Since many students have difficulty in preparing extended trial balances, the
above example will be carried out using the ‘step-by-step guide’ shown
below.
Step-by-step guide
Step 1
First of all, draw up a trial balance in the usual way (refer to Chapter 10,
Exhibit 10.3).
Remember:
Debit balances are Assets or Expenses
and
Credit balances are Liabilities, Capital or Income.
If there have been no errors, then the two sides should agree. Refer to Exhibit
29.3 and note that the balances have now been entered on the ETB under the
heading ‘ledger balances’.
Step 2
Deal with the adjustments at the bottom of the trial balance.
Note: Each item must be dealt with twice to comply with the double entry
rules.
Adjustments fall into four categories:
1 accruals
2 prepayments
3 closing inventory valuation
4 other adjustments:
• depreciation provision
• provision for doubtful debts
• correction of errors.
When dealing with adjustments think double entry, that is,
which account should be debited
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and
which account should be credited.
When entering the adjustment on the extended trial balance, first of all look
to see if there is already an account for the transaction and, if so, use it. If not,
then open an account at the foot of the extended trial balance. (This is
illustrated in the following examples.)
Step 3
Deal with accruals and prepayments.
1 Accruals (amounts owing)
For example, referring to Exhibit 29.2 note (a), rent owing amounts to
$1,000, this is entered as follows:
Debit: Rent account $1,000
Credit: Accruals – Rent $1,000 (as this item is a liability).
This transaction is labelled in Exhibit 29.3 as (a) in the adjustments column –
see the debit entry of $1,000 next to the ‘Rent account’ and the credit entry of
$1,000 entered below the totals of the trial balance under the heading
‘Accruals – rent’.
2 Prepayments (amounts paid in advance)
Note (b) of Exhibit 29.2 shows a rates prepayment of $500, which is entered
as follows:
Debit: Prepayments – rates $500
Credit: Rates account $500.
This again is shown in Exhibit 29.3 as (b) in the adjustments column – see
the debit entry of $500 entered below the totals of the trial balance under the
heading ‘Prepayment – rates $500’ and the corresponding credit entry shown
for ‘Rates and insurance’.
3 Dealing with the closing inventory valuation
At the end of the financial year a business usually undertakes an inventory
valuation. Note (c) of Exhibit 29.2 shows a closing inventory of $12,042,
which is entered as follows:
Debit: Inventory account (to be shown in the statement of financial
position as an asset)
Credit: Inventory account (shown in the profit and loss account as a
deduction from the cost of goods sold calculation).
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This is labelled in Exhibit 29.3 as (c) against the trial balance totals in the
adjustments column.
4 Dealing with other adjustments
Depreciation provision – Note (d) of Exhibit 29.2 requires provision for
depreciation of 20% on motor vehicles using the straight line method. Motor
vehicles cost $9,000, therefore, 20% of cost equals $1,800 depreciation to be
charged against the profit and loss account. This transaction is entered on the
extended trial balance in the adjustments column in Exhibit 29.3, see items
labelled (d) as follows:
Debit: Depreciation of motor vehicle $1,800 (amount to be charged to
profit and loss account)
Credit: Depreciation provision of motor vehicle $1,800 (amount to be
shown as a deduction from the value of the asset in the statement
of financial position).
Provision for doubtful debts – Note (e) of Exhibit 29.2 requires the creation
of a provision for doubtful debts amounting to 2% of the accounts receivable
figure of $23,200 which amounts to $464. The entry in the extended trial
balance will appear in the adjustments column – see items labelled (e) in
Exhibit 29.3 as follows:
Debit: Creation of provision for doubtful debts $464 (this amount to be
charged in the profit and loss account)
Credit: Provision for doubtful debts $464 (this amount to be shown as
deduction from the accounts receivable in the statement of
financial position).
Correction of errors – To keep the worked example as straightforward as
possible, no errors require correcting in Exhibit 29.2.
Step 4
The next step is to add up both parts of the adjustments column. Providing
the adjustments have been carried out correctly, the two columns should
agree – in other words, the adjustments column acts rather like a mini trial
balance.
Step 5
It is now necessary to add/subtract the figures across the extended trial
balance and enter the total in either the profit and loss account or in the
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statement of financial position column. This step requires a certain amount of
skill from the students since they must be fully conversant with the position
of each balance figure in the financial statements. A useful hint is to carry out
this identification before starting the analysis by entering either of the
following immediately before the description column (see Exhibit 29.3),
namely:
• PL Profit and loss account
• SFP Statement of financial position
to indicate which analysis column to use.
It is important to note when carrying out the analysis that if the balance is
shown as a debit balance in the ledger balance column then it will appear as a
debit balance in either the profit and loss account column or the statement of
financial position column. The same thing applies to the credit balances,
which will appear in either the profit and loss account column or statement of
financial position column as a credit balance. While carrying out the analysis,
any figures appearing in the adjustments column must be taken into
consideration; for example, referring to items labelled (a) in Exhibit 29.3, the
balance of rent will be analysed as:
This will be analysed into the profit and loss account column as a debit
balance of $12,000.
Note: Refer to Exhibit 29.3 where this task has been carried out.
A further example can also be seen in items labelled (b) Exhibit 29.3
where the prepayment of rates $500 will be analysed as follows:
The amount to be shown in the profit and loss account column will be $3,400
debit balance.
Step 6
Add up the profit and loss account columns. The difference between the two
figures will represent a profit or loss for the period. In our example of Sam
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Taylor, the difference between these two columns is $14,402, representing a
net profit. This figure will now be entered on the extended trial balance as net
profit $14,402, a debit entry in the profit and loss account column.
The corresponding credit entry will appear under the statement of financial
position columns.
Helpful Hint!
Get the appropriate stationery and practise filling in the above table
after you have read and understood it. Did you fill in your document
correctly? If you didn’t, re-read the appropriate section in the book to
ensure you understand what you did wrong.
Step 7
The only remaining task to carry out is to add up the statement of financial
position column totals and, provided all transactions have been carried out
correctly, the totals should agree.
Note: Refer to Exhibit 29.3 where you can see that the extended trial
balance balances with a total of $79,042.
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Exhibit 29.3 Sam Taylor – extended trial balance at 31 December 2017
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Exhibit 29.4
29.5 Other considerations
In the above example of Sam Taylor, the transactions involving depreciation
and provision for doubtful debts were kept as straightforward as possible to
avoid complications. However, assuming it is the next accounting period of
Sam Taylor, the following adjustments will now be shown:
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1 Depreciate the motor vehicle by 20% using the straight line method (for
the second year).
2 Increase the provision for doubtful debts to $550.
3 Write off a bad debt amounting to $100.
1 Depreciate the motor vehicle by 20% using the straight line method
First of all, the amount of depreciation to be charged against the profit and
loss account needs to be calculated. As the method of depreciation to be used
is the straight line method, the amount of depreciation will be the same each
year, namely, 20% of $9,000 = $1,800. This amount is then entered on the
extended trial balance as follows:
The above example shows that the motor vehicle account remains a debit
balance of $9,000 which appears in the statement of financial position
column as a debit (an asset). The provision for depreciation of motor vehicle
appears under the ledger balances column as $1,800, representing the amount
of depreciation charged for the first year. To this figure another $1,800 is
added representing the depreciation for this year showing a total of
depreciation to date of $3,600. This is shown as a credit balance in the
statement of financial position column of the extended trial balance.
When the statement of financial position is prepared it will appear as
follows:
The remaining debit balance of depreciation of motor vehicle $1,800 will be
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charged in the profit and loss account. This is shown in the extended trial
balance under the profit and loss account column as a debit balance (see
above in the extended trial balance extract).
2 Increase the provision for doubtful debts to $550
In the accounts for the year ended 31 December 2017, Sam Taylor created
a provision for doubtful debts equal to 2% of the accounts receivable which
amounted to $464 (this is illustrated in the extract from extended trial balance
below).
In the year to 31 December 2018, it was decided to increase the provision
to $550, representing an increase of $86 ($550 less $464). To record this
increase, the following entries need to be made:
• Show the increase of provision for doubtful debts of $86 as a debit entry in
the adjustments column to be charged in the profit and loss account.
• Increase the existing ‘provision for doubtful debts account’ by $86 to $550;
this will be shown as a credit entry in the adjustments column of the
extended trial balance.
This figure is then extended to the statement of financial position column as
$550 (credit entry).
This can now be seen in the following extract from the extended trial
balance.
3 Write off a bad debt amounting to $100
After the preparation of the draft accounts one of the business’s customers
was reported to have been declared bankrupt. The balance on the customer’s
account was $100 and it was decided to write the debt off as bad.
This would be entered on the extended trial balance as follows:
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Helpful Hint!
Examination Tip:
Ensure that you know the categories of adjustments and the specific
types of adjustments and whether to debit or credit the relevant
accounts.
The above entries show that the accounts receivable, which we have assumed
are $26,000 for this year ended 2018, have been reduced by $100 and will
appear in the statement of financial position as $25,900. The bad debt will
also be charged to the profit and loss account. This is shown as a debit entry
in both the adjustments column and the profit and loss account column.
Summary
• The extended trial balance is often referred to as a ‘worksheet’
since it provides a useful aid where a large number of adjustments
are needed prior to the preparation of the financial statements.
• Initially a trial balance is prepared in the usual way with debit
balances consisting of assets or expenses and credit balances
being liabilities, capital or income.
• At the end of the financial year there are often several adjustments
to be made. These consist of accruals and prepayments, closing
inventory valuation and making provisions for depreciation and
doubtful debts.
• It is important to remember that each adjustment must be recorded
twice on the extended trial balance, one being a debit entry the
other the credit entry.
• A careful systematic approach must be applied when entering
items in the extended trial balance. Each category must be entered
one step at a time, that is, accruals, prepayments, dealing with the
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closing inventory valuation and then other adjustments.
• It is important to ensure that the ‘adjustment columns’ add up
correctly, rather like a mini-trial balance.
• The next step is to add/subtract the figures across the extended
trial balance entering the total in either the profit and loss or
statement of financial position columns. The balancing figure in the
profit and loss columns represents the profit or loss for the period
which is also entered in the statement of financial position columns.
All columns are then added up with each section agreeing.
• Finally, the financial statements can be prepared, that is, the
trading and profit and loss accounts (income statement) and the
statement of financial position.
Chapter 29 Exercises
Note: A blank worksheet for preparing extended trial balance
exercises is given in Appendix B and on the website.
29.1 The following trial balance contains some errors and you are
required to reconstruct it after making the necessary corrections.
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29.2 From the following list of balances taken from the books of G.
Causwell, you are required to draw up a trial balance as at 31
December 2017.
29.3X From the list of balances from the accounts of Reitzen & Co.,
you are required to prepare a trial balance as at 31 December
2016.
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29.4 The following is a list of balances extracted from the books of J
Samuda, a sole trader, as at 31 January 2018.
The following additional information is available as at 31 January
2018:
(a) Wages unpaid amounted to $351.
(b) Insurance paid in advance $600.
(c) Closing inventory was valued at $14,730.
You are required to take the above adjustments into account and
prepare the figures for the final accounts for J. Samuda for the
year ended 31 January 2018, using the extended trial balance.
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Note: Remember to use the blank extended trial balance
worksheet in Appendix B and on the website.
29.5X The following is a list of balances taken from the ledgers of C.
Travares as at 31 July 2018, the end of the financial year.
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The following additional information is available as at 31 July
2018:
(a) Motor expenses owing $200.
(b) Insurance paid in advance $3,500.
(c) Closing inventory was valued at $30,700.
(d) Depreciate motor vehicles at 25% and fixtures and fittings at
15% per annum using the straight line method.
You are required to take the above adjustments into account and
prepare the figures for the final accounts of C. Travares for the
year ended 31 July 2018, using the extended trial balance.
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30 Inventory valuation
Specific objectives
After you have studied this chapter you should be able to:
• understand that there can be more than one way of valuing
inventory
• calculate the value of inventory using three different methods
• understand how the closing inventory valuation affects the profit
figures
• adjust inventory valuations, where necessary, by a reduction to net
realisable value
• adjust inventory valuations in respect of goods on sale or return
• understand the importance of the final inventory valuation figure
that appears in the statement of financial position and maintaining
appropriate inventory levels.
30.1 Different valuations of inventory
Inventory is the name given to goods purchased for re-sale; it can also
include work in progress and raw materials, which you will learn about
in Chapter 37.
Most people would assume that there can only be one figure for the
valuation of inventory. This is, however, untrue. This chapter will examine
how the valuation of inventory can be calculated using different figures.
Assume that a business has just completed its first financial year and is
about to value inventory on hand at cost price. The business has only dealt
with one type of goods. A record of the transactions is now shown below in
Exhibit 30.1.
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Exhibit 30.1
The balance of inventory on hand at 31 December 2017 is 8 units. The total
figure of purchases is $1,440 and that of sales is $1,840. The trading account
for the first year of trading can now be completed if the closing inventory is
brought into the calculations.
But what value do we put on each of the 8 units left in inventory at the end
of the year? If all of the units bought during the year had cost $30 each, then
the closing inventory would be 8 x $30 = $240. However, we have bought
goods at different prices. This means that the valuation depends on which
goods are taken for this calculation: the units at $30, or those at $34, or yet
others at $40.
Many businesses do not know exactly whether they have sold all the oldest
units before they sell new units. For instance, a business selling spanners may
not know whether the oldest spanners had been sold before the newest
spanners.
The inventory valuation will, therefore, be based on an accounting custom,
and not on the facts of exactly which units were still in inventory at the year
end. The three main methods of doing this are now shown.
30.2 First in, first out method
This is usually known as FIFO, the first letters of each word. The method
says that, as far as the accounts are concerned, the first goods to be received
are the first to be issued. Using the figures in Exhibit 30.1, we can now
calculate the closing figure of inventory as follows:
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The closing inventory at 31 December 2017 is therefore valued at $320 using
the FIFO method.
30.3 Last in, first out method
This is usually known as LIFO. As each issue of goods is made, the goods
are said to be from the last batch received before that date. Where there is not
enough left of the last batch, then the balance of goods needed is said to come
from the previous batch still unsold.
From the information shown in Exhibit 30.1, the calculation under this
basis can now be shown.
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The closing inventory at 31 December 2017 is therefore valued at $240 using
the LIFO method.
30.4 Average cost method (AVCO)
Using the AVCO method, with each receipt of goods the average cost for
each item of inventory is recalculated. Further issues of goods are then at that
figure, until another receipt of goods means that another recalculation is
needed.
From the information in Exhibit 30.1, the calculation can be shown thus:
Helpful Hint!
Question:
How do the opening and closing inventory figures compare in the
above three methods? Are they the same or different? Give reasons
for your answers.
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Note: *In April, the average cost is calculated as follows:
inventory 10 × $30 = $300 + inventory received (10 x $34) $340 = total
$640
20 units in inventory, so the average is $640 ÷ 20 = $32.
**In October, the average is calculated as follows:
inventory 12 × $32 = $384 + inventory received (20 x $40) $800 = $1,184.
32 units in inventory, so the average is £1,184 ÷ 32 = £37.
The closing inventory at 31 December 2017 is therefore valued at $296
using the AVCO method.
30.5 Inventory valuation and the
calculation of profits
Using the figures from Exhibit 30.1, with inventory valuations shown by the
three methods of FIFO, LIFO, and AVCO, the trading accounts would appear
as set out in the table.
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As can be seen from the table above, different methods of inventory valuation
will mean that different profits are shown.
30.6 Reduction to net realisable value
The net realisable value of inventory is calculated as follows:
Saleable value (what it can be sold for) less any expenses needed to
complete the item or get it in a condition to be sold = Net realisable value.
The concept of prudence is used when inventory is valued. Inventory
should not be overvalued; otherwise, profits shown will be too high.
Therefore, if the net realisable value of inventory is less than the cost of the
inventory, prudence dictates that the figure to be taken for the final accounts
is that of net realisable value.
Example 1: An item of inventory was purchased at cost price $300.
Unfortunately, the item was damaged in the warehouse and the cost of repair
and repainting amounted to $50 after which it was estimated it could be sold
for $200. The item would be valued as follows:
Saleable value $200 less cost of repair and repainting $50 = Net realisable
value of $150.
30.7 Goods on sale or return
Goods received on sale or return
Sometimes we may receive goods from a supplier on a sale or return basis.
This means that we do not have to pay for the goods until we sell them. If we
do not sell them we have to return them to our supplier.
This means that the goods do not belong to us. If we have some goods on
sale or return at the inventory checking date, they should not be included in
our inventory valuation.
Goods sent to our customers on sale or return
We may send goods on a sale or return basis to our customers. The inventory
will belong to us until it is sold. At our inventory checking date, any goods
held by our customers on sale or return should be included in our inventory
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valuation.
30.8 The inventory check and the
statement of financial position
Students often think that all the counting and valuing of inventory is done on
the last day of the accounting period. This might be true in a small business,
but it is often impossible in larger businesses. There may be too many items
of inventory to do it so quickly.
This means that inventory check may take place over a period of days. To
get the figure of the inventory valuation as on the last day of the accounting
period, we will have to make adjustments. Exhibit 30.2 gives an example of
such calculations.
Lee Ltd has a financial year that ends on 31 December 2017. However, the
inventory check is not carried out until 8 January 2018. When the items in
inventory on that date are priced out at cost, it is found that the inventory
value amounts to $28,850. The following information is available about
transactions between 31 December 2017 and 8 January 2018.
(a) Purchases since 31 December 2017 amounted to $2,370 at cost.
(b) Returns inwards since 31 December 2017 were $350 at selling price.
(c) Sales since 31 December 2017 amounted to $3,800 at selling price.
(d) The selling price is always cost price + 25%.
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Exhibit 30.2
Note: *Inventory is at cost (or net realisable value) and not at selling price.
As this calculation has a sales figure in it, which includes profit, we must
deduct the profit part to get to the cost price. This is true also for returns
inwards.
At one time it was very rare for auditors to attend at inventory checking
time as observers. The professional accounting bodies now encourage
auditors to be present if at all possible.
30.9 Inventory levels
Helpful Hint!
Examination Tip:
List the three inventory valuation methods. Be able to calculate the
cost price for closing inventory using each method.
One of the most common faults found in the running of a business is that too
high a level of inventory is maintained. A considerable number of businesses
that have problems with a shortage of finance will find that they can help
matters by having a sensible look at the amounts of inventory they hold. It
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would be a very rare business indeed which, if they had not investigated the
matter previously, could not manage to let parts of their inventory run down.
As this would save spending cash on items not really necessary, this cash
could be better utilised elsewhere.
Summary
• There are three methods of valuing inventory namely: first in, first
out (FIFO), last in, first out (LIFO) and the average cost method
(AVCO).
• Each of the above methods gives a different closing inventory
valuation that subsequently affects the profit figure. The lower the
closing inventory figure the lower the profit while the higher the
closing inventory figure the higher the profit.
• Net realisable value is the sales value of goods less expenses
before sale.
• When a business supplies goods to a customer on sale or return
they belong to the supplier until such time as the customer decides
they wish to purchase them and an order is placed.
• It may be necessary to make adjustments to the final inventory
figure which appears in the statement of financial position
depending upon when the physical inventory take has taken place.
• It is important that businesses do not maintain a high level of
inventory since this means funds are tied up, which could cause a
cash flow problem.
Chapter 30 Exercises
30.1 Rule up a card suitable for the recording of the quantity of an
item in inventory. The card should show receipts, issues and
balance. The names of suppliers should be shown against
receipts, and the requisition number against issues.
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30.2 Henriques is a sole trader whose year end is 31 January each
year. Owing to pressure of business, he is unable to value his
inventory in trade at the close of business on 31 January 2017
but he does so on 7 February 2017 when the value, at cost price,
is calculated at $2,830.
For the period 1–7 February his purchases were $296, of which
goods costing $54 were in transit at the time of inventory
checking.
Sales for the period 1–7 February amounted to $460, all of which
had left the warehouse at the time of inventory checking. His
gross profit is 20% of sales.
Also during the period 1–7 February, Henriques took goods
costing $38 for his personal use. Included in the valuation figure
of $2,830 given above were goods that cost $120, but which had
a market price of $97 only at the date of the year end, that is, 31
January 2017.
Required: Calculate the figure that should be shown as
‘Inventory valuation at 31 January 2017’ in Henriques’ trading
account for the year ended 31 January 2017.
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Note: Calculations must be shown.
30.3X C. Jones, a builders’ merchant, has no reliable method of
recording his inventory receipts and issues. At the present time
he has no means of obtaining a valuation for his inventory-intrade (without undertaking a lengthy and costly inventory
checking).
Jones has produced the following data from the month ended 30
September 2017.
All inventory and purchases are priced at $50 per tonne. All
issues of inventory are priced at $65 per tonne.
You are required to show Jones’ trading account for the month
ended 30 September 2017.
30.4 (a) From the following figures, calculate the closing inventoryin-trade that would be shown using (i) FIFO, (ii) LIFO, (iii) AVCO
methods.
There was no opening inventory in hand.
(b) Draw up trading accounts for 2016 using each of the three
methods for inventory valuation.
30.5 Receipts and issues of an inventory item are as follows.
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There was no opening inventory in hand.
(a) You are required to calculate the closing inventory-in-trade
using (i) FIFO; (ii) LIFO; (iii) AVCO.
(b) Draw up the trading account for the year ended 31
December 2017 showing the different reported gross profits
from the figures given in (a).
30.6X (a) From the following figures, calculate the closing inventoryin-trade that would be shown using:
(i) FIFO,
(ii) LIFO
(iii) AVCO methods.
There was no opening inventory-in-hand.
(b) Draw up trading accounts for 2017 using each of the three
methods for inventory valuation.
30.7X You are valuing inventory at your business as it was at 31
December 2017. The actual date on which the inventory was
taken was 7 January 2018. The inventory sheets show a total of
$85,980 at cost as on that date. You are to adjust this figure to
find out the inventory as at 31 December 2017. The rate of gross
profit was 25% on selling price.
On further scrutiny you find:
• goods received after 1 January and for which invoices bear
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•
•
•
•
the date of January amounted to $3,987
one of the inventory sheets has been added up to give a total
of $4,897 instead of $4,798
goods selling at $480 had been sent to a customer on ‘sale or
return’ during December; these had not been sold to the
customer and had been omitted from the inventory figures
an item of 360 items priced at $1.60 each had been extended
on the inventory sheets as $420
goods had been returned to suppliers amounting to $98 during
the first week of January.
30.8X JCD Ltd, which deals in radios, has the following purchases
for May 2017:
JCD Ltd sold 15 radios at $40 each on 16 May, and 10 radios
$45 each on 28 May.
(a) Use the FIFO method to calculate the following:
(i) value of closing inventory at 31 May 2017
(ii) gross profit.
(b) Use the LIFO method to calculate the following:
(i) value of closing inventory at 31 May 2017
(ii) gross profit.
(CSEC style)
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31 Errors and their effect on
accounting records
Specific objectives
After you have studied this chapter you should be able to:
• appreciate that every transaction should be entered twice in the
accounts: once on the debit side and once on the credit side of an
account
• understand that there are two types of error: those that effect the
agreement of the trial balance and those that do not
• appreciate that errors are usually identified after a period of time
has elapsed
• distinguish between the different kinds of errors
• correct errors using the journal.
31.1 Introduction
So far you have learnt that each accounting transaction requires two entries:
• one entry must be on the debit side of an account, and
• one entry must be on the credit side of an account.
At the end of an accounting period, each account is balanced up and a trial
balance drawn up to check the arithmetical accuracy of the book-keeping
entries. Provided that every item has been entered correctly, the two sides of
the trial balance should equal each other, that is:
However, it is inevitable that errors will occur when data is entered into the
books of account.
There are two main classifications of errors:
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• those that affect the balancing of the trial balance
• those that do not affect the balancing of the trial balance.
Errors affecting trial balance agreement
These errors result in the total of the debit columns in the trial balance not
being the same as the total of the credit column. Suppose we correctly entered
cash received of $103 from H. Lee, our customer, in the cash book as shown
below:
However, when posting this item to H. Lee’s account we entered the amount
received on the credit side as $13, see below:
When the trial balance is drawn up, the totals will be different by ($103 –
$13) = $90. This effect will arise in every case where a debit entry does not
equal a credit entry for a transaction. Correction of these types of errors is
covered in Chapter 32.
Errors not affecting trial balance agreement
Although the trial balance totals agree, complete accuracy cannot be
guaranteed. Certain errors can still be made which do not affect the balancing
of the trial balance, that is, the trial balance would still appear to balance even
though certain errors have occurred. The errors that lead to this situation are
listed below:
Helpful Hint!
Discussion:
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Write a brief explanation of why you think some errors affect the trial
balance while others do not. Discuss your answer with your teacher
or an accountant.
• errors of commission – where a correct amount is entered, but in the
wrong person’s account
• errors of principle – where an item is entered in the wrong type of
account, for example a non-current asset entered in an expense account
• errors of original entry – where an item is entered, but both debit and
credit entries are of the same incorrect amount
• errors of omission – where a transaction is completely omitted from the
books.
• compensating errors – where two errors of equal amounts but on opposite
sides of the accounts cancel out each other
• complete reversal of entries – where the correct amounts are entered
in the correct accounts, but each item is shown on the wrong side of each
account.
In Sections 31.3 to 31.8, each of the above errors are illustrated together with
the journal entries required to correct the error.
31.2 Correction of errors
Most errors are discovered after a period of time has elapsed. Once identified,
they need to be corrected properly via the journal and not by crossing out
items or tearing a page out of a ledger or even using correcting fluid. If the
latter was permitted, then there is more risk of fraudulent transactions taking
place.
Corrections are recorded in the journal which, as already mentioned in
Chapter 22, is a book of original entry. By entering them in the journal, a
permanent record is made for future reference.
Since many students have difficulty with journal entries, you may
remember from Chapter 22 that it is often useful to think ‘double entry’
before entering the details in the journal. In other words, think where the
transaction has been entered in the double entry accounts and then where the
entry should have been made; this then gives you the basis for preparing the
journal entry. Work through the following sections with this in mind.
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31.3 Errors of commission
An error of commission arises when a correct amount is entered in the
books, but in the wrong person’s account.
Example 1: D. Long paid us $50 by cheque on 18 May 2017. The
transaction is correctly entered in the cash book, but it was entered by
mistake in the account for T. Lee. This means that there had been both a debit
of $50 and a credit of $50. It has appeared in the personal account as:
The error was found on 31 May 2017. This will now have to be corrected and
requires two entries:
Accounting entries
Debit T. Lee’s
account
Credit D. Long’s
account
Explanation
To cancel out the error on the credit side of that
account
To enter the amount in the correct account
The accounts will now appear thus:
The journal
The ways by which errors have been corrected should all be entered in the
journal. The correction has already been shown above in double entry. In
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fact, the journal entries should be made before completing the double entry
accounts for the transaction. For teaching purposes only in this chapter, the
journal entries are shown last.
The journal entry will be thus:
31.4 Errors of principle
An error of principle is where a transaction is entered in the wrong type of
account. For instance, the purchase of a non-current asset should be debited
to a non-current asset account. If in error it is debited to an expense account,
then it has been entered in the wrong type of account.
Example 2: The purchase of a motor car for $5,500 by cheque on 14 May
2017 has been debited in error to a motor expenses account. In the cash book
it is shown correctly. This means that there has been both a debit of $5,500
and a credit of $5,500.
It will have appeared in the expense account as:
The error is detected on 31 May 2017 and is corrected. To do so, two entries
are needed:
Accounting entries Explanation
Debit Motor Car
To put the amount in the correct account
account
Credit Motor
To cancel the error previously made in the
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Expenses account
Motor Expenses account
The accounts then are corrected thus:
The journal entries to correct the error will be shown as:
31.5 Errors of original entry
An error of original entry occurs where an original amount is entered in
the accounting records incorrectly.
Example 3: Sales of $150 to T. Marley on 13 May 2017 have been entered
as both a debit and a credit of $130. The accounts would appear thus:
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The error is found on 31 May 2017. The entries to correct it are now shown:
To correct the error, the journal entries will be:
31.6 Errors of omission
Errors of omission are where transactions are not entered into the books at
all.
Example 4: We purchased goods from C. Richards for $250 on 13 May
2017 but did not enter the transaction in the accounts. So there were nil debits
and nil credits. We found the error on 31 May 2017. The entries to correct it
will be thus:
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The journal entries to correct the error will be:
31.7 Compensating errors
Compensating errors cancel each other out.
Example 5: Let us take a case where incorrect totals had purchases of
$7,900 and sales of $9,900. The purchases day book adds up to be $100 too
much. In the same period, the sales day book also adds up to be $100 too
much.
If these were the only errors in our books, the trial balance totals would
equal each other. Both totals would be wrong – they would both be $100 too
much – but they would be equal. In this case, the accounts would have
appeared as follows:
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When corrected, the accounts will appear as:
Journal entries to correct these two errors will be thus:
31.8 Complete reversal of entries
This error is where the correct amounts are entered in the correct accounts,
but each item is shown on the wrong side of each account.
Example 6: We pay a cheque for $200 on 28 May 2017 to D. Charles. We
enter it as follows in accounts with the letter (A). There has, therefore, been
both a debit and a credit of $200.
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This is incorrect. It should have been debit D. Charles Account $200, credit
Bank $200. Both items have been entered in the correct accounts, but each is
on the wrong side of its account.
The way to correct this is more difficult to understand than with other
errors. Let us look at how the items would have appeared if we had done it
correctly in the first place. We will show the letter (B) behind the account
names.
We found the error on May 31 and it was corrected as follows:
1 First we have to cancel the error. This would mean entering these amounts:
Dr: D. Charles $200
Cr: Bank
$200
2 Then we have to enter up the transaction:
Dr: D. Charles $200
Cr: Bank
$200
Altogether then, the entries to correct the error are twice the amounts first
entered.
When corrected, the accounts appear as follows, marked (C).
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You can see that accounts (C) give the same final answer as accounts (B).
Journal entries would be shown as follows:
Helpful Hint!
Examination Tip:
Write a sentence on the type of error you have identified in an
examination question and how it will affect the accounts of the
business before carrying out the correction. You will then find it useful
to refer to your sentence as you do any correction needed.
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31.9 Casting
You will often notice the use of the expression casting, which means adding
up. Overcasting means incorrectly adding up a column of figures to give an
answer that is greater than it should be. Undercasting means incorrectly
adding up a column of figures to give an answer that is less than it should be.
Summary
• Periodically businesses balance their accounts and prepare a trial
balance to check the arithmetical accuracy of the book-keeping
entries. However, agreement in the trial balance does not
necessarily mean that no errors have occurred.
• There are two types of errors: those that affect the balancing of the
trial balance and those that do not.
• Errors that can occur and yet the trial balance still agree are errors
of commission, principle, original entry, omission, compensating
and complete reversal of entries.
• Once identified, the errors are corrected by using the journal.
However, it is sometimes easier for students to carry out the double
entry first followed by the journal entry. In normal circumstances
you would prepare the journal entry first followed by postings to the
appropriate ledger accounts.
• The term ‘casting’ refers to figures that are added up. Overcasting
means adding figures up to an amount greater than they should be,
whereas, undercasting means adding a column of figures up to
less than it should be.
Chapter 31 Exercises
31.1 Show the journal entries necessary to correct the following
errors.
(a) A sale of goods $678 to J. Harris had been entered in J.
Hart’s account.
(b) The purchase of a machine on credit from L. Pyle for $4,390
had been completely omitted from our books.
(c) The purchase of a motor van $3,800 had been entered in
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error in the motor expenses account.
(d) A sale of $221 to E. Fitzwilliam had been entered in the
books, both debit and credit, as $212.
(e) Commission received $257 had been entered in error in the
sales account.
31.2X Show the journal entries needed to correct the following
errors.
(a) Purchases of $699 on credit from K. Wong had been
entered in H. Wood’s account.
(b) A cheque of $189 paid for advertisements had been entered
in the cash column of the cash book instead of in the bank
column.
(c) Sale of goods $443 on credit to B. Ming entered in error in
B. Gordon’s account.
(d) Purchase of goods on credit K. Isaacs $89 entered in two
places in error as $99.
(e) Cash paid to H. Marcano $89 entered on the debit side of
the cash book and the credit side of H. Marcano’s account.
31.3 The following errors have been found in the accounts at the
year end 31 March 2018.
(a) A receipt of $400 from Paul Palmer, a customer, had been
entered in the cash book correctly but was posted to the
account of Brian Palmer in error.
(b) The purchase of a new computer costing $5,000 had been
posted in error to the stationery account.
(c) A purchase invoice from Belfields Marketing Agency for
services rendered amounting to $683 had accidently been
thrown away and not entered in the accounting records. The
error was only discovered when the Agency rang asking for
payment of the outstanding invoice.
(d) A sales invoice for goods sold on credit to Kirkham & Co for
$760 had been entered in both the sales account and the
personal account of Kirkham & Co as $670.
Required:
Prepare journal entries to correct the errors shown above,
narratives are not required.
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31.4X R. James drew up the following statement of financial position
on 31 December 2017.
When checking the books, the following errors and omissions
were found.
(i) A purchase of fittings, $140, had been included in the
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purchases account.
(ii) Motor vehicles should have been depreciated by $280.
(iii) A debt of $41 included in accounts receivable was
considered to be bad.
(iv) Closing inventory had been overvalued by $124.
Required:
(a) show your calculation of the correct net profit
(b) draw up a corrected statement of affairs as at 31 December
2017.
31.5X Tom Ainsworth runs a successful stationery business. After
preparation of his month end accounts the following errors were
revealed:
(a) The sale of unwanted fixtures and fittings for $1,000 had
been credited to the sales account.
(b) Expenditure incurred repairing the motor van $420, had
been debited to motor van account.
(c) A payment of $800 received from C. Clark had been posted
in error to the credit of C. Clarkson’s account.
(d) Drawings of $500 taken by Mr Ainsworth had been debited
to the salaries account.
(e) A payment of $240 for office cleaning had been debited to
office equipment account.
Required:
Write up journal entries, including narratives, to correct the
above errors.
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32 Suspense accounts and
errors
Specific objectives
After you have studied this chapter you should be able to:
• understand the reason for using a suspense account
• create a suspense account in order to balance the trial balance
• correct errors using a suspense account
• recalculate profits after errors have been corrected
• appreciate the limitations of trial balances.
32.1 Introduction
In the previous chapter errors that did not affect the balancing of the trial
balance were discussed. However, there are many errors which occur that do
affect the balancing of the trial balance, for example:
• incorrect additions in any account
• making an entry on only one side of the accounts – for example a debit but
no credit, or a credit but no debit
• entering a different amount on the debit side from the amount on the credit
side.
32.2 Suspense account
We should try very hard to find errors immediately when the trial balance
totals are not equal. When they cannot be found, the trial balance totals
should be made to agree with each other by inserting the amount of the
difference between the two sides in a suspense account. This occurs in
Exhibit 32.1, where there is a $40 difference in the trial balance of S. James.
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To make the two totals the same, a figure of $40 for the suspense account has
been shown on the credit side. A suspense account is opened and the $40
difference is also shown there on the credit side.
Exhibit 32.1
32.3 Suspense account and the
statement of financial position
If the errors are not found before the financial statements are prepared, the
suspense account balance will be included in the statement of financial
position. Where the balance is a credit balance, it should be included under
current liabilities on the statement of financial position. When the balance is a
debit balance, it should be shown under current assets on the statement of
financial position. Large errors should always be found before the financial
statements are drawn up.
32.4 Correction of errors
When errors are found, they must be corrected using double entry. Each
correction must be described by an entry in the journal.
One error only
We will look at two examples:
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Example 1: Assume that the error of $40 as shown in Exhibit 32.1 is found
in the following year on 31 March 2018, the error being that the sales account
was undercast by $40. The action taken to correct this is:
• Debit the suspense account to close it: $40.
• Credit the sales account to show the item where it should have been: $40.
The accounts now appear as Exhibit 32.2.
Exhibit 32.2
This can be shown in journal form as follows:
Example 2: The trial balance on 31 December 2017 shows a difference of
$168. It was a shortage on the debit side. A suspense account is opened and
the difference of $168 is entered on the debit side.
On 31 May 2018, the error is found. We had made a payment of $168 to K.
Small to close his account. It was correctly entered in the cash book, but it
was not entered in Small’s account.
To correct the error, the account of K. Small is debited with $168, as it
should have been in 2017, and the suspense account is credited with $168 so
that the account can be closed. The accounts and journal entry now appear as
in Exhibit 32.3.
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Exhibit 32.3
Helpful Hint!
Practice Tip:
Lots of practice is needed to be able to correct errors properly in
accounting. Take a few publicly available accounting reports from
newspapers, the internet, etc., and practise using these to identify
any correction of errors.
More than one error
We can now look at an example where the suspense account difference has
been caused by more than one error.
Example 3: A trial balance at 31 December 2017 shows a difference of
$77, being a shortage on the debit side. A suspense account is opened, and
the difference of $77 is entered on the debit side of the account.
On 28 February 2018, all the errors from the previous year were found:
(a) A cheque of $150 paid to L. King had been correctly entered in the cash
book, but had not been entered in King’s account.
(b) The purchases account has been undercast by $20.
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(c) A cheque of $93 received from K. Saunders has been correctly entered in
the cash book but has not been entered in K. Saunders’ account.
These three errors have resulted in a net error of $77, shown by a debit of $77
on the debit side of the suspense account.
These are corrected by:
• making correcting entries in the accounts for (a), (b) and (c)
• recording the double entry for these items in the suspense account.
These are now shown in Exhibit 32.4:
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Exhibit 32.4
Only those errors that make the trial balance totals different from each other
have to be corrected via the suspense account.
32.5 The effect of errors on profits
Some of the errors will have meant that the calculation of original profits will
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be wrong. Other errors will have no effect upon profits. We will use Exhibit
32.5 to illustrate the different kinds of errors. Exhibit 32.5 shows a set of
accounts in which errors have been made.
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Exhibit 32.5
Errors that do not affect profit calculations
If an error affects items only in the statement of financial position, then the
original calculated profit will not need altering. The example below shows
this:
Example 4: Assume that in Exhibit 32.5 the $60 debit balance on the
suspense account shown in the statement of financial position was because,
on 1 November 2017, we paid $60 to a supplier, T. Monk and it was correctly
entered in the cash book, but it was not entered anywhere else. The error was
found on 1 June 2018.
We can see that when this error is corrected, only two items in the final
accounts will have to be altered. These are (F) accounts payable, which will
have to be reduced by $60, and (G) suspense account, which will now be
cancelled and not shown in the statement of financial position. This means
that neither the trading account nor the profit and loss account have been
affected. The profit as shown for 2017 is correct, but the statement of
financial position is incorrect.
The double entry records needed are as follows:
The journal entries to correct it will be thus:
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Errors that do affect profit calculations
If the error is in one of the entries labelled (A), (B), (C) or (D) shown in the
trading and profit and loss account, then the original profit will need altering.
Example 5 shows this:
Example 5: Assume that in Exhibit 32.5 the $60 debit balance was because
the rent account (C) was added up incorrectly: it should be shown as $260
instead of $200. The error was found on 1 June 2018. The journal entries to
correct it are:
Rent last year should have been increased by $60. This would have reduced
net profit by $60. A statement of corrected profit for the year is now shown.
Where there have been several errors
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Example 6: If in Exhibit 32.5 there had been four errors found in the accounts
of K. Black on 31 March 2018, their correction can now be seen. Assume that
the net difference had also been $60, with the four errors as:
Error (A) affected the profits: both gross and net profit were shown $70 too
much because of this error. It also affected the Suspense account (G).
Error (B) showed purchases too high by ($95 – $59) = $36. This means
that gross and net profits were shown $36 too little. The other item affected is
(F) Accounts payable, which is shown as being $36 too much. This error does
not affect (G) Suspense account.
Error (D) needs insurance increasing by $40. This will reduce the net profit
by $40. It also affects the Suspense account (G).
Error (E) does not affect the profits at all. It affects only items in the
Statement of financial position, namely (E) Accounts receivable and (G)
Suspense.
Note: Error (B) is known as an error of transposition, as the correct figures
have been shown in the wrong order; that is, they have been ‘transposed’.
The entries in the ledger accounts are as follows:
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The entries in the suspense account and the journal entries will be as follows:
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Note: *In (B), the correction of the understatement of purchases does not pass
through the Suspense account.
Now we can calculate the corrected net profit for the year 2017. Only items
(A), (B) and (D) affect figures in the trading and profit and loss account.
These are the only adjustments to be made to profit.
32.6 Limitations of trial balances
In this and the previous chapter, you have seen various kinds of errors. Those
in Chapter 31 were not revealed by trial balance totals being unequal. This
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shows a serious limitation in depending completely on the trial balance as an
absolute check on the accuracy of the entries in the books of account. To
refresh your memory, the kinds of errors not disclosed by a trial balance are:
• errors of commission
• errors of principle
• errors of original entry
• errors of omission
• compensating errors
• complete reversal of entries.
Even when the balances in a trial balance agree, there can be very large errors
of various kinds, which may mean that profits have been wrongly calculated
and that the statement of financial position is incorrect. This current chapter
has demonstrated these kinds of errors, where they have resulted in a
difference being put into a suspense account until the error(s) has been found.
A very small amount in a suspense account could hide very large errors.
For instance, a $50 credit in a suspense account could eventually be found to
be either of the following:
• Sales overcast $10,000, accounts receivable total overcast $10,050. If the
errors are not found, then both the gross and net profits will be overstated
by $10,000 and the figure of accounts receivable in the statement of
financial position overstated by $10,050.
• Rent expense undercast by $2,000, total of accounts payable undercast by
$1,950. In this case the net profit will be shown at $2,000 more than it
should be, while accounts payable in the statement of financial position
will be understated by $1,950.
This shows that there is always a possibility of serious errors occurring
without it being obvious at first sight.
32.7 Suspense accounts: examinations
and business
Examinations
Unless it is part of a question, do not make your statement of financial
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position totals agree by using a suspense account. The same applies to trial
balances. Examiners are very likely to penalise you for including a suspense
account when it should not be required.
Helpful Hint!
Examination Tip:
You should know how to prepare the Suspense account to calculate
the original difference in the trial balance and how to correct errors
using the Suspense account.
Business
When preparing financial statements for a business every effort should be
made to ensure that trial balance and statement of financial position balance.
However, if all else fails it may be necessary to open a suspense account and
hopefully the error(s) may subsequently be located and posted to the suspense
account, as shown in this chapter, and the balance eliminated.
Summary
• If the totals in the trial balance do not agree it may be necessary to
open a suspense account and enter the difference into the account
until the error(s) can be located.
• In the unlikely event that the error(s) is not found when the
statement of financial position is prepared, it may be necessary to
include the suspense account. If the suspense account shows a
credit balance, then it should be entered under the current liabilities
whereas a debit balance would be shown under current assets.
• Any errors found should be corrected using a journal and
subsequently posted to the appropriate double entry accounts. If
the error affects the suspense account, then the posting should be
made to that account.
• Some errors may affect the gross profit and net profit calculations
and adjustments have to be made to these profit figures.
• Other errors that do not affect the profit calculations may affect a
figure in the statement of financial position. If this is the case, then
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the figure in the statement of financial position will require
amending.
• While the balancing of the trial balance is seen to ensure that the
book-keeping entries have been carried out correctly, the trial
balance does have limitations in that certain errors occur which are
not revealed by the trial balance agreement.
Chapter 32 Exercises
32.1 On 31 March 2017 the following items are to be corrected via
the journal. Show the corrections. Narratives are not required.
(a) T. Thomas, a customer, had paid us a cheque for $900 to
settle his debt. The cheque has now been returned to us
marked ‘Dishonoured’.
(b) We had allowed C. Charles, a customer, a cash discount of
$35. Because of a dispute with her, we have now
disallowed the cash discount.
(c) Office equipment bought for $6,000 has been debited to the
motor vehicles account.
(d) The copy sales invoice of sales to J. Graham $715 was lost,
and therefore was completely omitted from our books.
(e) Cash drawings of $210 have been correctly entered in the
cash book, but have been credited to the wages account.
(CSEC style)
32.2 The following errors in the books of J. Holt have been found.
1 Equipment bought $2,500 by cheque has been debited to the
general expenses account.
2 $149 received from E. Grey has been correctly entered in the
cash book but debited to Grey’s account.
3 Goods sold $973 to J. Crook have been entered in error as
$937.
4 A discount allowed to P. Paul of $44 has been debited to the
discounts allowed account as $144.
5 $135 goods bought from D. D. Ltd have been credited to B. B.
Ltd.
From the above you are to:
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(a) state how each error affects the agreement of the trial
balance totals
(b) state which errors will affect net profits, and how
(c) state which errors will affect gross profits, and how
(d) state which of the above is:
(i) an error of principle
(ii) an error of commission
(iii) an error of original entry.
(e) show the journal entries needed to correct each error –
narratives are not required.
32.3X At the close of business on 26 February 2017, John Blake, a
sole trader, extracted a trial balance from his books. The trial
balance did not agree, but Blake entered the difference in a
suspense account. He then prepared his trading and profit and
loss accounts for the year ending 26 February 2017 in the
normal way. The profit and loss account so prepared showed a
net profit amounting to $2,370.
During March 2017, Blake discovered the following errors in his
books and these accounted for the entire difference in the trial
balance.
1 The bad debts account had been debited with items of $62
and $54 in respect of bad debts, but the personal accounts of
the individual customer’s had not been credited.
2 The sales day book was overcast by $140.
3 Cash $72 received from Simon Johnson had been correctly
entered in the cash book, but the double entry had been made
on the wrong side of Johnson’s personal account in Blake’s
ledger.
4 The discount allowed total in the cash book – $84 – had not
been entered in the discount account.
Required:
(a) Calculate the correct figure for net profit
(b) Show the journal entries necessary to correct the above
(c) Draw up the suspense account, showing the amount of the
original balance on it.
32.4 The following is a trial balance which has been incorrectly
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drawn up:
In addition to the mistakes evident above, the following errors
were also discovered:
1 A payment of $75 made to a supplier had been entered in the
cash book but not posted to the personal account.
2 A cheque for $56 received from a customer had been
correctly entered in the cash book but posted to the
customer’s account as $50.
3 A purchase of fittings $120 had been included in the
purchases account.
4 The total of the discounts allowed column in the cash book of
$38 had not been posted into the general ledger.
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5 A page of the sales day book was correctly totalled as $564
but carried forward as $456.
Show the trial balance as it would appear after all the errors had
been corrected. You are required to show all workings.
32.5X Show how each of the following errors would affect trial
balance agreement.
1 Equipment repairs $720 was debited to the equipment
account.
2 $1,700 discounts allowed credited to discounts received
account.
3 Inventory at close overvalued by $2,000.
4 $750 commission received was debited to the sales account.
5 Drawings $305 credited to the capital account.
6 Cheque paying $170 to C. Charles entered in cash book but
not in the personal account.
7 Cheque $248 received from L. Barnes credited to L. Barrett.
Format should be as follows:
32.6 The following trial balance was extracted by J. Pottinger from
her books as at 30 June 2018. She is unable to get the totals to
agree.
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The following errors are found:
1 Sales day book overcast by $350.
2 Discounts allowed undercast by $100.
3 Fixtures, bought for $850, have been entered in the cash
book but not in the fixtures account.
4 Credit purchase of $166 was entered in the purchases day
book only, but not in the supplier’s account.
5 Cheque payment to a supplier of $490 had been debited to
the drawings account in error.
You are required to:
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(a) draw up the suspense account to record the corrections
(b) redraft the trial balance after all corrections have been
made.
32.7X D. Fearon extracted the following trial balance from his books.
He could not get the totals to agree with each other.
The following errors are discovered:
1 Purchases day book was overcast by $258.
2 A repayment of loan $2,000 was debited in error to the wages
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account.
3 A cheque payment for equipment $1,500 has been entered in
the equipment account but not in the cash book.
4 Returns outwards $168 have been entered in the returns
outwards day book but not in the supplier’s account.
5 Sundry expenses $44 have been entered in the cash book
but not in the sundry expenses account.
You are required to:
(a) draw up the suspense account, showing corrections
(b) redraft the trial balance after all corrections have been
made.
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Multiple-choice questions – Set 4 (61 to 80)
Each multiple-choice question has four suggested answers: (A), (B),
(C) or (D). You should read each question and then decide which
choice is best: (A), (B), (C) or (D). Write down your answers on a
separate piece of paper. You will then be able to repeat the set of
questions later without the distraction of previously written attempts.
When you have completed a set of questions, check your answers
against those given in Appendix C.
61 A debit balance brought down on an insurance account means
that:
(A) we owe that insurance on that date
(B) we have paid too little insurance
(C) we have paid that insurance in advance on that date
(D) we have paid too much insurance.
62 Inventory of packing material at the end of the period is:
(A) carried forward as a debit balance
(B) carried forward as a credit balance
(C) transferred to the debit of the profit and loss account
(D) deducted from carriage outwards.
63 A new business started on 1 May. During the first month $4,800
goods (retail price) were bought at a trade discount 20%. Of these
75% are sold at full retail price. Returns inwards (at retail price)
amounted to $120. What is the cost price of inventory the
business should have on 31 May?
(A) $960
(B) $864
(C) $990
(D) $1,056
64 Which of the following do not affect trial balance agreement?
(i) Purchases of $210 from P. Cook entered in C. Cook’s
account.
(ii) Sales $890 to J. Lowe entered in both accounts as $809.
(iii) Cheque payable to R. Noble of $155 entered only in the cash
book.
(iv) Motor vehicle purchased $5,000 entered in motor expenses
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account.
(A) (i) and (ii)
(B) (ii) only
(C) (ii) and (iv)
(D) (i), (ii) and (iv)
65 Which of the following are correct?
66 Roger has owed us $3,600 for a long time. He agrees to a charge
for interest on the debt at 5% per annum. Assuming all months to
be taken as the same length, what entry should we make for one
month in respect of the interest?
(A) Debit Interest received $180; Credit Roger $180.
(B) Debit Roger $180; Credit Interest received $180.
(C) Credit Interest received $15; Debit Roger $15.
(D) Debit Bad debts $15; Credit Roger $15.
67 The journal is:
(A) part of the double entry system
(B) a form of sales day book
(C) a form of diary
(D) a supplement to the statement of financial position.
68 The straight line method of depreciation consists of:
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69
70
71
72
73
(A) unequal amounts of depreciation each year
(B) increasing amounts of depreciation each year
(C) reducing amounts of depreciation each year
(D) equal amounts of depreciation each year.
At the start of the year the accounts payable amounted to
$16,100; during the year $92,750 was paid to suppliers and $455
was received from them in discounts. At the end of the year, the
amount owing to the accounts payable was $18,375. From the
information given, the Purchases were:
(A) $92,750
(B) $95,480
(C) $94,598
(D) $95,025
Which of the following do not affect trial balance agreement?
(i) Purchases of $585 from C. Owens completely omitted from
the books.
(ii) Sales of $99 to R. Morgan entered in account as $90.
(iii) Rent account added up to be $100 too much.
(iv) Error on sales invoice of $14 being entered in the books.
(A) (i) and (iv)
(B) (i) and (ii)
(C) (i) and (iii)
(D) (iii) and (iv)
If a provision for depreciation account is in use, then the entries
for the year’s depreciation would be:
(A) debit asset account, credit profit and loss account
(B) credit asset account, debit provision for depreciation account
(C) credit profit and loss account, debit provision for depreciation
account
(D) None of the above.
When the trial balance totals do not agree, the difference is
entered in:
(A) the balance account
(B) a suspense account
(C) an errors account
(D) the profit and loss account.
Which of these errors would be disclosed by the trial balance?
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74
75
76
77
78
79
(A) An error on a purchase invoice.
(B) Purchases from T. Morgan entered in C. Morgan’s account.
(C) Carriage outwards debited to the sales account.
(D) Overcast of total on the sales account.
In a purchase ledger control account, the discounts received
should be shown:
(A) as a debit
(B) as a credit
(C) sometimes as a debit, sometimes as a credit
(D) as a balance carried down.
Given closing accounts receivable of $65,220, sales of $50,000
and receipts from accounts receivable of $44,000, the opening
accounts receivable should have been:
(A) $60,220
(B) $65,220
(C) $109,220
(D) None of the above.
A reduction in a provision for doubtful debts is recorded by:
(A) Dr. profit and loss, Cr. bad debts.
(B) Cr. profit and loss, Dr. provision for doubtful debts.
(C) Cr. profit and loss, Dr. statement of financial position.
(D) Dr. profit and loss, Cr. provision for doubtful debts.
A trial balance prepared for the accounting period will show:
(A) provision for depreciation in the debit column
(B) sales returns in the credit column
(C) commission received in the debit column
(D) discounts received in the credit column.
If last year’s capital is $57,500, this year’s capital is $64,300 and
drawings are $11,800, then profit must have been:
(A) $18,600
(B) $18,100
(C) $16,600
(D) $19,600
If last year’s capital was $74,500, closing capital was $46,200
and drawings were $13,400, then the:
(A) profit for the year was $14,900
(B) loss for the year was $14,900
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(C) loss for the year was $15,900
(D) profit for the year was $16,800.
80 If this year’s closing capital is $29,360, the year’s net profit is
$8,460 and drawings are $5,320, what was the capital at the
beginning of the year?
(A) $29,360
(B) $26,220
(C) $34,680
(D) None of the above.
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33 Receipts and payments
accounts and income and
expenditure accounts
Specific objectives
After you have studied this chapter you should be able to:
• appreciate that non-profit-making organisations such as clubs,
charities, associations and societies prepare different financial
statements from profit-making organisations
• prepare a receipts and payments account
• prepare income and expenditure accounts and statements of
financial position for non-profit-making organisations
• calculate profits and losses from special activities and incorporate
them into the financial statements
• appreciate that various forms of income may need special
treatment
• be aware of the treasurer’s responsibilities.
33.1 Non-profit-making organisations
The organisations we have covered so far have all been profit-making
businesses. However, there are other organisations whose objective is not to
make a profit but instead provide facilities for their members to pursue a
hobby, sporting activity or provide voluntary services. These clubs and
associations do not have to prepare a trading and profit and loss account since
they are not formed to carry on trading and make profits. Instead the financial
statements prepared by them are either receipts and payments accounts
or income and expenditure accounts.
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33.2 Receipts and payments accounts
Receipts and payments accounts are usually prepared by the treasurer of the
club or association. This account is a summary of the cash book for the
period and if the organisation has no assets (other than cash) and no
liabilities, a summary of the cash book tells the members all they need to
know about the financial activities during a period. Exhibit 33.1 is an
example of a receipts and payments account.
Exhibit 33.1
33.3 Income and expenditure accounts
When assets are owned, and/or there are liabilities, the receipts and payments
account is not a good way of drawing up financial statements. Other than the
cash received and paid out, it shows only the cash balances; the other assets
and liabilities are not shown at all.
What is required is:
• a statement of financial position
• an account showing whether the association’s capital has increased.
The second of these two requirements is provided via an income and
expenditure account. Such an account follows the same rules as trading and
profit and loss accounts (income statements), the only difference being the
terms used.
A comparison of terms used is shown below:
Profit-making organisation
Non-profit organisation
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Trading and profit and loss
account
Net profit
Net loss
Income and expenditure account
Surplus of income over
expenditure
Excess of expenditure over
income
33.4 Profit or loss for a special purpose
Sometimes there are reasons for a non-profit-making organisation wanting a
profit and loss account. This is when something is done to make a profit. The
profit is not to be kept, but will be used to pay for the main purpose of the
organisation.
For instance, a football club may have discos or dances that people pay to
attend. Any profit from these events helps to pay football expenses. For these
discos and dances, a trading or profit and loss account (income statement)
would be drawn up. Any profit (or loss) would be transferred to the income
and expenditure account.
33.5 Accumulated fund
A sole trader or a partnership will have capital accounts. A non-profit-making
organisation will instead have an accumulated fund. It is in effect the
same as a capital account, as it lists the difference between assets and
liabilities.
In a sole trader or partnership:
In a non-profit-making organisation:
33.6 Drawing up income and
expenditure accounts
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We can now look at the preparation of an income and expenditure account
and a statement of financial position of a club. This is drawn up on the basis
of a trial balance (see Exhibit 33.2).
Exhibit 33.2
The following information is also available:
(i) Bar inventory at 31 December 2018 amount in value to $2,362.
(ii) There is a need to provide for depreciation: sports equipment $1,700;
furniture and fittings $1,315.
The club’s trading account will look thus:
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The result of the club bar operation is calculated separately. The gross
profit/loss will then be incorporated into the club’s income and expenditure
account for calculation of the overall result, as shown below:
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33.7 Subscriptions
No subscriptions owing
Where there are no subscriptions owing, or paid in advance, at the beginning
and the end of a financial year, then the amount shown on the credit side of
the subscriptions account can be transferred to the credit side of the income
and expenditure account, as follows:
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Subscriptions owing
On the other hand, there may be subscriptions owing at both the start and the
end of the financial year. In a case where $325 was owing at the start of the
year, a total of $5,668 was received during the year, and $554 was owing at
the end of the year, then this would appear as follows:
In the statement of financial position, the subscription owing at the end of
December 2017 would be shown under the heading of ‘Current assets’ as an
accounts receivable for subscriptions, as shown below:
Subscriptions owing and paid in advance
In the third case, at the start of the year there are both subscriptions owing
from the previous year and also subscriptions paid in advance. In addition,
there are also subscriptions paid in the current year for the next year (in
advance) and subscriptions unpaid (owing) at the end of the current year. The
example below concerns an amateur theatre organisation.
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Example: An amateur theatre organisation charges its members an annual
subscription of $20 per member. It accrues for subscriptions owing at the
end of each year and also adjusts for subscriptions received in advance. The
following applies:
(a) On 1 January 2017, 18 members owed $360 for the year 2016.
(b) In December 2016, 4 members paid $80 for the year 2017.
(c) During the year 2017, the organisation received cash subscriptions of
$7,420:
(d) At the close of 31 December 2017, 11 members had not paid their 2017
subscriptions.
These facts are translated into the accounts as set out below:
In the statement of financial position as at 31 December 2017, the amounts
owing for subscriptions (D), $220, will be shown under current assets as an
accounts receivable for subscriptions. The subscriptions (C) paid in advance
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for 2018 will appear as an item under current liabilities as subscriptions
received in advance, $140, shown below:
Note: Treasurers of clubs and societies are very much aware that if
subscriptions are outstanding for a long time it is unlikely that they will ever
be paid – the member may have lost interest or moved on to another
organisation. Consequently, many clubs and indeed charities do not include
unpaid subscriptions as an asset in the statement of financial position.
Helpful Hint!
Practice Tip:
Draw a table in your notebook to show the main differences in
correctly preparing the three (3) types of Subscription Accounts
discussed in the previous sections. Use this table to revise or as a
check-list when preparing Subscription Accounts.
33.8 Donations
Any donations received are shown as income in the year that they are
received.
33.9 Entrance fees
New members often have to pay an entrance fee in the year that they join, in
addition to the membership fee for that year. Entrance fees are normally
included as income in the year that they are received.
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33.10 Life membership
In some clubs and societies members can pay a one-off amount for life
membership. This membership will last for their lifetime. In this case, all
of the money received from life membership should not be credited to the
income and expenditure account of the year in which it is received.
In a club where members joined at age 20 and would probably be members
for 40 years, then one-fortieth (2½%) of the life membership fee should be
credited in the income and expenditure account each year. The balance not
transferred to the income and expenditure account would appear in the
statement of financial position as a long-term liability. This is because it is
the liability of the club to allow the members to use the club for the rest of
their lives without paying any more for membership.
On the other hand, a club especially for people over the age of 60 would
transfer a much bigger share of the life membership fee paid to the income
and expenditure account. This is due to the age of the people on joining and
their estimated years of use of the facilities. It may be, in those
circumstances, that 10% of the life membership fee per year would be
transferred to the credit of the income and expenditure account.
33.11 Treasurers’ responsibilities
Treasurers of clubs or societies have a responsibility for maintaining proper
accounting records in the same way as an accountant has when looking after
the financial affairs of a business. It is important to ensure that any monies
paid out by the treasurer have been properly authorised, especially when
purchasing an item of capital expenditure (such as new sound equipment for
a dramatic society). In such cases, the authorisation for purchase will more
than likely have been approved at a committee meeting and noted in the
minutes of the meeting. For smaller items of expenditure such as postage,
telephone calls etc., the club or society’s rules will provide the treasurer with
the authority to make payments against receipted bills.
Helpful Hint!
Examination Tip:
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Ensure that you know when to use an Income and Expenditure
Account as opposed to a Receipt and Payment Account. What is the
main difference between them?
It is also important for the treasurer to keep all invoices, receipted accounts
and any other documents as evidence against payments. Treasurers should
also provide receipts for any monies received. All documents should be filed
and available at the year end for the club’s auditor to carry out an audit and
for preparation of the club’s year-end financial statements.
Summary
• The main objective of non-profit-making organisations is to provide
members with facilities to pursue a leisure activity and not to trade
and make profits.
• The financial statements prepared for non-profit-making
organisations may either be a ‘receipts and payments account’ or
‘income and expenditure account’.
• A ‘receipts and payments account’ is very much like a cash book
summary.
• An ‘income and expenditure account’ is very similar to a trading
and profit and loss account except that the terminology used is
different. A profit/surplus in the income and expenditure account is
expressed as ‘surplus of income over expenditure’. A loss would be
referred to as ‘excess of expenditure over income’.
• The ‘accumulated fund’ is basically the same as a capital account.
• Although clubs and societies are non-profit making, sometimes
activities are held to generate profits for the benefit of the
organisation and its members.
• The treatment of members’ subscriptions may involve subscriptions
owing and/or paid in advance.
• Donations should be treated as income in the year in which they
are received.
• Entrance fees are usually treated as income in the year in which
the member joins the organisation.
• Life membership subscriptions should be spread over the
anticipated length of membership which is usually decided by the
club’s committee or may be set out in the rules and regulations.
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• Club treasurers carry an important role and, as such, are
responsible for maintaining the organisation’s accounting records
and looking after their financial affairs.
Chapter 33 Exercises
33.1 The following trial balance was extracted from the books of the
Marabella Town Sports Club at the close of business on 31
March 2018.
Notes:
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(a) All bar purchases and sales are on a cash basis. Bar
inventory at 31 March 2018 were $2,460.
(b) No subscriptions have been paid in advance but
subscriptions in arrears at 31 March 2018 amounted to $90.
(c) Rates pre-paid at 31 March 2018: $60.
(d) Provision for depreciation as follows: sports equipment
$600; office furniture $120.
Required:
Prepare the bar trading account and the income and expenditure
account of the club for the year ended 31 March 2018, together
with a statement of financial position as on that date. For this
purpose, the wages of staff $5,280 should be shown in the
income and expenditure account and not the bar trading
account.
33.2 The East Point Social Club has 600 members, each paying an
annual subscription of $50. Rent is payable of $500 per month.
All money received is banked immediately. All payments are by
cheque.
On 31 December 2017 the financial position of the club was as
follows:
Twenty-four members did not pay their 2017 subscriptions until
2018.
During the year to 31 December 2018, the following transactions
occurred:
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You are to draw up the following.
(a) A receipts and payments account.
(b) A refreshment bar trading account for 2018.
(c) An income and expenditure account for 2018, taking the
following into account.
(i) Bar inventory at 31 December 2018 was $940.
(ii) Some subscriptions are owed by members at 31
December 2018.
(iii) Equipment to be depreciated by 20%.
(iv) Rent of $1,000 was owing at 31 December 2018.
(v) Insurance paid in advance at 31 December 2018: $210.
(d) Calculation of accumulated fund at 31 December 2017.
33.3X The following receipts and payments account for the year
ending 31 May 2017 was prepared by the treasurer of the Port
Maria Sports and Social Club.
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Notes:
(a) On 1 June 2016 the club’s equipment was valued at $680.
(b) Bar inventory was valued as follows: 31 May 2016, $176; 31
May 2017 $202. There were no creditors for bar supplies on
either of these dates.
(c) Allow $70 for depreciation of equipment during the year
ended 31 May 2017.
(d) No subscriptions were outstanding at 31 May 2016, but on
31 May 2017 subscriptions due but unpaid amounted to
$28.
Required:
Draw up the income and expenditure account of the Club for the
year ended 31 May 2017, and a statement of financial position
as at 31 May 2017.
33.4X The treasurer of the City Domino Club has produced the
following receipts and payments account for the year ended 31
December 2017.
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Notes:
(i) Coffee bar inventory was valued: 31.12.2016, $59;
31.12.2017, $103. There was nothing owing for coffee bar
stocks on either of these dates.
(ii) On 1.1.2017 the club’s equipment was valued at $2,788.
Included in this figure, valued at $77, was the equipment
sold during the year for $66.
(iii) The amount to be charged for depreciation of equipment for
the year is $279. This is in addition to the loss on equipment
sold during the year.
(iv) Subscriptions owing by members: 31.12.2016, nil;
31.12.2017, $29.
You are required to:
(a) draw up the coffee bar trading account for the year ended
31.12.2017. For this purpose, $650 of the pay is to be
charged to this account; the remainder will be charged in
the income and expenditure account.
(b) Calculate the accumulated fund as at 1.1.2017.
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(c) Draw up the income and expenditure account for the year
ended 31.12.2017, and a statement of financial position as
at 31.12.2017.
33.5X On 31 December 2017, the following information for the
Sunny Bay Social Club is made available to you.
In respect of the year to 31 December 2017, the following
information is given to you:
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Note that subscriptions due but unpaid at 31 December 2017
amounted to $370. Depreciate equipment 10%.
You are required to draw up the following:
(a) a subscription account for the year ended 31 December
2017;
(b) a receipts and payments account for the year 2017;
(c) an income and expenditure account for the year 2017.
(CSEC style)
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34 Partnership accounts: an
introduction
Specific objectives
After you have studied this chapter you should be able to:
• understand exactly what a partnership is and the rules relating to
the number of partners
• distinguish between limited and unlimited partners
• describe the main features of a partnership agreement
• understand the position if no partnership agreement exists
• draw up the capital and current accounts for the partnership
• prepare the financial statements of a partnership.
34.1 The need for partnerships
So far, we have considered mainly businesses owned by only one person.
Businesses that set up to make a profit can often have more than one owner
and there are various reasons for multiple ownership. There are two types of
multiple ownership: partnerships and limited companies. This chapter deals
only with partnerships. Limited companies will be the subject of later
chapters.
Advantages of partnerships
• More capital can be raised, that is, with additional partners.
• Additional partners bring in a variety of skills and expertise that benefit the
partnership.
• The experience or ability required to manage the business cannot always be
provided by one person working alone.
• The responsibility of management could be shared by additional partners.
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• A partnership of family members can bring a stronger desire to succeed
within a dependable environment.
• Partnerships are ideal organisations for professional practices such as
medicine, law and accounting.
• Profits from the partnership are taxed as personal income of the
partnership.
Disadvantages of partnerships
• The partners have unlimited liability (except a limited partner, see Section
34.3) and may be responsible for the debts of other partners.
• A partnership is dissolved on the death of a partner.
• It is difficult to liquidate or transfer partnerships.
• A partnership may have difficulty in raising sufficient capital for largescale operations.
• Increased unlimited liability could also be a deterrent to expanding the
business.
34.2 Nature of a partnership
A partnership has the following characteristics:
• It is formed to generate profits.
• It must obey the law as given in the Partnership Act of the Caribbean
Commonwealth. The partnership laws in each of the Caribbean countries
are very similar to one another. The differences will not affect your
understanding of this topic at this stage. The basic law from which the
various countries’ laws have evolved is the UK Partnership Act 1890.
Normally there can be a minimum of two partners and a maximum of 20
partners.
• Exceptions are banks, where there cannot be more than 10 partners.
• Each partner (except for limited partners described below) must pay his
or her share of any debts that the partnership cannot pay. If necessary,
partners can be forced to sell all their private possessions to pay their share
of the debts. This is what is meant by unlimited liability.
34.3 Limited partners
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A partnership may be unlimited, as previously discussed, or limited. In a
limited partnership there must be at least one partner who is not limited. All
limited partnerships must be registered with the Registrar of Companies.
Limited partners are not liable for the debts as in 34.2 above. The following
characteristics are found in limited partnerships:
1 Their liability for the debts of the partnership is limited to the capital they
have invested in the partnership. They can lose that capital, but they cannot
be asked for any more money to pay the debts unless they break the
regulations relating to the involvement in the partnership (2 and 3 below).
2 The partners are not allowed to take out or receive back any part of their
contribution to the partnership during its lifetime.
3 They are not allowed to take part in the management of the partnership
business.
4 All the partners cannot be limited partners as mentioned above; there must
be at least one partner with unlimited liability.
34.4 Partnership agreements
Agreements in writing are not necessary for partnerships. It is, however,
advisable to have a written partnership agreement or deed drawn up by a
lawyer or accountant to prevent problems between partners occurring. A
written agreement means less confusion about what has been agreed (see
below for the contents of a partnership agreement or deed).
34.5 Content of partnership agreements
The written agreement can contain as much, or as little, as the partners want.
The law does not say what it must contain. The usual accounting contents are
as follows.
1 The capital to be contributed by each partner
2 The ratio in which profits (or losses) are to be shared
3 The rate of interest, if any, to be paid on capital before the profits are
shared
4 The rate of interest, if any, to be charged on partners’ drawings
5 Salaries to be paid to partners
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6 Performance-related payments to partners
7 Arrangements for the admission of a new partner
8 Procedures to be carried out when a partner retires or dies.
We will now look at the first six points in the above list. The latter two will
be taken up later.
Helpful Hint!
Question:
What are the main characteristics of a partnership? How many did
you write? Check your answers with the relevant section in this
chapter. If you missed any, write these in at the bottom of your list.
1 Capital contributions
Partners need not contribute equal amounts of capital. What matters is how
much capital each partner agrees to contribute.
2 Profit- (or loss-) sharing ratios
Although partners can in fact agree to share profits/losses in any ratio that
they desire, it is often thought by students that profits should be shared in the
same ratio as that in which capital is contributed. For example, suppose the
capital amounts were: Allen $2,000 and Beet $1,000. Many people would
share the profits in the ratio of two-thirds to one-third, even though the work
to be done by each partner is similar.
The division of the first few years’ profits on such a basis is shown in
Exhibit 34.1.
Exhibit 34.1
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It can be seen from the above table that Allen would receive $9,200, or
$4,600 more than Beet. To treat each partner fairly, the difference between
the two shares of profit when the duties of the partners are the same should be
adequate to compensate Allen for putting extra capital into the firm. Some
might feel that $4,600 extra profits are more than adequate for this purpose.
Consider too the capital ratio sharing of profits when one partner has put in
$99,000 and the other $1,000 as capital. In this case, one partner would get
99/100ths of the profits, while the other would get only 1/100th!
To overcome the difficulty of compensating for the investment of extra
capital, the concept of interest on capital was devised.
3 Interest on capital
If the work to be done by each partner is of equal value but the capital
contributed is unequal, it is reasonable to grant interest on the partners’
capital. This interest is treated as a deduction prior to the calculation of
profits and the latter’s distribution according to the profit-sharing ratio. The
rate of interest is a matter of agreement between the partners, but it should
equal the return they would have received if they had invested the capital
elsewhere.
Taking Allen and Beet’s business again, but sharing the profits equally
after charging 5% per annum interest on capital, the division of profits is
shown in Exhibit 34.2. Here Allen has received $250 more than Beet, this
being adequate return (in the partners’ estimation) for her having invested an
extra $1,000 in the firm for five years.
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Exhibit 34.2
4 Interest on drawings
It is obviously in the best interests of the business if cash is withdrawn from
the business by the partners in accordance with the two basic principles of:
(a) as little as possible and (b) as late as possible. The more cash that is left in
the business, the more expansion can be financed, the greater the economies
of having ample cash to take advantage of bargains and not missing out on
cash discounts, and so on.
To deter the partners from taking out cash unnecessarily, the concept can
be used of charging the partners interest on each drawing or withdrawal,
calculated from the date of withdrawal to the end of the financial year. The
amount charged to them helps to swell the profits divisible between the
partners. The rate of interest should be sufficient to achieve this without
being too harsh.
Suppose that Allen and Beet have decided to charge interest on
drawings at 5% per annum, and that their year end was 31 December. The
drawings made are shown in Exhibit 34.3.
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Exhibit 34.3
The interest charged to each partner would vary depending on when and how
much money was taken out as drawings.
5 Partnership salaries
One partner may have more responsibility or tasks than others. As a reward
for this and rather than change the profit and loss-sharing ratio, that partner
may have a salary, which is deducted before sharing the balance of profits.
6 Performance-related payments to partners
Partners may agree that commission or performance-related bonuses should
be payable to some or all the partners in a way that is linked to their
individual performance.
As with salaries, these would be deducted before sharing the balance of
profits.
34.6 An example of the distribution of
profits
Taylor and Clarke have been in partnership for one year, sharing profits and
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losses in the ratio of three-fifths to Taylor and two-fifths to Clarke. They are
entitled to 5% per annum interest on capital, Taylor having $20,000 capital
and Clarke $60,000. Clarke is to have a salary of $15,000. They charge
interest on drawings, Taylor being charged $500 and Clarke $1,000. The net
profit, before any distributions to the partners, amounted to $50,000 for the
year ended 31 December 2017.
The results are shown in Exhibit 34.4.
Exhibit 34.4
The $50,000 net profits have therefore been shared as follows:
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34.7 The financial statements
If the sales, inventory and expenses of a partnership were exactly the same as
that of a sole trader, then the trading and profit and loss account (income
statement) would be identical with that as prepared for the sole trader.
However, a partnership would have an extra section shown under the profit
and loss account (income statement). This section is called the profit and loss
appropriation account, and it is in this account that the distribution of profits
is shown. The heading to the trading and profit and loss account does not
include the words ‘appropriation account’. It is purely an accounting custom
not to include it in the heading.
The trading and profit and loss account of Taylor and Clarke from the
details given would appear as shown in Exhibit 34.5.
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Exhibit 34.5
34.8 Fixed and fluctuating capital
accounts
There is a choice available in partnership accounts. Partnerships can operate
either fixed capital accounts plus current accounts, or fluctuating capital
accounts. Each option is described below, with a final comment on which is
generally preferable.
Fixed capital accounts and current accounts
With fixed capital accounts, the capital account for each partner remains year
by year at the figure of capital put into the business by the partners. The
profits, interest on capital, and the salaries to which the partner may be
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entitled are then credited to a separate current account for the partner, and the
drawings and the interest on drawings are debited to it. The balance of the
current account at the end of each financial year will then represent the
amount of undrawn (or withdrawn) profits. A credit balance will be undrawn
profits, while a debit balance will be drawings in excess of the profits to
which the partner is entitled.
For Taylor and Clarke, capital and current accounts, assuming drawings of
$12,000 for Taylor and $20,000 for Clarke, will appear thus:
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Notice that the salary of Clarke was not paid to him but was merely credited
to his account. If in fact it was paid in addition to his drawings, the $15,000
cash paid would have been debited to the current account, changing the
$10,000 credit balance into a $5,000 debit balance.
Examiners often ask for the capital accounts and current accounts to be
shown in columnar form. For the previous accounts of Taylor and Clarke,
these would appear as follows:
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Fluctuating capital accounts
In this arrangement of fluctuating capital accounts the distribution of
profits would be credited to the capital account, and the drawings and interest
on drawings is debited. Therefore, the balance on the capital account will
change each year, that is, it will fluctuate.
If fluctuating capital accounts had been kept for Taylor and Clarke, they
would have appeared as follows:
Fixed capital accounts preferred
The keeping of fixed capital accounts plus current accounts is considered
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preferable to operating fluctuating capital accounts. When partners are taking
out greater amounts than the share of the profits that they are entitled to, this
is shown up by a debit balance on the current account and so acts as a
warning.
34.9 Where no partnership agreement
exists
A special section of the Partnership Act 1890 covers this situation. Quite
simply, if there is no partnership agreement, written or otherwise, the
following provisions will apply:
• Profits and losses will be shared equally.
• There is to be no interest on capital.
• No interest is to be charged on drawings.
• Salaries are not allowed.
• If a partner puts a sum of money into a firm in excess of the capital he or
she agreed to subscribe, that partner is entitled to interest at the rate of x%
per annum on such an advance. (The percentage rate varies in different
countries.)
34.10 The statement of financial
position
The capital side of the statement of financial position will appear as follows
for our example. Note that a figure in brackets, for example (20,000), is an
accounting convention indicating a negative amount.
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Helpful Hint!
Examination Tip:
Be careful when entering appropriation items in the Current
Accounts. Check to see that you have entered items like drawings,
interest on drawings, partner’s salary, etc., on the correct sides.
If one of the current accounts had finished in debit – for instance, if the
current account of Taylor had finished up as $8,000 debit – the figure of
$8,000 would appear in brackets and the balances would appear net in the
totals column as shown below:
If the net figure, for example the $2,000 just shown, turned out to be a debit
figure, then this would be deducted from the total of the fixed capital
accounts.
Summary
• Partnerships are formed with two or more partners carrying on in
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•
•
•
•
•
•
•
business with a view to making a profit.
There are two types of partnership: unlimited and limited
partnership.
Where there is a limited partnership, there must be at least one
unlimited partner within the partnership.
Limited partners cannot withdraw any of the capital they invested in
the partnership nor may they take part in the management of the
partnership.
It is advisable for all partnerships to draw up a Partnership
Agreement detailing the accounting requirements of the partnership
(Section 34.5).
If there is no partnership agreement, then the provisions of the
Partnership Act 1890 will apply (Section 34.9).
The partners may use either fixed or fluctuating capital accounts.
The financial statements of a partnership are: trading and profit and
loss account that has an additional section called the ‘appropriation
account’ and statement of financial position which shows the
capital and current accounts of all the partners.
Chapter 34 Exercises
34.1 Stephens, Owen and Jones are partners. They share profits
and losses in the ratios of two-fifths, two-fifths and one-fifth
respectively.
For the year ended 31 December 2017, their capital accounts
remained fixed at the following amounts:
They have agreed to give each other 10% interest per annum on
their capital accounts.
In addition to the above, partnership salaries of $3,000 for Owen
and $1,000 for Jones are to be charged.
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The net profit of the partnership, before taking any of the above
into account, was $25,200.
You are required to draw up the appropriation account of the
partnership for the year ended 31 December 2017.
34.2 Draw up a profit and loss appropriation account for the year
ended 31 December 2017 and statement of financial position
extracts at that date, from the following.
1 Net profit $30,350.
2 Interest to be charged on capital: Williams, $2,000; Powell,
$1,500; Howe, $900.
3 Interest to be charged on drawings: Williams, $240; Powell,
$180; Howe, $130.
4 Salaries to be credited: Powell, $2,000; Howe, $3,500.
5 Profits to be shared: Williams, 50%; Powell, 30%; Howe, 20%.
6 Current accounts: Williams, $1,860; Powell, $946; Howe,
$717.
7 Capital accounts: Williams, $40,000; Powell, $30,000; Howe,
$18,000.
8 Drawings: Williams, $9,200; Powell, $7,100; Howe, $6,900.
34.3X Wain, Brown and Cairns own a garage, and the partners
share profits and losses in the ratio of Wain 50%, Brown 30%
and Cairns 20%. Their financial year end is 31 March 2017 and
the following details were extracted from their books on that
date:
The net profit for the year ended 31 March 2017 amounted to
$60,000 before taking any of the above into account.
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You are required to:
(a) prepare an appropriation account for the year ended 31
March 2017
(b) draw up the partners’ capital and current accounts in
columnar form for the year ended 31 March 2017.
34.4X Dent, Bishop and White are in partnership. They share profits
and losses in the ratio 3:2:1 respectively. Interest is charged on
drawings at the rate of 10% per annum and credited at the same
rate in respect of the balances on the partners’ capital accounts.
Bishop is to be credited with a salary of $2,000 per annum.
In the year to 31 December 2017, the net profit of the firm was
$50,400. The partners’ drawings of Dent $8,000, Bishop $7,200
and White $4,800 were taken in two equal instalments by the
partners on 1 April 2017 and 1 October 2017.
The balances of the partners’ accounts 31 December 2016 were
as follows (all credit balances):
You are required to:
(a) prepare the firm’s profit and loss appropriation account for
the year ended 31 December 2017
(b) show how the partners’ capital and current accounts are
recorded in the statement of financial position as at 31
December 2017.
34.5 Mendez and Marshall are in partnership, sharing profits and
losses equally. The following is their trial balance as at 30 June
2017.
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Prepare a trading and profit and loss appropriation account for
the year ended 30 June 2017, and a statement of financial
position as at that date.
1 Inventory, 30 June 2017: $56,340
2 Expenses to be accrued: office expenses, $96; wages, $200.
3 Depreciate fixtures 10% on reducing balance basis.
Depreciate buildings $1,000.
4 Reduce provision for doubtful debts to $320.
5 Partnership salary: $800 to Mendez. Not yet entered.
6 Interest on drawings: Mendez, $180, Marshall, $120.
7 Interest on capital account balances at 10%.
34.6X Oscar and Felix are in partnership. They share profits in the
ratio, Oscar 60%, Felix 40%. The following trial balance was
extracted as at 31 March 2017.
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Draw up the financial statements for the year ended 31 March
2017 for the partnership. The following notes are applicable at 31
March 2017.
1 Inventory 31 March 2017: $27,340.
2 Office expenses owing, $110.
3 Provide for depreciation: motors, 20% of cost, office
equipment, 10% of cost.
4 Charge interest on capital at 10%.
5 Charge interest on drawings: Oscar, $180, Felix, $210.
34.7 Q and P have similar businesses and decide to amalgamate
and form a partnership. On 1 January 2017 they had the
following assets and liabilities:
From 1 January 2017, they agreed that:
1 Profits and losses would be shared equally
2 Interest on capital at 10% would be allowed
3 P was to get a salary of $2,000 per annum
4 Interest on drawings at 10% per annum would be charged; for
2017 this amounted to $120 for Q and $200 for P.
For the year to 31 December 2017, a net profit of $23,680 was
made. Q’s drawings were $5,200 and P’s, $8,400.
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You are required to:
(a) ascertain opening capital
(b) draw up a profit and loss appropriation account for the year
ended 31 December 2017
(c) draw up capital accounts as they would be shown in the
statement of financial position as at 31 December 2017,
assuming fluctuating capital accounts are to be used.
(CSEC style)
34.8X Steve and Jane are in partnership. The terms of the
partnership are:
1 profit and losses to be shared in the ratios Steve two-thirds,
Jane one-third
2 10% interest is allowable on fixed capital
3 10% interest is to be charged on drawings, whenever taken
4 Jane is to have a salary of $6,000.
The following profit and loss account for the year ended 31
December 2017 is:
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Steve and Jane are surprised at the above accounts.
The following is also made available:
(i) Wages includes Jane’s salary of $6,000
(ii) No interest has been charged on drawings
(iii) Other balances include the following as at 31 December
2017:
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Using the information above:
(a) Redraft the profit and loss account.
(b) Draw up the profit and loss appropriation account.
(c) Write up the current accounts of the partners.
(d) State what the balances on the current accounts signify.
(CXC style)
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35 New partners: entries on
admission, goodwill and
premiums
Specific objectives
After you have studied this chapter you should be able to:
• understand the need for new partners to enter a business
• understand the meaning of goodwill and the reasons why payment
for goodwill is made
• calculate the value of goodwill using various methods
• make adjustments for goodwill in partnership accounts.
35.1 Reasons for admission of a new
partner
New partners may be admitted to a partnership, usually for one of three
reasons:
1 As an additional partner, either because the business has grown or because
someone is needed who has different skills to those of the existing
partners.
2 To replace a partner who ceases to be a member of the firm: this might be
because of the retirement or death of a partner.
3 To bring in additional capital.
35.2 Capital to be contributed
As we saw in the last chapter, the amount of capital to be brought into a
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business by a new partner is dependent on the agreement drawn up between
the old partners and the new partner.
35.3 The nature of goodwill
Suppose you have been in business for some years and you want to sell up.
How much would you ask as the total sale price of the business? You decide
to list how much you could get for each asset if sold separately. This list
might be as follows:
Instead, however, you sell the whole of the business as a going concern to Ms
Lee for $450,000. She has, therefore, paid $50,000 more than the total for all
the assets. This extra payment of $50,000 is for what is called goodwill.
Ms Lee has paid this extra amount because she wanted to take over the
business as a going concern. Thus,
Goodwill is an intangible asset and represents the excess amount that has
to be paid to acquire a part or the whole of a business as a going concern over
and above the value of the net assets owned by the business.
35.4 Reasons for payment of goodwill
In buying an existing business, which has been established for some time,
there may be quite a few possible advantages. Some of them are listed below.
• There is a large number of regular customers who will continue to deal
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•
•
•
•
•
with the business under a new owner.
The business has a good reputation.
It has experienced, efficient and reliable employees.
The business is situated in a good location.
It has good contacts with suppliers.
It may have good brand names that are known and recognised within the
industry. Few of those advantages are available to a completely new
business. For this reason, many people will decide to buy an existing
business and pay an extra amount for goodwill.
35.5 Existence of goodwill
Goodwill does not necessarily exist in a business. If a business has a bad
reputation, an inefficient workforce or other negative factors, it is unlikely
that the owner(s) would be paid for goodwill on selling the business.
35.6 Methods of calculating goodwill
There is no single way of calculating goodwill on which everyone can agree.
The seller will probably want more for the goodwill than the buyer will want
to pay. All that is certain is that, when an agreement is reached between buyer
and seller, the selling price includes the amount of goodwill. Various
methods are used to help buyer and seller come to an agreed figure. The
calculations give buyer and seller a figure with which to begin discussions of
the value of the business.
Very often, each industry or occupation has its own customary way of
calculating goodwill.
Average sales method
In many retail businesses the average yearly sales for the past few years are
multiplied by an agreed figure. For instance, suppose that it is agreed that the
goodwill should be three times the average yearly sales for the last two years.
Exhibit 35.1 shows such a calculation.
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Exhibit 35.1
Average annual sales = $300,000 ÷ 2 = $150,000
Goodwill = 3 × $150,000 = $450,000
Annual fees method
Professional firms, such as accountants or lawyers, often use a method based
on gross annual income from fees, before charging expenses. Exhibit 35.2
shows such a calculation.
Exhibit 35.2
Average annual fees = $400,000 ÷ 2 = $200,000
Goodwill = 2.5 × $200,000 = $500,000
A firm of accountants is selling its business. It is asking a figure for goodwill
that is two and a half times the average annual fees received for the last two
years.
Average net annual profits method
Using this method, the average net profits for a number of years is multiplied
by a stated amount. An illustration is given in Exhibit 35.3. Suppose goodwill
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is taken to be four times the average net annual profits for the past three
years. The goodwill value is shown below:
Exhibit 35.3
Average net annual profits = $210,000 ÷ 3 = $70,000
Goodwill = 4 × $70,000 = $280,000
Super profits method
It may be argued, as in the case of a sole trader, for example, that the net
profits are not ‘true’ profits. This is because the sole trader has not charged
for the following expenses.
• The services of the proprietor. The proprietor has worked in the business,
but has not charged for such services. Any drawings that he or she makes
are charged to a capital account, not to the profit and loss account.
• The use of the money the proprietor has invested in the business. If this
money had been invested elsewhere it would have earned interest or
dividends.
Super profits are what is left of the net profits after allowances have been
made for the services of the proprietor and the use of his or her capital.
Helpful Hint!
Discussion:
If you were the buyer of a successful small retail company owned by
two partners, which method of calculating goodwill would you prefer
to use? Give reasons for your answer.
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It is usually calculated as follows:
The annual super profits are then multiplied by a number agreed by the seller
and purchaser of the business.
35.7 Goodwill on admission of new
partners
The new partner will be entitled to a share in the profits, and normally will
also be entitled to the same share of the value of goodwill. It is correct to
charge a new partner for taking over that share of the goodwill.
35.8 Calculation of goodwill
adjustments
This calculation is carried out in three stages.
1 Show the value of goodwill divided between the original partners in the
old profit- and loss-sharing ratios.
2 Then show the value of goodwill divided between the partners in the new
partnership in the new profit- and loss-sharing ratios.
3 Goodwill gain shown: charge partners for the gain. Goodwill loss shown:
give partners an allowance for their losses.
This is illustrated in Exhibits 35.4 and 35.5. We will see that the method in
Exhibit 35.5 is the same as that in 35.4 even when old partners take a
different share of the profit from each other than before the change.
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Exhibit 35.4
This means that A and B need to have their capital increased by $10,000
each. C needs his capital reducing by $20,000. You may well wonder why A
and B should have their capital increased by $10,000 each, that is, receive a
credit of $10,000 in each of their capital accounts. They have each given up
part of their ownership of an asset, in this case goodwill, to the new partner,
C. C should be charged for this, which is done by debiting his capital account
by $20,000. As it is A and B that have passed over to him part of their
ownership, the corresponding credits should be made in their capital accounts
for $10,000 each. If this were not done, they would have given up their shares
of the goodwill for nothing.
Note that A and B have kept their profits in the same ratio to each other.
While they used to have one-half each, now they have one-third each.
Exhibit 35.5
35.9 Accounting entries for goodwill
adjustments
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These depend on how the partners wish to arrange the adjustment. Three
methods are usually used.
1 Cash is paid in by the new partner privately to the old partners for his or
her share of the goodwill. No goodwill account is opened. In Exhibit 35.5,
F would therefore give $24,000 in cash: $18,000 to D and $6,000 to E. D
and E would bank these amounts in their private bank accounts. No entry
would be made for this in the accounts of the partnership.
2 Cash is paid by the new partner into the business bank account for his or
her share of the goodwill. No goodwill account is opened. Assume that the
capital balances before F was admitted were D $50,000 and E $50,000,
and F was to pay in $50,000 as capital plus $24,000 for goodwill. In
Exhibit 35.5 the entries would be shown in the capital accounts as seen in
Exhibit 35.6.
Exhibit 35.6
3 A goodwill account is to be opened. No extra cash is to be paid in by the
new partner for goodwill. The opening capital were D $50,000, E.
$50,000; F paid in $50,000 as capital.
Here the action required is as follows:
(i) Debit goodwill account with total value of goodwill. Credit capital of
old partners with their shares of goodwill in old profit ratios.
(ii) Debit adjustment gains to partners’ capital. Credit adjustment losses to
partners’ capital.
For Exhibit 35.5, the entries would now appear as shown in Exhibit 35.7.
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Exhibit 35.7
35.10 Premiums for goodwill
The amounts paid in by the new partners, or charged to them, for goodwill is
often known as a premium.
Sometimes all that is known is that a partner has paid a certain amount for
his or her share of the goodwill, but you are not told the total value of
goodwill. A little arithmetic will help you find the total value. Thus, $10,000
for a one-third share means that goodwill is valued at $30,000, while $10,000
for a one-fourth share means that goodwill is valued at $40,000.
Helpful Hint!
Examination Tip:
How is the share of goodwill of a current partner affected by the
admission of a new partner?
Summary
• The true value of goodwill can be established only when the
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•
•
•
•
business is sold, but for various reasons of fairness between
partners it is valued the best way possible when there is no
imminent sale of a business.
If the old partners agree, a new partner can be admitted without
paying anything in as capital.
Goodwill is usually owned by the partners in the ratio in which they
share profits.
If there is a change in partnership without adjustments for goodwill,
then some partners will make an unfair gain while others will quite
unfairly lose money.
If a new partner pays a specific amount for his or her share of the
goodwill, then that payment is said to be a ‘premium’.
Chapter 35 Exercises
35.1 June Graves and Cyril Regis want you to value the goodwill of
their business, which they are going to sell. You advise them that
for their kind of business the ‘average sales method’ is
appropriate.
They say that they would agree to a valuation of four times the
average yearly sales for the last three years. The sales for the
last three years have been: 2015, $240,000; 2016, $280,000;
2017, $275,000.
Show your calculation of the value of goodwill.
35.2X Hill and Dale are selling their business. They are asking for a
value for goodwill of one and a half times the average yearly
sales for the last four years.
Sales have been: 2014, $160,000; 2015, $192,000; 2016,
$188,000; 2017, $208,000. Calculate the value placed on the
goodwill by the partners.
35.3 Scott and Simpson are selling their dental practice. They are
asking a figure for goodwill which is five times the average
annual fees received for the last four years. The fees received
were as follows:
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You are required to calculate the value of goodwill in accordance
with the above figures.
35.4X Rivers and Nelson, a firm of patent agents, are selling their
business. For goodwill they are asking for a figure that is three
times the average annual fees received for the last five years.
The fees received amounted to the totals listed below:
You are to calculate the figure they are asking for goodwill.
35.5 James Barnes is selling his business. He has worked full-time
in the business. Drawings, as they should be, have been
charged up to his capital account, not to the profit and loss
account. The cash that Barnes has invested in the business
amounts to $200,000. If he had invested it elsewhere he would
have been able to get interest on it of 12%.
Barnes is a qualified engineer. If he had not been working in his
own business, he could have been employed elsewhere for
$60,000 a year.
His accountant advises him to value his goodwill at a figure
equalling five years of ‘super profits’.
Required:
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Calculate the value of goodwill at the figure stipulated by the
accountant, given the above information and the fact that his
annual net profits amount to $110,000.
35.6X Rita Worrall wants to sell her business. For goodwill; she is
going to ask for a figure equalling eight years of ‘super profits’.
Worrall has invested $60,000 in her business. If she had
invested it elsewhere with similar risk, she would have earned
9% on her money.
If she had worked elsewhere, rather than in her own business,
she could have earned $35,000 a year.
Her annual net profits from the business have been $55,000 a
year.
From the above, you are required to calculate the figure that she
should be asking for goodwill.
35.7 Marshall and Russell are in partnership sharing profits and
losses in the ratio of Marshall two-thirds, Russell one-third. A
new partner, Sangster, is introduced. Profits will be shared in the
ratio: Marshall one-half, Russell one-quarter, Sangster onequarter. Just before the introduction of Sangster, the statement
of financial position had been as set out below:
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Show the different statements of financial position given the
different situations listed below, after Sangster is introduced as a
new partner on 1 January 2018.
(a) Sangster pays in an $8,000 cheque for capital, plus another
$3,000 for his share of the goodwill; or instead.
(b) Sangster pays in an $8,000 cheque for capital; the $3,000
for goodwill is paid privately by him to Marshall & Russell; or
instead.
(c) A goodwill account is to be opened of total estimated value
$12,000. Sangster pays into the business a cheque for
$8,000 only in respect of capital.
35.8X Lee and Henry are in partnership, sharing profits and losses in
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the ratios Lee 3: Henry 2. A new partner, Nunez, is introduced.
Profit will be shared in the ratios Lee 3: Henry 2: Nunez 1. Before
the introduction of Nunez, the statement of financial position had
been as follows.
Show the different statements of financial position under the
following different proposals:
(a) Nunez paid in $4,000 cheque as capital and $3,000 cheque
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for his share of the goodwill.
(b) Nunez paid in $4,000 cheque for capital; the $3,000 for
goodwill was paid privately by him to Lee and Henry.
(c) A goodwill account was opened for $18,000; Nunez paid in
a cheque for $4,000 only in respect of capital.
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36 Costing principles
Specific objectives
After you have studied this chapter you should be able to:
• appreciate that the object of cost accounting is to provide
management with information to enable them to manage the
business more effectively
• understand the elements of cost and differentiate between direct
and indirect costs and fixed and variable costs
• calculate the unit cost of a product or service
• appreciate the need for cost centres
• calculate the unit price of a product using cost-plus pricing
• understand the method of absorption costing whereby overhead
costs are charged to cost centres
• differentiate between allocation of costs where all costs are
allocated to one cost centre and apportionment of costs where
costs are apportioned (shared) between cost centres
• understand that the various methods used in apportioning costs
can be shown together with the cost price of a product, including
the overhead absorption rate.
36.1 Comparison of cost and
management accounting and financial
accounting
Financial accounting
A financial accounting system, which you have been looking at in this
textbook, records the financial transactions of the business such as those
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relating to income, expenses, assets and liabilities. The accounting system
shows you what the business owns and is owed. It also provides the
information needed to prepare the annual financial statements of the business.
The main purpose of the financial statements is to inform the owners (either
sole traders, partners and/or shareholders) of the performance of the
business during the last financial year. Other external bodies are also
interested in these statements such as the bank, tax authorities, etc.
The financial statements do not provide all the information that
management needs because they are produced at the end of the year and
management needs information throughout the year on the progress of the
company. A cost accounting system discussed below provides this periodic
information that is needed by management.
Cost and management accounting
An organisation may have both a financial accounting system and a separate
cost accounting system. A cost accounting system records the costs and sales
revenue for individual jobs, processes, activities and products or services.
• Like the financial accounting system, a costing system is based on a
double entry system of debits and credits, but this is outside the scope of
this book.
• However, the accounts in a cost accounting system are different from the
accounts in the financial accounting systems. This is because both accounts
have different purposes.
Here is a table summarising the key differences between the two accounting
systems:
Financial accounting Cost accounting system
system
Statutory requirement Not a statutory requirement
(required by law to be
prepared by
companies)
Used to prepare
financial statements for
shareholders and other
external users.
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Also provide information
for management
Records revenues,
expenditures, assets
and liabilities.
For internal use only by management
Records costs of activities and used to
provide detailed information about costs,
revenues, profits for specific products,
operations and activities.
36.2 The objective of costing
Costing is ascertaining the cost of a product or a service and providing
information to be used by management. It is imperative that management
know the cost of production or for providing a service and for the revenue
generated to enable them to ascertain how much profit is made thus allowing
them to remain in business.
Costing, therefore, provides managers with cost information that is
required to assist them to manage effectively for:
• decision making
• controlling expenditure
• planning and budgeting for the future
Costing assists management in making decisions such as:
• how much it costs to sell the products that it produces or provide its
services to customers
• which product produces the most profit and which items may be being
produced at a loss
• whether or not to accept another contract, which will depend on sufficient
profit being generated if the contract is accepted
• how many products does the business need to produce and sell to break
even
• what savings could be made if the business invests in a new machine and
reduces the labour input
• planning production so ensuring materials and labour are available when
required.
36.3 Elements of cost
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When producing goods, a business may incur many different types of costs;
the three main types are summarised below:
• materials – such as wood to manufacture furniture
• labour – to pay the employees their wages and salaries
• expenses – such as rent, rates and insurance.
These costs can be further divided into direct costs and indirect costs, as
follows:
Direct costs – a direct cost is one that can be identified with each unit of
production, for example:
• raw materials
• carriage on raw materials.
Indirect costs – simply a cost that cannot be identified with specific units of
output, for example:
Factory overheads
• factory rent and business rates
• factory power and lighting
• depreciation of plant and machinery
• wages/salary of supervisor or foreman
• insurance of buildings and machinery.
Administrative expenses
• wages and salaries of managers, secretarial and finance staff
• communication charges; telephone, internet
• legal and accountancy charges
• depreciation of office equipment.
Selling and distribution expenses
• sales staff salaries and commission
• advertising and marketing expenses
• depreciation of delivery vehicles.
Total cost of manufacture is made up of direct materials, direct labour and
direct expenses to which are added the indirect costs, that is, factory
overheads, administrative expenses, selling and distribution expenses and
finally profit to arrive at the selling price as illustrated below:
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Helpful Hint!
Discussion:
Role play with another student: you are a qualified accountant
explaining to a small business owner how knowing about the
elements of cost can help him or her run a more efficient business.
Exhibit 36.1
36.4 Fixed and variable costs
Costs can also be classified as either fixed or variable.
Fixed costs – A fixed cost is one which does not change as output
changes, in other words it does not change if the output moves either up or
down from one period to another; examples of fixed costs are:
• rent and rates
• insurance
• leased equipment charges
• design and technology.
Variable costs – A variable cost changes when output changes. Therefore,
if output increases then variable costs also increase; examples of variable
costs are:
• raw materials
• stock and components bought in
• labour costs.
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36.5 Unit cost
A unit cost of production relates to one unit such as the manufacture of a
wheelbarrow, table or television. Once the total cost of production has been
calculated and the number of units made known, then the unit cost can be
ascertained as shown in the following example.
Jowett’s Engineering Company manufactures metal tool boxes to sell to
wholesalers. During January, the company manufactures 8,000 tool boxes,
the production costs of which are shown below:
36.6 Cost centres
Parts of businesses to which costs can be charged are called cost centres.
The cost centre could be a whole factory, if the business is part of a large
group, down to a particular machine or staff member.
In a police force, for example, cost centres may be the different sections
such as traffic control, forensic, drugs unit, dog unit, administrative section,
call control and so on.
Managers are responsible for their cost centres. Therefore, having detailed
information of costs available is essential and assists them in controlling the
business.
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36.7 Margin and mark-up pricing
For comprehensive coverage of margin and mark-up pricing please refer to
Chapter 14 (Remember the acronym Mrs Muc!)
36.8 Cost-plus pricing
Cost-plus pricing is a costing method used for determining the selling
price for goods and services. With this method, the direct material cost and
direct labour cost is added to the overhead costs for a product. To the total of
these costs, a percentage mark-up is added, which gives a profit margin, to
arrive at the selling price of the product, that is,
1 Calculate the unit cost, that is:
2 Add a percentage mark-up
An example is now shown.
Moon’s Supplies Ltd. designs and manufactures household light bulbs. The
costs for producing 100 light bulbs are as follows:
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This method of costing may be used for single-buyer products that are made
to the buyer’s specific requirements, such as a machine or special equipment.
The advantages of using cost-plus pricing are as follows:
• easy to calculate
• easy to adjust the price if costs rise
• allows pricing decisions to be easily made.
The main disadvantage to this method of costing is that the businesses may
not cut or control costs efficiently. For example, costs may increase which in
turn increases the selling price which could make the business less
competitive and consequently it could lose business.
36.9 Absorption costing
The difference between direct costs and indirect costs was shown earlier in
the chapter where direct costs could easily be identified with each unit of
output, whereas indirect costs (overheads) could not.
Indirect costs (overheads) relate to the cost of operating the various
sections of the business, that is:
• factory overheads
• administration overheads
• selling and marketing overheads.
These costs cannot be allocated to a particular unit of production but must
instead be shared amongst all the cost units to which they relate.
The way in which the overheads are charged to cost units is via cost
centres. Cost centres vary according to the size of the organisation and the
products they manufacture.
Allocation of overheads
Sometimes overheads relate to one particular cost centre, for example:
• in a factory the salary of a foreman who only works in one department will
have all his salary allocated to that particular cost centre
• depreciation of the plant and equipment in that department
• the cost of power and heating for that department.
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Apportionment of overheads
If an overhead cannot be allocated to a specific cost centre, it has to be
apportioned or shared between the various cost centres and each charged with
a fair proportion of the overhead cost.
Taking the example shown above, if the foreman supervised two
departments of the business then the cost of his salary would need to be
shared between the two cost centres.
Equally, if there is more than one department then the cost of heating and
lighting would need to be apportioned between each department. In this case
the difficulty arises as to the appropriate method in which to apportion the
overheads between the cost centres. Since there are many different overheads,
the basis for apportionment differs with each overhead (see below):
Overhead
Rent and rates
Building insurance
Building depreciation
Insurance plant & machinery
Depreciation plant & machinery
Heating & lighting
Canteen
Human resources/welfare etc
Supervision
Basis of Apportionment
Area of department/section
Area of department/section
Area of department/section
Cost or net book value of
equipment
Net book value
Area of department/section
Number of employees
Number of employees
Number of employees or time
spent in each cost centre by
supervisor
The basis on which the overheads are apportioned depends on the particular
organisation with different methods being used for each overhead as shown
above.
The following example illustrates the apportionment of the canteen
overhead:
Example 1: Avery Products has three cost centres, namely production
departments A and B plus one non-productive cost centre, maintenance. The
total cost of running the canteen for the year amounts to $120,000; this
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overhead is to be apportioned to the three cost centres on the basis of number
of employees:
Workings:
1 Ascertain the amount of the overhead = $120,000
2 Ascertain the basis of apportionment = Number of employees
3 Ascertain the number of employees = 120
4 Divide the total cost of the overhead $120,000 by 120 = $1,000
5 Multiply the number of employees in each cost centre by the rate per
employee, namely, $1,000
6 Finally, ensure that the apportioned amounts equal the total canteen
overhead: $65,000 + $45,000 + $10,000 = $120,000
Example 2: Ace Components make and supply components to the electronic
market. The company operates two production departments A and B,
department B being smaller than department A. Details of each department
are shown below:
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At the end of the financial year the overheads that were to be allocated or
apportioned were as follows:
1
2
3
4
5
6
7
Rent and rates
Supervisor’s salary
Insurance of machinery
Depreciation of machinery
Building insurance
Heating and lighting
Canteen
$16,000
$25,000
$2,400
$6,000
$3,000
$5,000
$10,000
Workings:
1 Rent & rates = $16,000 divided by 800 square metres = $20 per square
metre
Dept A = 500 square metres × $20 = $10,000
Dept B = 300 square metres × $20 = $ 6,000
2 Supervisor’s salary = $25,000 divided by 20 employees = $1,250 per
employee
Dept A = 14 × $1,250 = $17,500
Dept B = 6 × $1,250 = $7,500
3 Machinery insurance = $2,400 divided by $80,000 = $0.03 per $ of
machinery
Dept A = $60,000 × $0.03 = $1,800
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4
5
6
7
8
Dept B = $20,000 × $0.03 = $600
Depreciation of machinery = $6,000 divided by $80,000 = $0.075 per $ of
machinery
Dept A = $60,000 × $0.075 = $4,500
Dept B = $20,000 × $0.075 = $1,500
Building insurance = $3,000 divided by 800 square metres = $3.75 per
square metre
Dept A = 500 × $3.75 = $1,875
Dept B = 300 × $3.75 = $1,125
Heating & Lighting = $5,000 divided 800 square metres = $6.25 per square
metre
Dept A = 500 × $6.25 = $3,125
Dept B = 300 × $6.25 = $1,875
Canteen = $10,000 divided by 20 employees = $500 per employee
Dept A = 14 × $500 = $7,000
Dept B = 6 × $500 = $3,000
Check that each of the apportioned overhead charges agrees with the total.
Calculation of the overhead absorption rate
The above information is then used to calculate the overhead absorption rate
for each department using the direct labour method as now illustrated:
Example 3: Using the figures from Ace Components, that is, $45,800 for
Dept A and $21,600 for Dept B, the overhead absorption rate can now be
calculated:
Assuming that the employees work a 40-hour week over 48 weeks in the
year, the total direct labour hours would be:
• Dept A, 40 hours × 48 weeks × 14 employees = 26,880 hours
• Dept B, 40 hours × 48 weeks × 6 employees = 11,520 hours
Using the above formula, the rates are:
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These rates are then used when calculating the price of a job or contract, see
Example 4.
Example 4: Assume that an enquiry is received by Ace Components for
various electronic parts to be manufactured in Dept A. To enable a cost to be
calculated the following information is available:
You will see from the above costing that the overhead rate of $1.70 per
labour hour × the number of labour hours, that is, 15 hours, has been added to
the cost of the direct materials and direct labour giving a total cost of
production of $305.50.
Helpful Hint!
Examination Tip:
Be able to use absorption costing, cost-plus pricing and mark-up
pricing methods to calculate the cost per unit for a business.
To this cost, the business would then add a percentage to represent their
profit.
Note: There are other methods of costing which you will encounter as you
progress in your studies but these are outside the scope of this book.
Summary
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• Cost accounting is an important function within an organisation
since it assists management in decision making, planning,
budgeting and control with the production of goods or services.
• The elements of cost are described.
• Overheads are divided into various categories, that is, factory,
administrative and selling and distribution.
• The prime cost of manufacture comprises of direct materials, direct
labour and direct expenses.
• Prime cost plus overheads equals total cost.
• Costs may be either fixed or variable.
• A unit cost of production relates to one unit.
• A cost centre is individual parts of the business to which costs can
be charged.
• Margin and mark-up are based upon the formula: Cost price +
Gross profit = Sales (see Chapter 14).
• Cost-plus pricing is any method of pricing to which a percentage, to
represent profit, is added to total cost of production.
• Absorption costing is a method whereby overhead costs are
charged to cost centres.
• Overheads can then be allocated to a specific cost centre or
apportioned (shared) between cost centres.
• Overheads are apportioned using, for example, floor area, number
of employees, cost or net book value.
• An example using the overhead absorption rate is illustrated.
Chapter 36 Exercises
36.1 What is the purpose of costing?
36.2 State clearly the difference between:
• direct and indirect costs
• fixed and variable costs.
36.3X (a) Define the following:
(i) cost unit
(ii) cost centre.
(b) Give one example of each for a printing and stationery
business.
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36.4 Duffy Furniture makes pine stools, chairs and tables. Below is
shown a list of costs incurred by the business. You are required
to state whether each cost is a direct or indirect cost.
(a) wood used to make the furniture
(b) rent and rates of the workshop
(c) glue used in the manufacture
(d) advertising costs
(e) joiners’ wages
(f) heating and lighting of the workshop
(g) depreciation of the joinery machinery
(h) book-keeper’s salary.
36.5X Gibbons is a small engineering works situated on the outskirts
of Georgetown. Below are listed figures relating to the accounts
for the last six months ending 30 June 2018:
You are required to prepare a cost statement for the six-month
period ending on 30 June 2018 which clearly shows:
• prime cost
• production cost
• total cost.
36.6X From the following information, you are required to ascertain
the production cost per unit for each of the two products:
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‘standard’ and ‘delux’.
The number of units produced in the six-month period were:
36.7X Berry’s Fashions make clothing and accessories for ladies
and children. The company has two cost centres, namely,
‘ladies’ and ‘children’. The following figures relate to the year
ended 31 December 2018:
At the end of the financial year, the overheads that were to be
allocated or apportioned are shown below:
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The employees work a 38-hour week for 47 weeks a year.
Required:
1 Draw up a table showing the analysis of production overheads
and the basis of allocation and apportionment for the two
departments.
2 Calculate the overhead absorption rate based on the direct
labour hours for each of the two departments.
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37 Manufacturing accounts
Specific objectives
After you have studied this chapter you should be able to:
• calculate prime cost and production costs of goods manufactured
• distinguish between inventory of raw materials, work in progress
and finished goods
• prepare a manufacturing account and appropriate trading and profit
and loss accounts
• adjust the accounts in respect of work in progress.
37.1 Introduction to manufacturing
accounts
So far, the accounts dealt with have related to retailing businesses; we will
now consider manufacturing businesses. For these businesses, a
manufacturing account is prepared in addition to the trading and profit
and loss account. Manufacturing accounts tend to be produced for internal
use by the owners and managers and are rarely shown to other people outside
the organisation.
The manufacturing account is prepared to show the production cost of
making goods. As shown below, these costs build up starting with the direct
materials, direct labour and direct expenses to give us the prime cost. Indirect
manufacturing costs, also known as factory overheads, are then added to give
the production cost of manufacture. The production cost is then shown in the
trading account (see Section 37.8).
37.2 Total cost of manufacturing:
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You may recall from Chapter 36 the way in which costs are divided into
different types; these are summarised again and shown below:
37.3 Direct and indirect costs
Referring to the chart in the previous section, you will see the word direct
followed by a type of cost, and you will know that it has been possible to
trace the costs of manufacturing an item. The total of all the direct costs is
known as the prime cost. If a cost cannot easily be traced to the item being
manufactured, then it is an indirect cost and will be included under the
indirect manufacturing costs (factory overhead expenses). Production
cost is the total of the prime cost plus the indirect manufacturing costs.
For example, the wages of a machine operator making a particular item
will be direct labour. The wages of a foreman in charge of several people on
different jobs will be indirect labour and will be part of the indirect
manufacturing costs. Other examples of costs being direct costs would be:
• cost of raw materials including carriage inwards on those raw materials
• hire of special machinery for a job.
37.4 Indirect manufacturing costs
(factory overhead expenses)
Indirect manufacturing costs are all those costs which occur in the factory or
other places where production is being carried out but that cannot easily be
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traced to the items being manufactured. Examples are:
• wages of cleaning staff
• wages of crane drivers
• rent and business rates for the factory
• depreciation of plant and machinery
• costs of operating fork-lift trucks
• factory power and lighting.
37.5 Administration expenses
Administration expenses consist of such items as managers’ salaries, legal
and accountancy charges, the depreciation of office equipment, and
secretarial salaries.
37.6 Selling and distribution expenses
Selling and distribution expenses are items such as sales staff salaries and
commission, carriage outwards, depreciation of delivery vehicles,
advertising, and display expenses.
37.7 Finance charges
Finance charges are those expenses incurred in providing finance facilities
such as interest charged on a loan, bank charges and discounts allowed.
37.8 Format of financial statement
Manufacturing account section
This is debited with production cost of goods completed during the
accounting period. It consists of:
• direct material, found as follows:
(i) opening inventory of raw materials
(ii) add the cost of purchases of raw materials plus carriage inwards
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charges
(iii) less closing inventory of raw materials.
This gives the cost of raw material consumed.
To this figure add the following:
• direct labour
• direct expenses.
This now gives the figure for prime cost.
Now add:
• indirect manufacturing costs (factory overhead expenses) such as indirect
wages, factory rent, depreciation of plant and machinery etc.
• opening work in progress
and deduct closing work in progress.
This gives production cost of goods completed.
Thus, when completed, the manufacturing account shows the total
production costs relating to the goods manufactured and available for sale
during the accounting period. This figure is then transferred to the trading
account section of the trading and profit and loss accounts.
Note: Many students are so used to deducting expenses such as wages,
rent, depreciation etc., in profit and loss accounts that they can easily fall into
the trap of deducting these instead of adding them in the manufacturing
account. Remember we are building up the cost of manufacture so all costs
are added.
Helpful Hint!
Examination Tip:
In the Manufacturing Account, remember to add expenses, that is,
wages, rent, insurance etc.
Trading account section
This account includes:
• production cost brought down from the manufacturing account
• opening and closing inventory of finished goods
• sales.
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When completed, this account will disclose the gross profit. This figure will
then be carried down to the profit and loss account section of the final
accounts.
The manufacturing account and the trading account can be shown in the
form of a diagram.
Helpful Hint!
Practice Tip:
Remember that the ‘Production Cost of goods completed’ is
transferred to the Trading Account.
(1) is production costs of goods unsold in the previous period.
(2) is production costs of goods unsold at the end of the period.
Profit and loss account section
This section includes:
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•
•
•
•
gross profit brought down from the trading account
all administration expenses
all selling and distribution expenses
all finance charges.
Since some of the charges usually found in the profit and loss account will
have already been included in the manufacturing account, only the remainder
need charging to the profit and loss account.
When complete, the profit and loss account will show the net profit.
37.9 A worked example of a
manufacturing account
Exhibit 36.1 shows the necessary details for a manufacturing account. It has
been assumed that there were no partly completed units (known as work in
progress) either at the beginning or end of the period.
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Exhibit 37.1
Sometimes, if a business has produced less than its customers have
demanded, the business may well have bought an outside supply of finished
goods. In this case, the trading account will have both a figure for purchases
and for the production cost of goods completed.
37.10 Work in progress
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The production cost to be carried down to the trading account is that of
production cost of goods completed during the period. If items have not been
completed, they cannot be sold. Therefore, they should not appear in the
trading account.
For instance, if we have the following information, we can calculate the
transfer to the trading account:
The calculation is:
37.11 A worked example for a
manufacturing account
The following information is available for the business of T. Hawkins:
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Exhibit 37.2
The trading account is concerned with finished goods. If in Exhibit 37.2 there
had been $3,500 Inventory of finished goods at 1 January 2017 and $4,400 at
31 December 2017, and the sales of finished goods amounted to $25,000,
then the trading account would appear thus:
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The profit and loss account is then constructed in the normal way.
37.12 Apportionment of expenses
Quite often, expenses will have to be split between:
An instance of this could be the rent expense. If the rent is paid separately for
each part of the organisation, then it is easy to charge the rent to each sort of
expense. However, only one figure of rent might be paid, without any
indication as to how much is for the factory part, how much is for the selling
and distribution part and that for the administration buildings.
How the rent expense will be apportioned in the latter case will depend on
circumstances, but will use the most equitable way of doing it. A range of
methods may be used, including ones based upon:
• floor area
• property valuations of each part of the buildings and land.
Helpful Hint!
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Question:
Why do figures for electricity, rent, cleaner/watchman’s wages need
to be allocated between manufacturing and non-manufacturing
costs?
37.13 Full set of final accounts: worked
example
A complete worked example is now given. Note that in the profit and loss
account the expenses have been separated to show whether they are
administration expenses, selling and distribution expenses, or financial
charges.
The trial balance in Exhibit 37.3 has been extracted from the books of R
James, Toy Manufacturer, as at 31 December 2017.
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Exhibit 37.3
Notes at 31.12.2017:
(i) Inventory of raw materials $2,400; Inventory of finished goods $4,000;
work in progress $1,500.
(ii) Lighting, rent and insurance are to be apportioned: factory five-sixths,
administration one-sixth.
(iii) Depreciation on productive machinery and office computers is at 10%
per annum on cost.
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Note: Students often find the preparation of manufacturing accounts difficult
to grasp and may find it useful to remember the following areas in which they
could easily make a mistake:
1 Remember to add any item appearing under the heading of ‘Indirect
manufacturing costs’, that is, rent, wages, depreciation, power and lighting
etc.
2 In the trading account ‘Cost of goods sold’ section ensure you use the
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‘Production cost of goods completed’, that is, $79,345 and not the
purchases figure.
3 In the statement of financial position, under Current assets, be sure to
include all three closing inventories if applicable to your question, that is,
(i) Inventory of raw materials
(ii) Inventory of work in progress
(iii) Inventory of finished goods.
Helpful Hint!
Examination Tip:
Ensure that you classify all items correctly: direct costs are those
costs that can be traced to the item being manufactured and are part
of the prime cost. Factory overhead costs are indirect costs which are
added to the prime cost to give the production cost.
Summary
• Where a firm makes goods rather than buying them ready made,
then the cost of production is found by drawing up a manufacturing
account.
• The cost of producing an item is made up of direct materials, direct
labour and direct expenses to give us the ‘prime cost’. To this
figure is added any indirect manufacturing costs (factory costs),
plus the opening inventory of work in progress less closing
inventory of work in progress to find the ‘production cost of goods
completed’.
• Direct costs are those costs that can be traced to the item being
manufactured.
• Indirect manufacturing costs (factory costs) are those costs relating
to the manufacture of an item that cannot be easily traced, for
example, a foreman’s wages. These are also called ‘indirect costs’.
• Where an organisation manufactures its own goods, then the
financial statements consist of a manufacturing account which
gives the production cost of goods completed, the trading account
showing gross profit and the profit and loss account showing net
profit.
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• It is important to adjust the manufacturing account for any work in
progress at the start and end of the accounting period.
• Be careful to watch out for the areas likely to cause errors when
preparing financial statements of a manufacturing organisation.
Chapter 37 Exercises
37.1 From the following information, prepare the manufacturing and
trading account of E. Smith for the year ended 31 March 2017.
37.2X From the following details, you are to draw up a
manufacturing, trading and profit and loss account of P. Lucas
for the year ended 30 September 2017.
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37.3X CCC Ltd makes ornaments, which it sells in wooden cases.
The following information is made available to you in respect of
the year ended 31 December 2017:
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The firm completely finished the manufacture of 1,000
ornaments. All ornaments were sold immediately on completion
for $80 each. In addition, consider the following.
• Factory plant was valued at $100,000 on 1 January 2017. It
depreciates by 20% for 2017.
• 80% of the wages are for productive workers, and 20% for
factory overheads.
• 50% of the lighting is for the factory.
Required:
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(a) Draw up a manufacturing account to disclose:
(i) cost of raw materials used
(ii) cost of wooden cases used
(iii) prime cost
(iv) factory overheads
(iv) cost of production.
(b) Draft the trading and profit and loss account for the year
ended 31 December 2017.
(c) Ascertain the production cost of each boxed ornament.
(d) Calculate the gross profit on each boxed ornament sold.
37.4 From the following ledger balances of G. C. & Co., prepare the
manufacturing, trading and profit and loss account, for the year
ended 31 December 2018.
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Rent and rates, and gas and fuel must be apportioned Factory
three-quarters, Office one-quarters.
Show clearly the prime cost in your answer.
37.5 The R. B. Manufacturing Co. has the following information in
respect of the year ended 31 December 2017.
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(a) Draw up the manufacturing account for the year ended 31
December 2017 to disclose:
(i) cost of raw materials used
(ii) prime cost
(iii) factory overheads
(iv) cost of production for goods completed.
(b) If R. B. Manufacturing had produced 1,000 units during the
year, calculate the unit cost of production.
(c) If the goods produced by R. B. Manufacturing could be
bought elsewhere at $120 per unit, should R. B.
Manufacturing carry on production? Give your reasons.
37.6X (a) Ideal Products deals in only one item. The following
information is in respect of the year ended 31 December 2018:
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The following information for 2018 is also available:
Draw up a manufacturing and trading account showing:
(i) cost of raw materials consumed
(ii) prime costs
(iii) factory overhead expenses
(iv) total cost of production
(v) cost of goods completed
(vi) cost of goods sold
(vii) gross profit.
(b) Another manufacturer, Other Things Ltd, makes similar
items. During 2018 the following figures were obtained:
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There was no work-in-progress.
The number of items produced was as follows:
Ideal Products: 10,000 items; Other Things Ltd: 11,000 items.
(i) Calculate the average cost per unit for each factory.
(ii) Which factory is more productive? Give reasons.
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38 Accounting for limited
liability companies
Specific objectives
After you have studied this chapter you should be able to:
• explain how limited liability companies differ from sole traders and
partnerships
• identify the features of a limited liability company and distinguish
between public and private limited liability companies
• calculate how distributable profits available for dividends are
divided between the different classes of shares
• appreciate the difference between shares and debentures
• prepare the journal and double entry records for the issue of
shares and debentures
• prepare the trading and profit and loss accounts (including the
appropriation account) for a limited liability company
• prepare a statement of financial position for a limited liability
company
• understand bonds and treasury bills.
38.1 Introduction
This chapter looks at further ways of owning a business other than the
arrangements of sole traders and partnerships. When a business needs to
expand, additional capital will probably be needed, and forming a limited
liability company makes it possible to raise more funds for the expansion.
38.2 Limited companies
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Limited companies are formed because of the advantages they provide over
the status of partnerships. The previous chapter has stated the terms under
which a partnership operates. Briefly, partnerships can have no more than 20
owners, not counting limited partners. In addition, if a partnership fails, a
partner is responsible for the business assets and could lose all or part of
privately owned assets. In contrast, a public limited company can have as
many owners as it wants and each owner cannot lose more than the amount
invested in the company. No private assets can be lost.
The law governing the preparation and publication of the financial
statements of limited companies in the United Kingdom is contained in the
Companies Act 2006. After several years of consultation, the provisions of
the 2006 Act became law in October 2009. This new Act consolidated and
replaced the previous Companies Acts of 1985, 1989 and 2004.
These are the Companies Acts of 1985 and 1989. Both Acts are in force for
this purpose, the 1989 Act adding to and amending the 1985 Act; it is on
these Acts that this chapter is based. However, you may need to refer to the
relevant statute in your own country, for example Jamaica has a new
Companies Act 2004.
Advantages
• The owners (shareholders) of the company have limited liability (see
Section 38.3).
• In law, a limited company is a ‘separate legal entity’ (see Section 38.6).
• Capital can be more readily raised to fund expansion.
• The long-term viability is not affected by the death of the owners
(shareholders).
• Larger companies can offer employees an incentive by giving shares and/or
offering employees the opportunity to purchase shares at an advantage
price.
• Shares in a public limited company are listed on the stock exchange and
can, therefore, be easily bought and sold.
Disadvantages
• A limited liability company must conform to government regulations and
legislation.
• Shares in a private limited company can only be bought and sold in private.
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• The decision-making process can take a longer time to achieve than in
smaller organisations, that is, sole traders and partnerships.
• Larger organisations can lose personal contact with their employees who
may lose interest as a result.
• Since financial reports of limited companies are sent to all shareholders and
in the case of public limited companies they are published, the financial
data no longer remains private.
38.3 Limited liability
The capital of a limited liability company is divided into shares. Shares can
be priced at $1, $5, $10 or any other amount per share. To become a member
of a limited company, that is, a shareholder, a person must buy one or more
of the shares.
If the shareholders have paid in full for their shares, their liability is limited
to those shares. If a company loses all its assets, all the shareholders can lose
is their shares. They cannot be forced to pay anything out of their private
money in respect of the company’s losses.
Shareholders who have only partly paid for their shares can be forced to
pay the balance owing on the shares. Apart from that, they cannot be forced
to pay out of their private money for company losses.
This is known as limited liability, and the company is known as a limited
company. You can see that these fit the need for organisations requiring
limited liability for their owners and where it is possible to have a large
amount of capital.
38.4 Private and public companies
There are two classes of company, the private limited company and the
public limited company. Generally, there are more private companies than
public companies.
In the Companies Acts (in the United Kingdom), a public company is
defined as one that fulfils the following conditions:
• Its Memorandum of Association (see Section 38.6) states that it is a public
company, and has registered as such.
• It has an authorised share capital of at least £50,000 (in the United
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Kingdom). However, see below in Section 38.8 regarding the Companies
Act 2006.
• Minimum membership is one; there is no maximum.
• The company name must end with the words PLC (Public Limited
Company).
A private company is usually – but not always – a smaller business, and may
be formed by one or more persons. It is defined by the Companies Act 2006
as ‘any company that is not a public company’. Many small businesses form
a private limited company to take advantage of limited liability (see above,
Section 38.3).
The main features of a private limited company are:
• no minimum requirement for issued share capital
• cannot offer its shares for sale to the general public
• have at least one member (shareholder) and one director who may be the
sole shareholder
• be registered at Companies House (incorporated)
• no need to have a company secretary, however, if it does have one it must
notify Companies House
• no need to hold an Annual General Meeting (AGM) unless it specifically
wishes to.
38.5 Company directors
A shareholder normally has the right to attend the general meetings of a
company, and can vote at such meetings. Shareholders use their votes to
appoint directors, who manage the business on behalf of the shareholders.
At each Annual General Meeting (AGM), the financial statements for
the year are given to the shareholders. The directors at the meeting have to
give a report on the performance made by the company during the last
financial period.
38.6 Legal status of a limited company
The most important feature of a limited company is its status in law as a
separate legal entity. This means that no matter how many individuals have
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bought its shares, it is treated in its dealings with the outside world as if it
were a ‘person’ in its own right.
When a limited company is formed, it is required by law to raise two
documents known as the Memorandum of Association and the Articles of
Association. The first document sets out the details of the company and its
objectives, while the Articles of Association state the regulations concerning
the powers of the directors. These regulations are of the utmost importance
when it is realised that the legal owners of the business, namely the
shareholders, have entrusted the running of the company to the directors.
38.7 Share capital and dividends
The term ‘share capital’ refers to:
(a) Authorised share capital – the total of the share capital that the
company would be allowed to issue (as stated in the Memorandum of
Association); also called ‘nominal capital’. Note: In the Companies Act
2006 a company is no longer required to have authorised share capital
and only the issued/allotted share capital will be included in the financial
statements. However, it was felt necessary to include the definition of
authorised share capital since many of the examination bodies may be
still be using existing syllabuses when setting their examination papers.
(b) Issued share capital – the amount of share capital actually issued to
shareholders.
(c) Called-up capital – where only part of the amounts payable on each
share has been asked for; the total amount requested on all the shares is
known as the ‘called-up capital’.
(d) Uncalled capital – the amount that is to be received in future, but
which has not yet been requested.
(e) Calls in arrears – the amount for which payment has been requested
(that is, called for), but has not yet been paid by shareholders.
(f) Paid-up capital – the total of the amount of share capital that has been
paid for by shareholders.
If all of the authorised share capital has been issued, then items (a) and (b)
above are the same. The example below illustrates these different meanings.
Example: Better Enterprises Ltd was formed with the legal right to be able
to issue 100,000 shares of $1 each. The company has actually issued 75,000
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shares. None of the shares has yet been fully paid up; so far the company has
made calls of 80 cents ($0.80) per share. All of the calls have been paid by
shareholders except for $200 owing from one particular shareholder. On this
basis, therefore:
(a) Authorised (or nominal) share capital is $100,000.
(b) Issued share capital is $75,000.
(c) Called-up capital is (75,000 × $0.80) = $60,000.
(d) Uncalled capital is issued share capital less called up capital ($75,000 –
$60,000) = $15,000.
(e) Calls in arrears amounted to $200.
(f) Paid-up capital is called-up capital less calls in arrears ($60,000 – $200) =
$59,800.
When a company makes a profit, the directors will have to decide how this is
to be used. They will probably retain part of the profit as reserves, which will
be used to expand the business. The remaining part is likely to be used to
reward the shareholders for investing in the company. This share of the
profits is known as the dividend.
The dividend is usually shown as a percentage. A dividend of 10% in Firm
A on 500,000 ordinary shares of $1 each will amount to $50,000. A dividend
of 6% in Firm B on 200,000 ordinary shares of $2 each will amount to
$24,000. A shareholder having 100 shares in each firm would receive $10
from Firm A and $12 from Firm B.
There are two main types of shares:
• Preference shares – Preference shareholders get an agreed percentage
rate of dividend before the ordinary shareholders receive anything.
• Ordinary shares – Ordinary shareholders receive the remainder of the
total profits available for dividends. There is no upper limit to the amounts
of dividends they can receive.
For example, if a company had 10,000 5% preference shares of $1 each and
20,000 ordinary shares of $1 each, then the dividends would be payable as in
Exhibit 38.1.
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Exhibit 38.1
It can be seen that preference shareholders receive a fixed amount of dividend
each year, while the ordinary shareholders receive a variable amount
depending on the performance of the company. The profit level in Year 4 was
very good and the ordinary shareholders received a substantial 13% dividend.
There are two main types of preference shares.
• Non-cumulative preference shares – These can receive a dividend up to
an agreed percentage each year. If the amount paid is less than the
maximum agreed amount, any shortfall is lost by the shareholders.
• Cumulative preference shares – These also have an agreed maximum
percentage dividend. However, any shortage of dividend paid in a year can
be carried forward.
• These arrears of preference dividends will have to be paid before the
ordinary shareholders receive anything.
Exhibit 38.2 illustrates the two types of shares. A company has 5,000 $1
ordinary shares and 2,000 5% non-cumulative preference shares of $1 each.
The profits available for dividends are: year 1, $150; year 2, $80; year 3,
$250; year 4, $60; year 5, $500.
Exhibit 38.2
If instead the preference shares in Exhibit 38.2 had been cumulative, the
dividends would be as shown in Exhibit 38.3 (differences asterisked).
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Exhibit 38.3
Helpful Hint!
Question:
What are the differences between Authorised Share Capital and
Issued Share Capital?
38.8 Trading and profit and loss
accounts
The trading and profit and loss accounts for both private and public
companies are drawn up in exactly the same way.
The trading account of a limited company is no different from that of a
sole trader or a partnership. However, some differences may be found in the
profit and loss account. The two main expenses that would be found only in
company accounts are directors’ remuneration and any debenture interest.
• Directors’ remuneration – As directors exist only in companies, this
type of expense is found only in company accounts. Directors are legally
employees of the company, appointed by the shareholders. Their
remuneration is charged to the main profit and loss account.
• Debenture interest – The term debenture refers to money received by
the company as a loan from someone. A special written agreement shows
all the agreed terms for the debenture. For this loan, the lender is paid
interest at an agreed percentage. This is known as debenture interest. It
must be paid even if the company is making a loss. In contrast, dividends
are payable only if profits have been made. Debenture interest is an
expense to be charged in the main profit and loss account.
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38.9 The appropriation account
There is a section under the profit and loss account called the profit and loss
appropriation account (see Chapter 34 Section 34.7). The appropriation
account shows how the net profits are to be appropriated, that is, how the
profits are to be used.
We may find any of the following in the appropriation account.
Credit side
• Net profit for the year – This is the net profit brought down from the main
profit and loss account.
• Balance brought forward from last year – As you will see, all the profit
may not be appropriated during a period. This then will be the balance on
the appropriation account, as brought forward from the previous year. They
are usually called retained profits.
Debit side
• Transfers to reserves – The directors may decide that some of the profits
should not be included in the calculation of how much should be paid out
as dividends. These profits are transferred to reserve accounts. There
may be a specific reason for the transfer, such as a need to replace noncurrent assets; in this case an amount would be transferred to a non-current
assets replacement reserve. Alternatively, the reason may not be specific,
and in this case an amount would be transferred to a general reserve
account.
• Amounts written off as goodwill – Any amounts written off as goodwill
should be shown in the appropriation account and not in the main profit
and loss account.
• Amounts written off as preliminary expenses – When a company is
formed, there are many kinds of expenses concerned with its formation.
These include, for example, legal expenses and various government taxes.
The amount of preliminary expenses can be written off and charged in the
appropriation account.
• Taxation payable on profits – Although this is not on your syllabus,
taxation in fact is an appropriation of profits and would be shown as a debit
in the appropriation account.
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• Dividends – Out of the remainder of the profits, the directors propose the
amount of dividends to be paid.
• Balance carried forward to next year – After the dividends have been
proposed, there will probably be some profits that have not been
appropriated. These retained profits will be carried forward to the
following year.
Exhibit 38.4 shows the profit and loss appropriation account of a new
business for its first three years of trading.
• IDO Ltd has a share capital of 40,000 ordinary shares of $1 each and
20,000 5% preference shares of $1 each.
• The net profits for the first three years of business ended 31 December are:
2016 $15,967; 2017 $17,864; 2018 $18,822.
• Transfers to reserves are made as follows: 2016 nil; 2017 general reserve
$10,000; 2018, non-current assets replacement reserve $11,500.
• Dividends were proposed for each year on the preference shares and on the
ordinary shares at: 2016 10%; 2017 12.5%; 2018 15%.
• In 2018, $750 was written off as goodwill. Thus, we have:
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Exhibit 38.4
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38.10 The statement of financial
position
Prior to the Companies Act 1981 in the United Kingdom, a company could,
provided it disclosed the necessary information, draw up its statement of
financial position and profit and loss account for publication in any way that
it wished. The 1981 Act, however, stopped such freedom of display, and laid
down the precise details of how the statements should be presented. More
recently, in the Companies Act 2006, this has not changed although the
current legal requirements are noted in the Companies Act 1985. The UK is
now conforming to International Standards which are not specific about the
layout, therefore, UK companies continue to use the Companies Act’s layout.
We are, therefore, showing two specimen statements of financial position
containing the same facts:
Exhibit 38.5 is for students sitting examinations based on UK laws. The
specimen shown does not contain all the possible items that could be shown,
as this chapter is an introduction to the topic only.
Exhibit 38.6 is for students sitting local overseas examinations not based
on UK legislation.
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Exhibit 38.5 (for students sitting examinations based on UK legislation)
Notes:
(A) Intangible assets are those not having a ‘physical’ existence; for
instance, you can see and touch tangible assets under (B), that is,
buildings, machinery etc., but you cannot see and touch goodwill.
(B) Tangible non-current assets under a separate heading. Note that figures
are shown net of depreciation. In a note accompanying the accounts, the
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cost and depreciation on these assets would be given.
(C) Only items payable within one year go under this heading.
(D) The term ‘net current assets’ replaces the more familiar term of
‘working capital’.
(E) These particular debentures are repayable several years hence. If they
had been payable within one year, they would have been shown under
(C).
(F) An analysis of share capital will be given in supplementary notes to the
statement of financial position.
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Exhibit 38.6 (for local overseas examinations)
Notes:
(A) Non-current assets should normally be shown either at cost or,
alternatively, at some other valuation. In either case, the method chosen
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should be clearly stated.
(B) The total depreciation from date of purchase to the date of the
statement of financial position should be shown.
(C) The authorised share capital, where it is different from the issued share
capital, is shown as a note to the accounts for information only.
(D) Where shares are only partly called up, then it is the amount actually
called up that appears in the statement of financial position and not the
full amount.
(E) Reserves consist either of those unused profits remaining in the
appropriation account, or those transferred to a reserve account
appropriately titled, for example, general reserve, non-current assets
replacement reserve. At this point, all that needs to be said is that any
account labelled as a reserve has originated by being charged as a debit
in the appropriation account and credited to a reserve account with an
appropriate title. These reserves are shown in the statement of financial
position after share capital under the heading of ‘Reserves’.
(F) The share capital and reserves should be totalled to show the book
value of all the shares in the company. Either the term ‘shareholders’
funds’ or ‘members’ equity’ is often given to the total of share capital
plus reserves.
38.11 Accounting for an issue of shares
When a company is first formed, it raises its capital by issuing shares. Thus,
if it needs $100,000 to finance its business, it may issue 100,000 ordinary
shares at $1 each to provide the money.
The company invites people to apply for the shares. If the full amount is to
be paid on application, then the would-be shareholders send in $1 for each
share they have applied for. If people send in more money than the number of
shares to be allotted, then refunds will have to be made for excess
applications.
Let us look at the accounting needed in two exhibits. In Exhibit 38.7,
exactly the correct number of shares have been applied for; in Exhibit 38.8
people have applied for more shares than are available.
The double entry is as follows:
1 Cash received as applications for shares.
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• Debit bank.
• Credit share applicants.
2 Any excess money received, when refunded.
• Debit share applicants.
• Credit bank.
3 Shares allotted.
• Debit share applicants.
• Credit share capital account.
These three points are to show the double entry needed, since there were no
refunds made in Exhibit 38.7, no entries regarding the second point are
required.
The company has 10,000 ordinary shares of $1 each to issue. Exactly
10,000 shares are applied for with the applicants paying $1 per share. The
shares are then allotted.
Firstly, the journal entries will be shown, followed by the double entry
accounts.
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Exhibit 38.7
The company has 20,000 ordinary shares of $2 each to issue. Applications,
with the payment, are received for 23,000 shares. Refund is made in respect
of the excess money received.
Firstly, the journal entries are shown followed by the double entry.
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Exhibit 38.8
When a company first starts up in business, any shares that are issued to
shareholders will be at par. The ‘par value’ means that, for instance, a $1
share will be issued for $1. So, a shareholder buying 50 of such shares will
pay $50.
After a year or two, the company may have prospered, and the 50 shares
originally bought by the shareholder may be worth more money. If the
original shareholder wanted to purchase another 50 new $1 shares, then he
would have to pay more per share. The company have now offered these
shares at $1.50, $0.50 more than the par value. This extra amount is known as
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the share premium.
Similarly, if the company had made some losses, then shares originally
issued for $1 each might be worth less than that. Any more shares may then
be issued at less than par value. If, for instance a $1 share is issued for $0.75,
then the $0.25 difference is known as the discount on shares.
However, the accounting requirement of your syllabus is limited to
recording the issue of shares at par value.
38.12 Accounting for an issue of
debentures
Another way of raising the necessary finance for a business is to issue
debentures. By this method, people lend money to the company and are given
a debenture deed that shows the rate of interest that is to be paid on the
debenture each year.
The method of recording the issue of debentures in the accounting records
follows a similar pattern to that of the issue of shares. For example, if we had
10 debentures of $1,000 each to issue and exactly this amount was applied
for, then the accounts would appear as Exhibit 38.9. The journal entries will
be shown first followed by the double entry.
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Exhibit 38.9
38.13 Investments
Where a company buys shares in another company as an investment, the
investment is shown as an asset in the statement of financial position. It is
shown as a separate item in the accounts between the non-current assets and
the current assets.
The market value of such investments is shown in the statement of
financial position as a note in brackets, for example:
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In the above case, the market value is above cost. If the market value falls
below cost, then the difference is written off to the debit of the profit and loss
appropriation account, so that the statement of financial position will then
show the investment at the written-down figure.
38.14 Revaluation of land and buildings
When there is a surplus on revaluation, the value of land and buildings in the
statement of financial position is shown at the higher figure. The amount of
surplus cannot be used for the payment of cash dividends and is therefore
shown as an addition to reserves in the statement of financial position. It must
be described as, for example, ‘surplus on revaluation of land and buildings’.
38.15 Bonds and treasury bills
Treasury bills and bonds are sold to the public to finance governments’
budgetary requirements and special development projects. When investors
purchase these marketable securities, they are lending their money to the
government. Treasury bills and bonds can usually be purchased at auctions
directly from the country’s Central Bank and the Ministry of Finance and
Planning, respectively. These marketable securities may also be bought and
sold after the auction through licensed financial institutions, stockbrokers and
primary dealers. They are called marketable securities because after their
original issue they can be bought or sold in the secondary (commercial)
market at prevailing market prices.
Treasury bills are short-time obligations with a term of twelve months or
less and are usually accepted as liquid assets. Treasury bills are bearer notes
and must be transferred ‘under cover’, that is, a cover letter is given to the
purchaser by the seller effecting the transfer. No interim interest is paid on
treasury bills before maturity.
Treasury bills are usually sold below par value (face value). The difference
between the purchase price of the bill and the amount that is paid at maturity
(par) is the interest earned on the bill.
Treasury bill rates may be determined in two ways: (1) non-competitive
bid – this is where the investor agrees to accept a rate determined by the
auction; (2) competitive bid – the investor submits a tender specifying a
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discount rate. If the bid falls within the range accepted at the auction, the
investor will be awarded the security. Where the bid is at the high rate of
yield, the investor may not be awarded the full amount bid. Competitive
bidders may be at a disadvantage as there is the possibility that their bids
might be rejected, and in multiple-price auctions they may pay a higher price
for the security than the non-competitive bidder.
The major types of bonds usually available are debentures and local
registered stocks (LRS). Debentures and LRS are not regarded as liquid
assets. LRS only become liquid assets less than nine months prior to
maturity.
The interest rates in the beginning for debentures and LRS are usually
fixed for the first three to six months (depending on the terms of issue).
Thereafter interest can, for example, be paid every three to six months at a
variable rate between 2–2.75 percentage points above the weighted average
yield rate applicable to the six-month Treasury Bill Tender held immediately
prior to the commencement of each half-yearly interest period.
Treasury bills, debentures and LRS cannot be redeemed before maturity,
unless by the terms of their issue they are callable. Generally, bonds are longterm instruments.
Helpful Hint!
Examination Tip:
List the advantages and disadvantages of being shareholders in a
limited liability company.
Summary
• When more than one person wishes to own and run a business
they can form either a partnership or limited company. The
advantage of forming a limited company is the owners of the
company have ‘limited liability’. This means that the liability of the
shareholders in a company is limited to any amount they have
agreed to invest and their personal assets are safe if the company
gets into financial difficulties.
• A public limited company is one that can issue its shares publicly;
there must be a minimum of one shareholder and there is no
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•
•
•
•
•
•
•
•
•
•
maximum. It must also have an issued share capital of at least
£50,000 (for UK companies). A private limited company must issue
its shares privately and there is no minimum requirement for issued
share capital (for UK companies).
Limited companies are a separate legal entity to the shareholders
and as such can sue and be sued in their own name.
Public limited companies hold an annual general meeting (AGM)
once a year at which the financial statements and annual report are
submitted for approval by the shareholders who have a right to
attend and vote at the meeting. Shareholders vote to appoint the
directors who manage the business on behalf of the shareholders.
Private limited companies do not need to hold an AGM unless they
wish to.
Authorised share capital is the total amount of share capital or
number of shares the company would be allowed to issue. Note
that in the Companies Act 2006, from October 2009, there will no
longer be a requirement to have an authorised share capital.
Issued share capital is the amount of share capital actually issued
to shareholders.
There are two main types of shares: (1) preference shares – here
the shareholders get an agreed percentage rate of dividend before
the ordinary shareholders receive anything; (2) ordinary shares –
the shareholders are entitled to a dividend after the preference
shareholders have been paid their dividends. The amount they
receive fluctuates depending on the profits available.
A debenture is a loan to the company upon which a fixed rate of
interest is paid annually. The interest must be paid even if the
company makes a loss. Debentures are often secured on the
assets of the business.
The financial statements for a limited company consist of a trading
and profit and loss account, which includes an appropriation
section, and a statement of financial position.
Both debenture interest and directors’ remuneration must be
charged to the profit and loss account.
Any unappropriated profits are carried forward to the next
accounting period and must also be shown in the statement of
financial position. (Note: these are sometimes referred to as
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‘retained profits’ and ‘profit and loss account balance’.)
• Reserve accounts contain appropriated profits that have been
transferred for use in future years.
• Share premium is another class of reserve that arises when shares
are issued above the face or nominal value. The extra amount
received above the nominal value is credited to the share premium
account.
• Bonds and treasury bills are purchased by the public from various
sources including licensed financial institutions, stockbrokers and
primary dealers. They are usually sold below par (face value). The
difference between the purchase price of the bill and the amount
paid at maturity (par) is the interest earned on the bill.
Chapter 38 Exercises
38.1 Draw up a statement of financial position for R. O. Ltd from the
following as at 31 December 2017:
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38.2X C. Blake Ltd has an authorised share capital of 90,000
ordinary shares of $1 each and 10,000 10% preference shares
of $1 each. The company’s trial balance, extracted after one year
of trading, was as follows on 31 December 2017:
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The directors decide to transfer $1,500 to the general reserve
and to recommend a dividend of 12.5% on the ordinary shares.
The preference dividend was not paid until after January 2018.
You are required to:
(a) draw up the appropriation account for the year ended 31
December 2017
(b) draft a statement of financial position as at 31 December
2017.
38.3 The C. A. Company Ltd, who manufacture agricultural
implements, made a net profit after taxation of $210,000 for the
year to 31 December 2018. Retained profits at 31 December
2017 amounted to $17,000. At the directors’ meeting, the
following appropriations were agreed:
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It has also been agreed that a dividend of 10% be proposed on
the ordinary share capital; this amounted to 500,000 shares of
$2 each.
Preference share dividends of 10% had been paid during the
year on 250,000 preference shares of $1 each.
You are required to draw up the company’s profit and loss
appropriation account for the year ended 31 December 2018.
38.4X Baker Ltd was authorised to issue a total of $200,000 share
capital, divided into 150,000 ordinary shares of $1 and 50,000
8% preference shares. All ordinary shares were issued and fully
paid up. Of the preference shares, 20,000 only were issued and
fully paid. 100 10% debentures of $100 each were issued at par.
These were all taken up and paid in full.
From the above, answer the following:
(a) How much was received from the issue of preference
shares?
(b) Assuming there are sufficient profits, how much would be
received in total by preference shareholders as annual
dividends?
(c) How much was received from the issue of debentures?
(d) How much will be paid annually as debenture interest?
(e) If net profits before charging debenture interest were
$35,000 and it was all distributed, what was the rate of
dividend paid to ordinary shareholders?
38.5 The following is the trial balance of BBC Ltd as on 31
December 2017.
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From the following information, you are required to prepare the
trading and profit and loss accounts for the year ended 31
December 2017, and a statement of financial position as at that
date.
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(a) Authorised share capital: $100,000 in ordinary shares $1.
(b) Inventory at 31 December 2017, $54,300.
(c) Motor expenses owing, $445.
(d) Ordinary dividend proposed of 20%.
(e) Transfer $2,000 to general reserve.
(f) Provide for depreciation of all non-current assets at 20%
reducing balance method.
(g) Ignore taxation.
38.6X You are to draw up trading and profit and loss accounts for
the year ended 31 December 2017, and a statement of financial
position as at that date, from the following trial balance and
details of B. Tyler Ltd.
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Notes: as at 31 December 2017
(a) Inventory at 31 December 2017, $52,360.
(b) Rent, $280; office expenses owing, $190.
(c) Ordinary dividend of 10% proposed.
(d) Transfer to reserves: general, $1,000; foreign exchange,
$800.
(e) Depreciation on cost: buildings, 5%; equipment, 20%.
(f) Ignore taxation.
38.7 A limited company had an authorised share capital of $200,000
in ordinary shares of $1 each. On 1 January 2017 they decided
to issue half of the shares capital at par payable in full on
application.
Applications were received for 110,000 shares on 15 January
2017. The shares were allotted to the shareholders on 31
January 2017 and the excess monies refunded on 1 February
2017.
You are required to show:
(a) the journal entries (narratives not required)
(b) ledger accounts to record the above transactions.
38.8X Bell Limited decided to raise some additional funds to finance
an expansion programme and decided to issue 75.6%
debentures of $1,000 each payable in full on application and
repayable 5 years later at par.
Applications were received for exactly 75.6% debentures on 4
June 2017 and allotments were made on 30 June 2017.
Required:
(a) Prepare journal entries to record the above issue of the
debentures; narratives not required.
(b) State the difference between a share and a debenture.
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39 Accounting for cooperatives
Specific objectives
After you have studied this chapter you should be able to:
• define the term cooperative society
• define the legal status and types of cooperative societies
• understand who owns cooperative societies
• appreciate the nine principles of cooperative societies
• define the different ways of raising capital
• understand how to apply accounting procedures in cooperatives
for:
– recording contributions/loans
– distribution of surplus
– preparing the financial statements of income and expenditure
account and statement of financial position.
39.1 What is a cooperative society?
A cooperative society is a legally constituted business entity formed for the
explicit purpose of furthering the economic welfare of its members and that
of the wider society by providing them with goods and services. It should be
noted that a cooperative society is not a charitable organisation funded by
donations or government grants. The income is largely earned by rendering
services to its members. A cooperative society may offer a variety of services
to its members, such as insurance, credit, housing, agricultural supplies or
consumer goods.
Cooperative societies are tax exempted, that is, they do not pay tax on
surplus income, or stamp duty on instruments executed by or on behalf of a
registered society. The surplus or profit earned by a cooperative is paid back
to their members based on their investment amount. Cooperative societies
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may also offer many benefits to their members, including scholarships for
members’ children and reduced rates on loans compared to other financial
institutions.
39.2 The legal status of cooperative
societies
All cooperative societies are required to be registered under the Cooperative
Societies Act. This registration makes them bodies corporate by the names
under which they are registered. Cooperative societies have perpetual
(everlasting) succession, power to hold property and enter into contracts, and
to institute and defend legal action taken against them and other legal
proceedings. The minimum number of persons required to form a cooperative
is ten and a Steering Committee (which can be five, seven or nine members)
must be elected from its members to control the affairs of the cooperative.
39.3 Who controls a cooperative
society?
A cooperative society is owned and controlled by its members. In Jamaica
and other Caribbean territories, cooperatives are governed by various
Cooperative Societies Acts and Regulations. Despite the varied Acts, all
cooperative societies are voluntarily formed and democratically operated with
the common purpose of meeting their members’ needs economically and
efficiently. Their primary purpose is to make a profit for the members/users
of the cooperatives and not for investors. The members are both the owners
and users of the service provided by cooperatives.
39.4 Types of cooperatives
The business ventures that cooperatives can operate are unlimited. A
cooperative may decide to embark on any number of business ventures
depending on the needs of its members. Cooperatives fall into two main
categories, namely service cooperatives and production or worker
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cooperatives.
Service cooperatives
Members can trade with cooperative societies, that is, they buy from them
and sell to them. Generally, service cooperatives provide marketing
opportunities, credit facilities, supplies, equipment and other such services to
their members. The success of this type of cooperative depends largely on the
extent to which members use it. Examples of service cooperatives include the
following:
• Suppliers cooperatives – These consist of groups of people who come
together to provide for themselves any necessities, such as farm or fishing
equipment and raw materials for industrial operations.
• Thrift or credit cooperatives – These cooperatives, many based in
Barbados, provide their members with savings as well as loan facilities, the
loans being available at an interest rate lower than the rates charged by
ordinary banks, etc. The credit unions belong to this category of
cooperative. Credit unions are the strongest sector of the cooperative
movement in the Caribbean and the rest of the world. A credit union may
be defined as a financial cooperative made up of groups of people who join
together to make certain financial services available to themselves, the
members of the credit union. Apart from providing savings and loans
facilities, credit unions offer other financial services, such as educating
their members on thrift, regular savings and the wise use of credit.
• Transport and tillage cooperatives – In these types of cooperatives, farmers
may pool their resources to provide necessary transport facilities for their
produce from the farm to the markets. Also, equipment may be provided to
till the soil, for example the purchase of a tractor.
• Consumer cooperatives – These are formed out of the need to always
provide a variety of goods and services at the lowest possible cost.
Consumer cooperatives may range in size from large, wholesale
distributors to small retail outlets. These cooperatives have not been
successful in the Caribbean as a whole.
• Housing cooperatives – These cooperatives provide housing solutions for
their members, either by purchasing the houses, providing loans to
purchase the houses or having the houses built for the members.
• Insurance cooperatives – These cooperatives provide a variety of insurance
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services to their members, for example, The Jamaica Agricultural Society
Cattle Insurance Cooperative insures cattle for its members. The CUNA
Mutual Insurance Society provides loan protection and life savings
insurance for credit union members worldwide.
• Marketing cooperatives – The members of these cooperatives organise
themselves to market their products, such as farming and handicrafts.
Examples of these cooperatives are the coffee and cocoa growers
cooperative societies in Jamaica.
• Multipurpose cooperatives – These cooperatives provide a wide range of
services for their members, such as credit, marketing, farm supplies, field
technology services, acquisition and development of land for residential,
recreational and commercial purposes. Examples of these cooperatives may
be found in Jamaica and the Bahamas.
Production or worker cooperatives
These cooperatives are also known as industrial cooperatives or workshop
cooperatives. The members of these cooperatives not only provide goods and
services to the public, but also employment for themselves. Cooperatives that
fall under this heading include the following types:
Agricultural cooperatives – In the Caribbean, agricultural cooperatives
are categorised according to the functions they perform for their members.
The two categories are:
• Service cooperatives which provide their members with different kinds of
assistance, such as distribution of farm supplies, marketing of produce,
provision of credit, adequate irrigation, agricultural technology, insurance,
farming equipment and transport services.
• Collective production cooperatives which involve members uniting and
farming collectively, thus providing themselves with employment and
producing marketable products.
• Communal production cooperatives – These exist where members live
together in a community owned by the cooperative and share common
dining and other facilities. Both collective production and collective
consumption is carried out.
• Entertainment service cooperatives – These cooperatives are formed by
people in the entertainment sector, with the aims of maintaining a high
standard of performance and establishing a single bargaining agency. One
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such cooperative was formed in Jamaica by a group of entertainers
providing entertainment for hotels on the north coast.
• Junior cooperative societies – These societies belong only to the Caribbean
territories of St Vincent and Trinidad and Tobago. They are organised to
educate students in thrift and the principles and practices of cooperation.
• Transport service cooperatives – The objective of these cooperatives is to
provide means of transport for the general public. The cooperative
management controls all contracts, despite the fact that the units are owned
by the members. Transport cooperatives are found in Jamaica and
Barbados. Presently, this system of providing public transport is being
altered by the government of Jamaica to make it more efficient, with a view
to providing a modern and reliable means of transport.
39.5 The principles of cooperatives
There are certain principles and practices which cooperatives are required to
follow. These principles could also be seen as the essential features of a
cooperative. These distinguish cooperatives from the normal commercial
business organisations. The following nine basic cooperative principles,
which are considered ‘essential to genuine and effective cooperative
practice’, were adopted at the International Cooperative Alliance (ICA) 23rd
Congress in 1966.
• Open membership – Membership should be open to all those who wish to
join and use the services provided, as long as they are prepared to accept
the responsibilities of membership. There should be no restriction to
membership based on social, political, racial or religious grounds. The
members carry out their responsibilities by:
• conducting business with the society; attending and participating in
membership meetings; ensuring that they understand and are kept
informed of the business operations of their society
• being available for election to office
• assisting in financing their cooperative.
A member can also leave freely whenever he wishes and stay as long as he
wishes.
• Democratic control – Cooperative societies are formed voluntarily by a
group of people, are controlled by their members and democratically
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operated by them. The affairs of cooperative societies are administered by
those who are elected or appointed through a committee in a manner agreed
by the members. These people are accountable to the members. Each
member has only one vote, irrespective of the size of their investment.
Whereas in a public company a stockholder may appoint a proxy (someone
else) to vote on his or her behalf; this is not allowed by cooperative
societies.
• Limited interest on capital – The focus of investing in a cooperative
society is not on the return on investment, but on the use of services
provided. Therefore, share capital should only receive a modest dividend.
However, there are cooperatives that pay no dividend on share capital.
• Patronage refund – The returns from the operations of a cooperative
society belong to the members, and therefore should be distributed to them
in such a manner that no member gains at the expense of the others. To
prevent any unfairness in the distribution of any surplus, the members may
decide to:
• provide for the development of the business of the cooperative
• make available to all members common services
• distribute (the surplus) among the members in proportion to the amount
of business that they have conducted with the society over the
accounting period.
Before distributing the surplus to members, a mandatory (that is, compulsory)
transfer of 20% must be made to a statutory reserve fund. (Currently this rate
is under review in Jamaica.) If a member did no business with the society,
even if he or she had a large investment, that member might receive only a
small dividend.
• Continuous education – It is the responsibility of all cooperative societies
to make provision for the continuous education of their members, officers,
employees and the public about the general operations of cooperatives as
well as on cooperative principles and techniques. This continuous
education process is designed to make members better able to guide their
cooperatives in a dynamic business environment.
• Finances – The finances of a cooperative society are contributed through
the purchase of shares by members. Normally cooperatives provide a
service to the less financially comfortable members of society, so their
contribution is normally very small.
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• Liability of members – A cooperative can be limited or unlimited but the
limited societies are more popular. Once a cooperative is set up as limited,
it must put the word ‘Ltd’ after its name.
• Service motive – A cooperative should be formed with the basic motive of
providing a service to its members. Their objective should not be to
maximise profits at the costs of others. However, it does not mean that they
should sustain losses.
• Cooperation among cooperatives – It is felt that cooperative
organisations can best serve the interests of their members and
communities if they work together at local, national and international
levels. The degree of cooperation is sometimes documented in the by-laws
of the societies, particularly in the case of credit unions. In the Caribbean,
there is a well-established network which links cooperatives regionally,
nationally and to the world body.
Advantages of cooperative societies
• The above nine principles and practices comprise the advantages of
cooperative societies over other types of business organisations.
• Everyone has equal opportunity to belong to and be part of an organisation
whose objectives are to provide services and benefits to their membership.
• Irrespective of the size of their investment in the cooperative society, each
member is entitled to one vote.
• A member is not allowed to appoint a proxy (someone else) to vote on their
behalf whereas a shareholder of a public limited company may appoint a
proxy.
• The financial statements of cooperative societies are available to their
members but not the general public, which is the case with public limited
companies.
Disadvantages of cooperative societies
• Perhaps the main disadvantage is the amount of return on the sum invested
since the focus is not on the return from the investment but on providing a
service to members. Some cooperative societies pay only modest dividends
while some pay no dividend at all.
• The members of the cooperative society need to support the organisation
and be fully committed in order for the operation to succeed. Without this
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commitment, the organisation could find itself in difficulties.
Helpful Hint!
Discussion:
Do the advantages of joining a cooperative outweigh the
disadvantages? Discuss with your classmates, supporting your
answers with what you have learned in this chapter.
39.6 Ways of raising capital
A cooperative society’s primary source of capital is its members, who
purchase goods and services from the society, and from the net earnings on
successful operations with reinvestment of part or all of the savings.
39.7 Members’ deposits
Cooperative societies offer to their members the facility of opening deposit
accounts. Deposit accounts are a convenient means of short-term savings and
payment of standing commitments through the standing order payment
facility associated with the account. These deposit accounts attract varying
rates of interest depending on the minimum balance held and the period of
time the deposits remain in the cooperative.
39.8 Affiliation fees
Cooperative societies that are members of local, regional and international
cooperative societies are required to pay membership fees – known as
affiliation fees – to these societies.
39.9 Accounts of cooperative societies
Cooperative societies prepare income and expenditure accounts, cash flow
statements and statements of financial position, accompanied by the
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appropriate notes to these financial statements. The accounts of the societies
must be audited and distributed to their members. There are no requirements
for these accounts to be made available to the public at large which is the
case for public companies.
The excess of income over expenditure is called a surplus, while the excess
of expenditure over income is referred to as a deficit.
The following example (Exhibit 39.1) is a typical set of accounts for a
cooperative society.
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Exhibit 39.1
Notes:
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1 By the law of the country, that is, on ‘statute’, a minimum percentage of
any net income should be transferred to a ‘statutory reserve’.
2 The special reserve is for any specific named purpose.
3 The honoraria (voluntary payments as an appreciation for services
performed) paid to members of the committee of management are treated
as an appropriation of profit, not an expense. As such, they will be shown
in the appropriation account instead of in the income and expense
account.
4 The dividends will be fixed at the annual general meeting. The statement
of financial position might appear as below.
Helpful Hint!
Examination Tip:
What are five essential features of a cooperative? What is the main
difference between a cooperative and a limited liability company?
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Summary
• Cooperatives are owned and controlled by their members. The
primary purpose of operation is to provide services for the
members/users of the cooperative society and any surplus made is
reinvested for the benefit of the members.
• The different types of cooperative societies can be divided between
service cooperatives and production or worker cooperatives.
• Service cooperatives allow members to trade with them, that is,
buy and sell. They also provide marketing opportunities, credit
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•
•
•
•
•
facilities, equipment, etc. to their members.
Production or worker cooperatives provide not only goods and
services to the public but also employment for the members.
There are nine basic principles and practices that cooperatives
have to follow.
A cooperative society’s primary source of capital is from its
members.
The financial statements of a cooperative society consist of income
and expenditure account, cash flow statement and statement of
financial position accompanied by the appropriate notes.
The excess of income over expenditure is called a surplus, while
the excess of expenditure over income is called a deficit.
Chapter 39 Exercises
39.1 Prepare the appropriation account of Farmers’ Cooperative Ltd
for the year ended 31 December 2017 from the information given
below:
39.2 The Teachers’ Cooperative Credit Union Ltd prepares annual
accounts on 31 December. From the following information,
prepare the appropriation account and statement of financial
position for the year ended 31 December 2018.
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39.3X Prepare the final accounts of the Printers’ Cooperative Credit
Union Ltd for the year ended 31 December 2015 from the
following trial balance as at 31 December 2015.
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The following must be taken into consideration as on 31
December 2015:
(a) accrued affiliation fees of $500: honorarium to retiring
secretary of $1,500
(b) advertising prepaid, $480
(c) provide for depreciation: buildings at 2% of cost; motor
vehicle at 10% of cost
(d) transfer to statutory reserve 10% of year’s surplus
(e) proposed dividends: 2% of share capital.
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40 Analysis and interpretation of
accounting statements
Specific objectives
After you have studied this chapter you should be able to:
• appreciate the importance of analysing financial statements for the
benefit of internal and external parties
• distinguish between profitability and liquidity
• calculate and analyse ratios on profitability, liquidity and efficiency
to assess a business’s performance
• understand the term ‘capital employed’
• calculate and understand the importance of working capital.
40.1 Interpretation of accounts
The whole purpose of recording and classifying financial information about a
business, and communicating this to the owners and managers in the form of
the financial statements, is to assess the performance of the business. The
information contained in the financial statements can be used to evaluate
various aspects of the company by the use of accounting ratios.
For the ratios to be a reliable guide to performance, two criteria need to be
applied:
• the financial statements used for calculating the current ratios must be
up to date.
• each ratio must be compared with the same ratio from the previous year’s
accounts or with those from a competitor’s accounts.
The concept of comparison is crucial, since this identifies trends in the
business and allows action to be taken.
The analysis of a business using accounting ratios is widely practised by
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both internal and external parties; the main parties are listed in Exhibit 40.1.
Exhibit 40.1
40.2 Profitability and liquidity
The two most important factors in the running of a business are, first, to see
that it operates at a profit and, second, to organise it so that it can pay its
suppliers and expenses at the correct times. If either of these points are not
covered effectively, it could mean that the business might have to be closed
down.
The ability to pay one’s debts as they fall due is known as having
liquidity. The ability to make a profit is known as profitability, and the
ratios commonly used to give valuable information on a business’s
performance are known as profitability ratios.
We will now consider the profitability ratios followed by the liquidity
ratios.
40.3 Profitability ratios
The main ratios used to examine profitability are:
1 Gross profit : sales ratio
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2
3
4
5
Net profit : sales ratio
Expenses : sales ratio
Return on capital employed (ROCE) ratio
Inventory turnover ratio.
In Chapter 14, we looked at three of the above profitability ratios, namely
gross profit to sales ratio, net profit to sales ratio and inventory turnover ratio.
To remind you of these ratios, we briefly examine them in addition to looking
at the other profitability ratios.
1 Gross profit to sales ratio
This ratio is calculated as follows:
Normally, this is referred to as a percentage and is calculated thus:
The figures of sales and gross profit are found in the trading account. If the
gross profit/sales percentage was 20%, this would mean that for every $100
of sales, $20 gross profit was made before any expenses were paid. This ratio
measures how effectively a company has controlled its cost of goods and sold
them at the right price to give maximum gross profit. If, however, there has
been a change in this ratio from one period to another, it may be attributed to
one or more of the following:
• Cost of goods may have increased resulting in lower gross profit.
• Selling price of goods may have been reduced in order to sell more but
targets have not been met. Alternatively, selling price could have been
increased and fewer goods sold.
• Wastage or theft of goods.
2 Net profit to sales ratio
This ratio is calculated as follows:
Normally, this is referred to as a percentage and is calculated thus:
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Again the figure of sales can be found in the trading account while the net
profit can be obtained from the profit and loss account. The net profit/sales
percentage takes into account the expenses incurred and shows the amount of
profit remaining. Changes in this ratio may be attributed to:
• the gross profit/sales percentage changing and/or
• the expenses changing.
Expenses need to be minimised to ensure a reasonable net profit is made.
3 Expenses to sales ratio
This ratio is calculated as follows:
Normally, this is referred to as a percentage and is calculated as follows:
It is useful to compare the expenses/sales percentage with the previous
results. If an increase was evident, this would indicate an increase in the
expenses of the business and would require further investigation by
management. If the result remained stable or had reduced, this would indicate
that expenses incurred in running the business had been carefully monitored.
4 Return on capital employed ratio (ROCE)
This ratio is calculated as follows:
Normally, this is referred to as a percentage and is calculated as follows:
It shows (as a percentage) the net profit made for each $100 of capital
employed in the business. The higher this ratio, the more profitable the
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business, while a lower ratio indicates that the business is less profitable. This
ratio is the most important ratio of all.
There has never been an agreed definition of the term ‘capital employed’.
Very often it has been taken to mean the average capital. For this, the
opening capital for the period is added to the closing capital; the total is then
divided by two, to give the average capital. In an examination, use the
method stated by the examiner. If you are given only the closing capital, use
the closing capital figure.
In the following example, two businesses of sole traders (A) and (B) have
made the same profits, but the capital employed in each case is different.
From the statements of financial position that follow, the return on capital
employed is calculated using the average of the capital account as capital
employed.
Return on capital employed is calculated thus for the two firms:
The ratio illustrates that what is important is not simply how much profit has
been made, but how well the capital has been employed. Business (A) has
made far better use of its capital, achieving a return of $40 net profit for every
$100 invested, whereas business (B) has received a net profit of only $24 per
$100.
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In this case, only the accounts of sole traders have been dealt with, so that
a straightforward example could be used. In Section 40.9 other meanings of
‘capital employed’ will be considered, when dealing with:
• sole traders who have received loans to help finance their businesses
• partnerships
• limited companies.
5 Inventory turnover ratio
The ratio is calculated as follows:
If the opening and closing inventories are known, the average inventory is
found by adding these two figures and dividing them by two (that is,
averaging them). The higher this ratio, the more profitable the business, for
example, if $5 gross profit was made on a particular product and the
inventory turnover is six times a year then the firm would make a gross profit
of $5 × 6 = $30. If, however, the inventory turnover ratio increased to nine,
then gross profit would be $5 × 9 = $45.
40.4 Liquidity ratios
A business that has satisfactory liquidity (see Section 40.2 above) will have
sufficient funds (normally referred to as ‘working capital’) to pay suppliers at
the required time. The ability to pay suppliers on time is vital to ensure that
good business relationships are maintained.
The ratios used to examine liquidity, that is, the liquidity ratios, are:
1 Current ratio (working capital ratio)
2 Acid test ratio (quick ratio)
3 Accounts receivable : sales ratio
4 Accounts payable : purchases ratio.
Each of the liquidity ratios stated can be compared, period by period, to see
whether that particular aspect of liquidity is getting better or worse. In the
case of the current ratio, it was often thought in the past that the ideal ratio
should be around 2 : 1 and that, ideally, the acid test ratio should be in the
region of 1 : 1 to 1.5 : 1. However, in recent years it has become recognised
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that such a fixed figure cannot possibly apply to every business, as the types
and circumstances of businesses vary so widely.
1 Current ratio (or working capital ratio)
The current ratio measures current assets against current liabilities. It will
compare assets that will be turned into cash within the next 12 months with
any liabilities that will have to be paid within the same period. The current
ratio is thus stated as:
If, therefore, the current assets are $125,000 and the current liabilities are
$50,000, the current ratio will be:
Alternatively, it could be said to be 2.5 times, that is, the business can cover
its short-term debts 2.5 times. If the ratio increases by a large amount, the
firm may have more current assets than it needs, in other words it may have
too much closing inventory or a large amount of money in the bank. The
business will then need to make decisions relative to employing their current
assets better by reducing the inventory level and/or investing surplus money.
If the ratio falls by a large amount, then perhaps too little is being kept as
current assets.
2 Acid test ratio (or quick ratio)
To determine a further aspect of liquidity, the acid test ratio takes into
account only those current assets that are cash or can be changed very quickly
into cash. This will normally mean Cash + Bank + Accounts receivable. You
can see that this means exactly the same as current assets less inventory. The
acid test ratio may, therefore, be stated as:
For instance, if the total of current assets is $40,000 and inventory is $10,000,
and the total of current liabilities is $20,000, then the ratio will be:
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Helpful Hint!
Question:
How is the quick ratio different from the current ratio? Give as many
differences as possible.
This ratio shows whether there are enough liquid assets to be able to pay
current liabilities quickly. It is dangerous if this ratio is allowed to fall to a
very low figure. If suppliers and others cannot be paid on time, supplies to
the business may be reduced or even stopped completely. Eventually, the
business may not have enough inventory to be able to sell properly. In that
case, it may have to cease business.
3 Accounts receivable to sales ratio
This ratio assesses how long it takes customers to pay what they owe. The
calculation is made as follows:
For example:
In firm (C), customers (accounts receivable) take three months on average to
pay their accounts, calculated from:
In firm (D), customers (accounts receivable) take two months on average to
pay their accounts, given from:
If the ratio is required to be shown in days instead of months, the formula
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should be multiplied by 365 instead of 12, as shown below:
The higher the ratio, the worse a business is at getting its accounts receivable
to pay on time. The lower the ratio, the better it is at managing its accounts
receivable.
Businesses should make certain that customers pay their accounts on time.
There are two main reasons for this. First, the longer a debt is owed, the more
likely it will become a bad debt. Second, any payment of money can be used
in the business as soon as it is received, and so this increases profitability; it
can help reduce expenses. For example, it would reduce a bank overdraft and
therefore reduce the bank overdraft interest.
4 Accounts payable to purchases ratio
This ratio shows how long it takes a business (on average) to pay its
suppliers. The calculation is made as follows:
For example:
Firm (E) therefore takes four months’ credit on average from its suppliers,
that is,
Firm (F) takes on average three months to pay its suppliers, that is,
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or in days:
Taking longer to pay suppliers could be a good thing or a bad thing,
depending upon circumstances. If so long is taken to pay that possible
discounts are lost, or that suppliers refuse to supply again, then it would be
undesirable. On the other hand, paying before it is necessary simply takes
money out of the business early without gaining any benefit.
40.5 Definition of capital employed in
various circumstances
In Section 40.3 item 4, it was pointed out that there is not one single agreed
definition of the term ‘capital employed’. In answering an exam question in
this area, you must follow the examiner’s instructions, if any are given;
otherwise, state what basis you have used.
Sole proprietorships
‘Capital employed’ could mean any of the following:
• closing balance on capital account at the end of a financial period
• average of opening and closing balances on the capital account for the
accounting period
• capital balances plus any long-term loans.
Partnerships
‘Capital employed’ could mean any of the following:
• closing balance on the fluctuating capital accounts at the end of a financial
period
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• average of opening and closing balances on the fluctuating capital accounts
for an accounting period
• total of fixed capital accounts plus total of partners’ current accounts at the
end of a financial period
• average of opening and closing balances on the partners’ capital and
current accounts for an accounting period
• any of the above, plus long-term loans to the partnership.
Limited companies
Given the following details, different figures for capital employed may be
used.
• To calculate return on ordinary shareholders’ funds, it would be (a)
$100,000 + (c) $35,000 = $135,000.
• To calculate return on total shareholders’ funds, it would be (a) $100,000 +
(b) $40,000 + (c) $35,000 = $175,000.
• To calculate return on total capital employed, that is, including borrowed
funds, it would be (a) $100,000 + (b) $40,000 + (c) $35,000 + (d) $60,000
= $235,000.
Any question involving return on capital employed for limited companies
should be read very carefully indeed. Use the method suggested by the
examiner. If no indication is given, use that of (a) + (c) above, but you must
state what method you have used.
40.6 Definition of working capital
Working capital is the amount by which current assets exceed current
liabilities. It is also known as ‘net current assets’ (see Chapter 12 Section
12.4).
It is vital for businesses to have sufficient working capital to enable them
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to have funds available to pay everyday running expenses. Working capital
tends to circulate through a business, as shown in the diagram in Exhibit
40.2. As it flows, profits are made as inventory is sold to customers; the
quicker it is sold, the quicker the business makes profits.
Exhibit 40.2
40.7 Summary of the formulae
appearing in this chapter
The formulae for this chapter are summarised in Exhibit 40.3.
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Exhibit 40.3
Helpful Hint!
Examination Tip:
Be able to explain how the profitability, liquidity and general
performance of a business can be deduced from comparisons of
relevant ratios for previous and comparable current fiscal periods.
Summary
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• Financial statements are analysed and interpreted for internal and
external parties. It is important to remember that a ratio on its own
is of no use at all. It must be compared with previous years’ results
or the results of a competitor to be meaningful.
• Profitability and liquidity are equally important factors when running
a business.
• The use of the profitability ratios ensures owners of a business
keep a careful check on figures such as cost of goods, sales,
expenses, gross and net profits.
• Liquidity ratios measure the ability of a business to pay its debts as
they fall due and ensure smooth cash flow.
• Working capital is found by deducting the total current assets from
the total current liabilities.
• There are various methods of calculating capital employed
depending upon the type of business, that is, sole trader,
partnership or limited company.
Chapter 40 Exercises
Notes: In Appendix B you will find a worksheet that you can
download from the website and use to answer questions on ratio
analysis.
40.1 You are to study the following financial statements for two
similar types of retail stores and then answer the questions that
follow.
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(a) Calculate the following ratios:
(i) gross profit as percentage of sales
(ii) net profit as percentage of sales
(iii) expenses as percentage of sales
(iv) inventory turnover
(v) rate of return of net profit on capital employed (use the
average of the capital account for this purpose)
(vi) current ratio
(vii) acid test ratio
(viii) accounts receivable: sales ratio
(ix) accounts payable: purchases ratio.
(b) Comment on the differences, and similarities, of the
accounting ratios for A and B. Which business seems to be
the most efficient? Give possible reasons.
40.2X Study the following final accounts of two companies and then
answer the questions that follow. Both companies are shops
selling textile goods.
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(a) Calculate the following ratios for each of R. Ltd and T. Ltd:
(i) gross profit as percentage of sales
(ii) net profit as percentage of sales
(iii) expenses as percentage of sales
(iv) inventory turnover
(v) rate of return of net profit on capital employed (for the
purpose of this question only, take ‘capital’ as being
total of share capital + reserves at the statement of
financial position date)
(vi) current ratio
(vii) acid test ratio
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(viii) accounts receivable: sales ratio
(ix) accounts payable: purchases ratio.
(b) Comment briefly on what you notice when you compare the
ratios of the two companies. State which company appears
to be the most efficient, giving what you consider to be
possible reasons.
40.3X (a) Draw up a statement of financial position for Rio Grande
Ltd as at 31 December 2017 using the balances now shown.
You will have to deduce whether the bank balance shows an
overdraft or otherwise, and also what the figure will be.
(b) Is Rio Grande in a good position financially? Give a reason
in support of your answer.
(CSEC style)
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Multiple-choice questions – Set 5 (81 to 100)
Each multiple-choice question has four suggested answers: (A), (B),
(C) or (D). You should read each question and then decide which
choice is best: (A), (B), (C) or (D). Write down your answers on a
separate piece of paper. You will then be able to repeat the set of
questions later without the distraction of previously written attempts.
When you have completed a set of questions, check your answers
against those given in Appendix C.
81 In a business an ‘accumulated fund’ would be known as:
(A) non-current assets
(B) total assets
(C) net current assets
(D) capital.
82 A receipts and payments account does not show:
(A) cheques paid out during the year
(B) the accumulated fund
(C) receipts from sales of assets
(D) bank balances.
83 Does a partnership have to ensure that each partner receives a
salary?
(A) Only when profits are split equally
(B) Only when profits are split unequally
(C) Only when there is agreement between partners
(D) Only when interest is charged on capital
84 With fluctuating capital accounts, interest on drawings must be:
(A) credited to partners’ current accounts
(B) credited to partners’ capital accounts
(C) debited to partners’ current accounts
(D) debited to partners’ capital accounts.
85 You agree to buy an existing business for $190,000. Buildings
are valued at $85,000, fixtures at $17,000, inventory at $30,000
and debtors at $38,000. This means that:
(A) you have made a mistake
(B) you are paying too much for the assets
(C) you are paying $20,000 for goodwill
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86
87
88
89
90
91
92
(D) you should not have bought an existing business.
Goodwill is normally owned by partners:
(A) equally
(B) in the same ratio as capital accounts
(C) in the same ratio as capital accounts + current accounts
(D) in the same ratio as profits shared.
Net profit divided by sales shown as a percentage measures:
(A) current sales trend
(B) liquidity
(C) profitability
(D) investments.
Which of the following should be charged to the manufacturing
account?
(A) Office rent
(B) Carriage on sales
(C) Managing Director’s salary
(D) Carriage on raw materials
The production cost is the total of:
(A) prime cost + works overhead expenses
(B) direct labour + direct materials + direct expenses
(C) administrative expenses + selling expenses
(D) None of the above.
Work-in-progress is the:
(A) sales less cost of goods sold
(B) sales plus cost of goods sold
(C) value of finished goods on hand
(D) value of partly finished goods.
What would be the totals on a trial balance given the following
balances: Loan from uncle $4,000; inventory $7,910; bank
overdraft $736; accounts receivable $6,184; fixtures $11,000;
petty cash balance $242; accounts payable $5,532; motor vehicle
$7,800; capital?
(A) $22,988
(B) $29,252
(C) $33,136
(D) $33,992
If $750 was added to the rent instead of being added to a non-
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93
94
95
96
97
current asset:
(A) gross profit would not be affected
(B) gross profit would be affected
(C) both gross and net profits would be affected
(D) just the statement of financial position items would be
affected.
If the cost price is $120 and the selling price is $150, then the:
(i) margin is 25%
(ii) mark-up is 20%
(iii) mark-up is 25%
(iv) margin is 20%.
(A) (i) and (ii)
(B) (i) and (iii)
(C) (iii) and (iv)
(D) (ii) and (iv)
If sales are $60,000, opening inventory $4,500, closing inventory
$7,500 and margin 20%, then inventory turnover is:
(A) 8 times
(B) 7 times
(C) 6 times
(D) 5 times.
In a limited company, which of the following are not shown in the
appropriation account?
(i) Wages
(ii) Proposed dividends
(iii) Transfers to reserves
(iv) Debenture interest
(A) (i) and (ii)
(B) (ii) and (iii)
(C) (ii) and (iv)
(D) (i) and (iv)
Paid-up capital is:
(A) authorised capital – calls in arrears
(B) called-up capital – calls in arrears
(C) issued capital + called-up capital
(D) authorised capital – issued capital.
The issued capital of a company is:
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(A) always the same as the authorised capital
(B) the same as preference share capital
(C) equal to the reserves of the company
(D) None of the above.
98 A company wishes to pay out all available profits as dividends.
Net profit is $26,600. There are 20,000 8% preference shares of
$1 each, and 50,000 ordinary shares of $l each. $5,000 is to be
transferred to the general reserve. What ordinary dividends are to
be paid, in percentage terms?
(A) 20%
(B) 40%
(C) 10%
(D) 60%
99 What is missing in this formula of the acid test ratio?
(A) Total of non-current + current assets
(B) Current assets
(C) Current assets – inventory
(D) Inventory + accounts receivable.
100 Net realisable value is:
(A) what inventory can be sold for
(B) what inventory can be replaced for
(C) estimated saleable value of inventory less its cost
(D) saleable value – expenses needed before completion of the
sale.
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41 The banking system and
payroll accounting
Specific objectives
After you have studied this chapter you should be able to:
• understand the various means of transferring money offered by the
banking system
• understand the basic procedure of operation of each method of
transferring money
• know how and why a business uses various methods of money
transfer
• understand the functions of the payroll
• calculate employees’ pay using various methods
• distinguish between statutory and non-statutory deductions
• calculate the net pay of an employee, given the details of the
employee’s gross pay and income tax and other deductions
• complete the payroll and wage documents from time cards, etc.
41.1 Introduction
Trading activity, in which all businesses are engaged, involves the transfer of
money as goods and/or services are bought and sold.
The banking system has changed dramatically over the last few years and
there are now a number of different ways in which money can be transferred
between businesses as shown below. More recently, the use of cheques for
making payments has declined with this method being replaced by the debit
card. The debit card can be used not only to make purchases, but also to
obtain cash using a cash machine known as an ATM (automatic teller
machine). Another further development is contactless payments; this
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method is used for making small purchases, currently under £30 sterling in
the UK. (Refer to Section 41.11).
41.2 Transferring money
This can be received or paid by a business or organisation by various
methods, including the following:
• cash
• cheques
• credit cards
• debit cards
• bank giro credit (BGC) transfer
• BACS – this is the Bankers’ Automated Clearing Service
• standing order
• direct debits
• contactless payments
• paying-in slips.
41.3 Cash
Receiving cash
Cash is still used extensively in the retail business by customers purchasing
goods. Security is a major problem in a number of ways for the business
receiving the cash, as shown below.
• It must be counted and checked to ensure that it corresponds with any
documentation showing the amount to be received.
• It must be stored safely and taken to the bank as soon as possible.
• Counterfeit money can be in circulation and detection equipment could be
needed to prevent this type of fraud.
• There should be regular internal checks to ensure that the persons handling
cash are honest and funds do not go astray.
Most cash sales are made where electronic cash tills are in operation and
these issue receipts automatically. The receipts should be kept by customers,
not only as proof of payment, but as evidence of the purchase should the
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goods have to be returned if faulty or unsuitable.
Cash that needs to be banked will be detailed on a paying-in slip – this is
described in Section 41.12.
Paying by cash
When payments are made by a business, it is safer and easier to use a noncash method such as cheques or the BACS system (this is described in
Section 41.8). Many firms who employ weekly paid staff still pay wages in
cash and this method involves all the security problems which have been
discussed previously. However, small value purchases can be made using the
petty cash system that is described in Chapter 21.
41.4 Cheques
Receiving cheques
Most customers who have received goods and/or services pay for them by
cheque. These customers will have established a credit account with the
business after credit-worthiness checks have been carried out.
Cheques received from these well-established credit account customers
should be carefully examined for the following:
• that the cheque is drawn payable to the receiver
• that the correct amount is stated both in words and in figures
• that the cheque is dated and is not out-of-date or post-dated
• that the cheque has been properly signed.
If any of these factors are not in order, the cheque will have to be returned to
the person writing the cheque (drawer) for amendment or for a new cheque to
be issued. It is not a legal requirement to issue a receipt for payment by
cheque since the cheque is evidence of such payment. In spite of this, many
businesses do issue receipts.
Until recently, cheques in the United Kingdom were covered by a Cheque
Guarantee Card Scheme which guaranteed to pay the cheque amount due.
However, the scheme recently closed and the cheque guarantee hologram has
been removed from debit cards. As a consequence, cheque payment by casual
customers has declined and has largely been replaced by the use of debit
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cards (see Section 41.6). The Cheque Guarantee Card Scheme was utilized
many years ago in some Caribbean countries for example, Trinidad and
Tobago but was subsequently discontinued.
Paying by cheque
When a business pays by cheque for goods or services, it must be signed by
an authorised signatory. The person signing the cheque for the business must
have the approval of the company. The bank will also have previously been
notified of the name of this person and will have carried out checks to verify
this person’s identity. They are legally bound to carry out this procedure to
prevent fraud and to counter money-laundering activities. Larger businesses
will usually insist on at least two authorised signatories to ensure that proper
payments are made.
It is vital that the business’s account has sufficient money in it to cover the
amounts paid otherwise the bank will not process the cheque.
The person writing the cheque and using it for payment is known as the
drawer. The person to whom the cheque is paid is known as the payee and the
drawee is the bank. A completed cheque is shown in Exhibit 41.1.
Exhibit 41.1
The completed cheque shows that J. Woodstock, the drawer, is paying K.
Marshall, the sum of $72.85 on 22 May 2017. The counterfoil, at the lefthand side of the cheque, is also completed and retained by J. Woodstock as a
record of the transaction.
Security of cheques
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All cheques used by business will be shown with two vertical lines preprinted on the face of the cheque with the words ‘A/c payee only’ between
these lines. The bank receiving such a cheque will ensure that it is paid into
the payee’s account only.
Cheque clearing
It is important to understand that when a cheque is sent from one business to
another it takes time to clear or process the cheque.
Helpful Hint!
Question:
What is an unpresented cheque? How does it affect the company’s
Bank Statement Balance? In answering this question, you will also
need to refer to Chapter 24.
Typically, the process takes 4–5 working days. For example, if a business
received a cheque from a customer on Monday and pays this into the bank on
Tuesday it will not have access to the money until Friday.
41.5 Credit cards
Credit card payments
Credit cards are a method for customers to purchase goods without needing
to pay by cash or make out a cheque. They can also be used when the
customer wishes to make a purchase by telephone, fax or via the internet.
Credit cards are issued by organisations such as Visa and Mastercard who
operate the system and charge a fee for providing the service. The business
will have an electronic card acceptance point into which the customer inserts
their card and keys in their PIN (personal identification number). The card
details are then fed into a computer system, checked and, if approved, the
proposed purchase value will be accepted. The business bank account will be
credited with the purchase sum automatically.
When customers are remote from the business they will have to provide
the following information:
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• card number – 16 digit and often the card holder will have to provide the
three digits of the security number shown on the reverse of the card
• expiry date of the card
• name printed on the card.
Again, the purchase sum is transferred automatically to the business and the
customer’s account with the credit company is charged. At the end of the
month, the customer receives a statement from the credit card company
stating the total amount outstanding for the month’s transactions; the
customer then arranges payment.
Credit card issued by organisation or
business
Some organisations provide business credit cards to their staff, usually to pay
for such things as hotel accommodation, travel expenses, etc.
When these are used, the charge will be made to the business, not to the
person who has used the card. The business will set limits of expenditure on
the card and will require copy vouchers and any other form of receipt to be
handed in regularly. These will then be compared with the monthly account
received from the credit card company.
41.6 Debit cards
Debit cards are issued by a number of banks in conjunction with Visa,
Mastercard, etc. and are used in a very similar way to credit cards. The
crucial difference is that at the time of making payment by debit card, funds
are electronically transferred from the purchaser’s bank account to the
supplier’s bank account. Purchasers must ensure that they have sufficient
money in their bank account before undertaking transactions. Over the last
decade, the use of debit cards has increased considerably, one special feature
being able to withdraw cash from cash machines both at home and abroad.
41.7 Bank giro credit (BGC) transfer
This is a safe and convenient way of receiving and paying money. Money
paid by this method will be received directly into the business’s bank account
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and the sums received will be shown on their bank statement.
Paying by this method requires the business to prepare the payments in the
usual way but in addition prepares a list and bank giro credit slips detailing
each payee’s banking details and the amount due. The list and slips are then
sent to the bank with one cheque to cover all the payments. These will be
automatically sent to the various bank accounts through a centralised system.
This form of money transfer is still in use but larger organisations have
adopted the BACS system.
41.8 BACS (Bankers’ Automated
Clearing Service)
This service enables the business to receive money due to it and to make
payments. BACS is a company owned by the Bank of England, the high
street banks and some building societies, which offers a computerised
payment transfer system that organisations may use to pay not only wages
and salaries but also suppliers, dividends, grants, pensions, etc.
Processing the transfers is a three-day cycle. Information is stored by the
BACS system to enable payments to be made on pre-set days, such as salary
payments.
It is important to note that a remittance advice should be sent to the
supplier when using BACS. Failing this, the supplier will not know that the
payment has been made until they receive their bank statement. They may
also have difficulty in tracing the identity of the business paying the amount.
When the business receives payment from their customers, they will also
need a remittance advice from the customer for exactly the same reason as
explained above and to know which invoices have been covered by the
payment.
41.9 Standing order
A person may make a regular payment from their bank account, or receive a
regular amount into their account by standing order. This is a straightforward
method of making regular fixed payments over which the payer has full
control. The steps necessary to make payments by a standing order are as
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follows:
• payer (person making the payment) instructs the bank in writing to pay a
certain amount, on a particular day to a specific organisation
• bank makes payment via the computer banking system.
The payer can instruct the bank to cease or amend the payment at any time by
giving written notification.
41.10 Direct debit
This has become a common method of paying both fixed and variable
amounts of money. Many businesses offer discounts on payment to
encourage their customers to use this method. The system of operation is as
follows:
• the payee (proposed receiver) of the money sends a mandate to the payer
• the payer completes the mandate and returns it to the payee
• the payee sends the mandate to the payer’s bank who will arrange to send
the money to the payee’s bank via the computer banking system.
The amounts that the payer has authorised to be withdrawn from their own
account can vary as the payee makes changes. Typical examples of variations
are usually increases in insurance premiums, business rates and loan
repayments. It is normal for the payee to advise the payer of such increases.
Payees prefer this method of regular payment since they have control over
them and should the payer wish to cancel a direct debit they have to do so
through the payee. While this method of payment is convenient for both
parties, the payer should exercise great care in giving permission for the
setting up of direct debits.
41.11 Contactless payments
In the UK, people are now able to make ‘contactless payments’ by using a
feature on their debit or credit card to quickly make payments of up to £30
(sterling). The card is a convenient way to make small payments and as such
its use is growing in popularity.
To make a payment:
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(i) identify the contactless logo at the retail outlet or similar
(ii) hold your card to the machine reader
(iii) make sure the amount on the machine is correct and does not exceed £30
(sterling).
(iv) a green light on the machine shows that the transaction has been
accepted.
Receipts are not normally given but the purchaser can request one if required.
41.12 Paying-in slips
A paying-in slip is prepared when the business wants to pay money into its
current account. Details of cash and cheques that are to be paid into the bank
are entered on the slip. The completed slip, cash and cheques are then taken
to the bank. The bank giro credit, Exhibit 41.2, shows how a paying-in slip
might be completed.
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Exhibit 41.2
41.13 Introduction to the payroll
To enable the payment of wages and salaries to be carried out efficiently and
accurately, all organisations, whether large or small, need to keep records of
all their employees, including recording basic personal details. Such
confidential personal records are usually kept in the personnel department
of an organisation.
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41.14 Functions of the payroll
The payroll is a list of employees that specifies the wage or salary that each
employee receives. The procedures and calculations which are necessary to
produce this list need to be fully understood and applied to ensure that all
employees are paid promptly and correctly.
The responsibility for producing the payroll will depend on the size of the
organisation. A large organisation will probably have a wages department,
whereas a small one will rely on a wages clerk. Irrespective of who carries
out the function, that person must ensure that the payments are:
(a) Accurate:
• Correct basic payment for work done.
• Additional entitlements such as bonus, overtime, expenses, etc.
included correctly.
• Correct deduction of taxes, national insurance and other deductions.
• Reliable wage-cost information for the employer.
(b) Regular and on time:
• Enables the employees to meet their own financial commitments and
plan future expenditure.
• In contrast, late or irregular payment would harm the morale of
employees and cause them to doubt the financial stability of the
organisation.
(c) Confidential:
• Staff involved in preparing the payroll must not divulge any of its
contents except to authorised people, for example, company executives,
government officials.
• Staff must be able to discuss with an employee that particular
employee’s wage/salary details.
(d) Secure
• The handling of cash and cheques must be carried out in a secure
environment to prevent loss, theft or loss of confidentiality.
• Checks must be built into the procedures to guard against the
possibility of fraud by wages staff.
• The distribution of wages must be organised so that the employee
receives his or her own wage and not someone else’s.
• All employee records must be kept in a secure place.
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41.15 Payments to employees
Payments to employees may be made by wages or salary. Wages are usually
paid weekly, often in cash, and often to manual workers. Salaries are paid
monthly by cheque or direct into the employee’s bank account or building
society.
Pay may also be referred to as remuneration, which simply means to
reward or pay for work carried out. This remuneration is often attached to pay
given to the directors of a company, where their pay is recorded in the
accounts as directors’ remuneration.
41.16 Gross pay and net pay
All employees are subject to income tax and other deductions which have to
be made by the employer from the gross pay, and so it is important to
distinguish between the gross pay figure and net pay. Gross pay is the
amount of wage or salary due to the employee before any deductions are
made. Net pay is the amount of wage or salary received by the employee after
all deductions have been made.
41.17 Methods of calculating pay
It is possible that not all employers will use the same methods for calculating
pay. The pay structure for employees may also vary depending on their
particular job. The main methods are as follows:
• Fixed amount of salary (usually per year) or wage (per week)
• Time rates – a fixed rate per hour multiplied by the number of hours
worked
• Piece rate – based on the number of units produced
• Commission – usually a percentage based on the amount of sales made
by the employee
Fixed amount of salary or wage
These represent an agreed annual or weekly wage.
Example 1: For an annual salary of $21,840 the monthly salary would be:
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whereas an equivalent weekly wage would be a set figure of $420 ($21,840
divided by 52).
Time rates
Here, a fixed basic rate per hour is paid, multiplied by the number of hours
worked.
Example 2: A bricklayer receives $12 per hour. If he works for 40 hours
during a particular week, his gross pay will come to:
If additional hours are worked, it is usual to pay overtime to each worker on
this pay scheme, and this payment is normally at a higher rate. Extra hours
worked during the week are often paid at ‘time and a quarter’, ‘time and a
half’ and ‘double time’ is frequently paid for weekend work.
If normal time is $12 per hour, then;
• time and a quarter is $12 × 1.25 = $15
• time and a half is $12 × 1.5 = $18
• double time is $12 × 2 = $24.
Example 3: We can look at the earnings of two workers. They are paid $12
per hour for a 40-hour week, time and a quarter for the next 10 hours, and
time and a half for any hours in excess of that.
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Helpful Hint!
Discussion:
If you and a friend owned a company, discuss how you would explain
to a new employee the overtime pay at a rate of ‘time and a half’.
Piece rate
Here, payment is based on the number of units produced or operations
completed. The employee is paid only for work completed although most
employers agree a minimum wage regardless of work completed. Piece rate
payment is an incentive to encourage workers to work faster – although it is
important to ensure that quality does not suffer as a result of faster
production.
Example 4: Lowe Production Co. manufactures parts for the motor-car
industry. It pays its workers piecework rates as follows:
• Part PCD 27 = $2.10
• Part JB 103 = $7.45
The company also has a minimum wage agreement of $175 per week.
During the first week of January, one of the workers, John Moss, produces
60 Part PCD 27s and 12 Part JB 103s. His wage for the week would be:
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Another worker, Philip Hanson, produces 50 Part PCD 27s and 8 Part JB
103s; his wage is calculated by the piece rates as follows:
but because there is a minimum wage agreement, Philip Hanson will receive
$175.
Commission
Commission is a percentage based on the amount of sales made by an
employee. Commission may be paid in addition to a basic salary or instead of
a salary.
Example 5: Carol Chapman and Diane Dawson work for a computer
software company. Their salaries are $12,000 and $10,800 respectively, plus
commission of 1% of total sales made each month. During July, Carol’s sales
totalled $30,000 and Diane’s $17,000. Their July salaries would be as
follows:
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41.18 Time cards and time sheets
In many businesses, employees will have a time card that must be
‘punched’ in a special machine when they arrive at work, and again when
they leave work. The machine contains a clock and a printing device that
prints the times onto the time card when it is inserted into the machine. It is
from such time cards that time sheets are made out.
The type of business where this is particularly important is where
employees are paid on a time basis; obviously, the business then needs
accurate measures of the time worked per employee to enable to wages to be
calculated correctly.
In other establishments staff may sign in by recording their names in a
book and adding the times of arrival and departure. It all depends on the
nature of the business and the firm’s attitude towards timekeeping. In the case
of fixed annual pay, irrespective of the number of hours worked, there is no
need for exact timekeeping for the purposes of earnings calculations.
Where a time card system or something similar is used, then time sheets
can be made out. Exhibit 41.3 shows a typical time sheet. In this case, if
overtime is paid at the rate of time and a half, then Hamilton will be paid for
40 + (3 × 1½ = 4½) = 44½ hours.
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Exhibit 41.3
41.19 Deductions from gross pay
Naturally, throughout the various countries in which students take the
examinations of the Caribbean Examinations Council, there are differences in
such deductions. Jamaica, for instance, has deductions for contributions to the
National Housing Trust; this is not found in Trinidad and Barbados; and so
on.
The main structure of deductions is, however, very similar in each country.
This chapter is concerned with general principles, not with matters of exact
detail for each island. All of the rates of income tax and of social security
deductions are for purposes of illustration only; it must not be thought that
these are the exact rates for your country.
Statutory and non-statutory deductions
Deductions that an employer has to make by law from the employees’ gross
pay are known as statutory deductions. The most common are:
• income tax
• social security contributions.
Non-statutory deductions are deductions made from pay at an employee’s
request. They include payments to:
• trade unions
• social clubs
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• pension/superannuation schemes (note: some organisations may operate
non-contributory schemes).
Income tax
The pay of all employees is liable to income tax. Normally each person
receives a non-taxable personal allowance that can vary relative to individual
circumstances. This allowance is then deductible from the gross pay to arrive
at the taxable pay which is then subject to income tax.
The relevant Income Tax Authority will advise both the employee and
employer of the personal allowance amount after which tax becomes payable.
The rates applicable to taxable income are set by governments and can vary
from time to time.
In the case of a person with a personal allowance of $10,000 who works
part-time and receives a salary of $8,500, no tax would be payable. Let us
look at another example where income tax is payable:
Example: Mr Hernandez earns $26,000 per annum, his personal allowance
amounts to $12,500, therefore, his taxable income will be:
If we assume that income tax is due on his taxable pay is at 20%, then the
amount of income tax he would pay would be 20% of $13,500 = $2,700.
Note: The procedures for calculating income tax and social security
contributions etc., vary across the Caribbean and it is outside the scope of this
book to examine these in detail.
Social security contributions
Employees are also liable to pay social security contributions. These
contributions are usually allowed as deductions from gross pay for income
tax purposes. Payment of social security contributions is for the benefit of the
employee enabling them to claim benefits from the State, such as retirement
and unemployment benefit, if, and when the need arises.
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Superannuation contributions
Many organisations have superannuation schemes to which employees and
often employers may contribute. These schemes provide the employee with a
pension on retirement, plus, very often, a lump sum payment in cash. They
also usually include benefits that will be paid to an employee’s wife or
husband if the employee dies before reaching retirement age. These
contributions are usually allowed as deductions for income tax purposes.
41.20 Calculation of net pay
Two illustrations of the calculation of the net pay to be made to various
employees can now be looked at. The percentages used for national insurance
and superannuation are for illustration purposes only.
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41.21 Payroll register
For each payment date, the organisation will prepare a payroll register. This
will show the earnings for all the employees. Exhibit 41.4 shows an
uncompleted payroll register. Each of the columns has a number in brackets.
If there were any additional deductions, an extra column could be added,
which would become column (11) with the total column then being
renumbered (12) and net pay (13).
We can now look at what needs to be entered in each column:
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1
2
3
4
5
6
7
8
9
10
11
12
the name of the employee
the total hours worked by the employee during the period
the number of hours worked at the regular rate of pay × pay per hour
the hours worked at overtime rates × pay per hour
the gross pay – that is, before deductions – earned during the period
the gross earnings of the employee from the start of the accounting year
until the end of this payroll period; that is, if 15 weeks’ earnings have
been paid, then this column shows the total of all the 15 weeks before any
deductions have been made
the amount of national insurance to be deducted for the period
the amount of income tax to be deducted for the period
the amount of life insurance to be deducted for the period
the amount to be deducted in respect of amount due to the credit union
the total amount of all the deductions
the gross pay column (5) less the total deductions column (11): that is, the
net pay for the period.
Exhibit 41.4
Now let us look at the completion of the payroll register for week 10 of the
accounting year in Exhibit 41.5. Taking a firm with only three employees (to
make the illustration easy to follow), we are given the following details
regarding the employees.
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Note: D. Scott joined the firm at the start of week 7 of the accounting year.
Hourly pay rates are: regular rates J. Blake, $5; R. Marley, $6; D. Scott,
$6. All overtime rates are at time and a half.
Completing the payroll register for week 10, we arrive at the figures in
Exhibit 41.5.
Exhibit 41.5
•
•
•
•
•
•
Let us see how the figures have been calculated for J. Blake.
Column (3): 40 × $5 = $200
(4): 8 × $5 × 1.5 = $60
(6): Previous week’s total $2,100 + column (5) $260 = $2,360
(7): 5% × column (5) = $13
(11): columns (7) + (8) + (9) + (10) = $103
(12): columns (5) – (11) = $157.
41.22 Employee’s earnings record
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For each employee, there will be an employee earnings record, showing the
full details of the employee’s earnings for the accounting year on a week-byweek basis. This will be similar to the payroll register, except that each sheet
will be for a separate employee.
Exhibit 41.6 shows such a record for J. Blake for weeks 10 and 11.
Exhibit 41.6
41.23 Computerised payroll packages
Finally, it must be pointed out that many businesses today operate their
payroll using a computerised package. This offers many advantages, most
importantly the speed and accuracy with which the payroll can be prepared.
Such accounting packages include Quick Books, Peach Tree Accounting and
Sage Accounting.
Summary
• Trading activity is emphasised as meaning the purchase or sale of
goods and/or services between organisations or people.
• Fundamental to the trading activity is the receipt and payment of
money.
• Transferring money in the business can be carried out in various
ways: cash, cheque, credit cards, debit cards, bank giro credit
(BGC) transfer, BACS, standing order, direct debits and
contactless payments.
• Each of the above methods is discussed and reasons given as to
why a business might use a particular method(s).
• Paying-in slips are described since they can be used to deposit
both cash and cheques into a bank account.
• All organisations, whether large or small, need to keep records of
all their employees. Such records containing the personal details
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•
•
•
•
•
•
•
•
•
etc, are usually kept in the personnel department.
It is important that the basic functions of the payroll are observed
by organisations to ensure that the payment of wages and salaries
is carried out efficiently and accurately.
Gross pay is the amount of wage or salary before deductions are
made.
Net pay is the amount of wage or salary after deductions are made.
There are various methods of calculating pay including fixed
wage/salary, time rates, piece rates and commission.
Time cards are used by employees to ‘clock in’ and ‘out’ of their
place of work. From these time cards the employer completes the
employees’ time sheets, see below.
Time sheets are forms used by employees to record the overall
weekly attendance. It is from these forms that the employees’ gross
pay is calculated.
There are various deductions from pay that an employee has to
pay. The statutory deductions include income tax and social
security contributions. Non-statutory deductions would be payment
to a trade union, social club etc.
Each country in the Caribbean will have certain differences in its
legislation concerning deductions from earnings. In particular,
income tax rates will vary.
Each employee should be given full details of earnings and
deductions on his or her payslip which should accompany the cash,
cheque or bank credit used for payment.
Helpful Hint!
Examination Tip:
Ensure that you are able to calculate the Income Tax for different
levels of incomes. Remember to subtract any personal allowances
from a person’s income before applying the appropriate tax
percentage.
Chapter 41 Exercises
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41.1 Businesses in the retail sector are highly likely to receive cash
from their customers in payment for goods/services. State what
steps a business should take in the handling, storage and
transfer of cash to a bank.
41.2 State briefly what other non-cash methods are available to
businesses in both receiving and paying out money.
41.3X Direct debits are a convenient method of making payments.
Explain how the system operates and say what the advantages
are for the payer and payee.
41.4X (a) When a business makes a payment by cheque to a
supplier, what other document would they include with the
payment?
(b) State three reasons why a cheque may not be honoured by
the bank.
(c) State the difference between a debit card and a credit card.
41.5 The following hours have been worked by the employees of
Engineering Associates for the week commencing 15 May 2017.
The firm’s employees work a basic week of 40 hours; anything
above that is paid at the rate of time and a half. The Design
employee works a basic week of 37.5 hours, with anything
above that at time and a third. The Office employee works a
basic week of 37.5 hours, all overtime being paid at a rate of
time and a quarter.
From the above you are to draft a time sheet for the week for
each employee. Note down your answer; you will need it when
attempting Question 41.6.
41.6 Using the information given about the employees in 41.5, draw
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up the payroll register for Engineering Associates for the week
commencing 15 May 2017, taking into account the following
information.
1 Basic pay rates: Works, $6 per hour, Design, $8 per hour;
Office, $6 per hour.
2 Income tax deductions for the week: Jones, $48; Thomas,
$59; Wallace, $85; Worrall, $37.
3 National insurance for the week: Jones, $17; Thomas, $16;
Wallace, $26; Worrall, $14.
4 Life insurance: $15 per employee.
5 Credit union: Jones and Thomas, $20 each; Worrall and
Wallace, $28 each.
6 Accumulated earnings up to the end of the previous week
(week 5); Jones, $1,387; Thomas, $1,488; Wallace, $1,932;
Worrall, $1,312.
You are required to:
(a) draw up the payroll register for the week commencing 15
May 2017
(b) given the following details for R. Thomas for the succeeding
week, commencing 22 May 2017, complete the employee’s
earnings record for R. Thomas in respect of the two weeks
shown: regular earnings, $240; overtime earnings, $18;
national insurance, $15; income tax, $55; life insurance,
$15; credit union, $20
(c) show the completed payslip for V. Wallace for the week
commencing 15 May 2017.
41.7X The following hours have been worked by the employees of
Chemical Laboratories Ltd for the week commencing 1 February
2016.
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The Processing employees work a basic week of 40 hours;
anything above that is paid at the rate of time and a quarter. The
Chemist is paid a fixed amount for a week of 30 hours; if he
works more than that he is entitled to double time. The Office
worker works a basic week of 37.5 hours, anything above that
being at the rate of time and a half.
Draft a time sheet for the week for each employee from the
above information. Note down your answer; it will be used when
tackling question 41.8X.
41.8X Using the information given about the employees in 41.7X,
draw up the payroll register for the week commencing 1
February 2016, taking the following extra information into
account.
1 Basic pay rates: Processing, $10 per hour; Chemist: $600 per
week, but overtime at $30 per hour; Office worker, $12 per
hour.
2 Income tax deductions: the workers are allowed to have the
following earnings free of tax each week; on the excess the
rate of tax is 25%; Richards, $75; Garner, $90; Weekes, $100;
Walcott, $80.
3 National insurance: Richards, $29; Garner, $27; Weekes, $40;
Walcott, $32,
4 Life insurance: $30 each for Processing workers; $25 for other
workers.
5 Credit union: Richards and Garner, $40 each; Weekes, $50;
Walcott, $35.
6 Their accumulated earnings up to the end of the previous
week were: Richards, $1,990; Garner, $2,050; Weekes,
$2,400; Walcott, $2,280.
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You are required to:
(a) draw up the payroll register for the week commencing 1
February 2016 (week 5)
(b) given the following details for L. Richards for the week
commencing 8 February 2016, complete the employee’s
earnings record for him in respect of the two weeks shown:
regular earnings, $400; overtime earnings, $115; income
tax and national insurance at same rates as previous week;
life insurance and credit union at the same amounts as the
previous week
(c) show the completed payslips for Garner and Walcott for the
week commencing 1 February 2016.
41.9 H. Smith is employed by a firm of carpenters at a rate of $6 per
hour. During the week to 18 May 2017, he worked his basic
week of 40 hours. The income tax due on his pay was $10, and
he is also liable to pay social security contributions of 5%.
Calculate his net pay.
41.10 B. Charles is employed as an undertaker’s assistant. Her
basic working week consists of 40 hours, paid at the rate of $4
per hour. For hours worked in excess of this, she is paid at the
rate of 1.5 times her basic earnings. In the week ended 12 March
2016, she worked 60 hours. Up to $240 a week she pays no
income tax, but she pays it at the rate of 30% for all earnings
above that figure. She is liable to pay social security at the rate
of 5% on gross earnings. Calculate her net pay.
41.11X R. Kennedy is a security van driver. His pay is $220 per
week, and danger money of $10 per hour in addition for every
hour he spends transporting gold bullion to Piarco Airport. During
the week, 20 of the hours he works are spent in taking gold
bullion to the airport. He pays income tax at the rate of 30% on
all his earnings above $280 per week. He pays social security at
the rate of 5% on gross earnings. Calculate his net pay for the
week.
41.12X A firm employs Jane Jones at a standard rate of $6 per hour.
Time and a half is paid for all hours worked in excess of 40. All
employees pay a superannuation contribution of 5% of all pay
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earned in a normal working week (40 hours). Time worked in
excess of 40 hours is not subject to superannuation. Social
security contributions are 5% of gross pay. In the week ending 7
June, Jane Jones has worked 50 hours. She pays income tax at
30% on all she earns over $200 per week after superannuation
has been deducted.
You are required to:
(a) calculate her gross pay
(b) show the value of each deduction and calculate her net pay.
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42 Single entry and incomplete
records
Specific objectives
After you have studied this chapter you should be able to:
• understand why it is sometimes not appropriate to use a double
entry book-keeping system
• deduce the figure of profits where only the increase in capital and
details of drawings are known
• ascertain figures of sales and purchases from incomplete records
• draw up a trading and profit and loss account (income statement)
and statement of financial position from records not kept in a
double entry system.
42.1 Why double entry is not used
It would be impractical to expect every small shopkeeper, market stall or
other small business to record their finances using a full double entry system.
First of all, a large number of the owners of such businesses would not know
how to write up double entry records, even if they wanted to. It is more likely
that they would enter details of a transaction once only, using a single entry
system. Also, many of them would fail to record every transaction, resulting
in incomplete records.
It is, perhaps, only fair to remember that accounting is supposed to be an
aid to management; it is not something to be done as an end in itself.
Therefore, many small businesses, especially retail shops, can have all the
information they want by merely keeping a cash book and a record of their
accounts receivable and accounts payable, not necessarily in double entry
form.
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The profits, however, will still need to be calculated in some way. This
could be for the purpose of calculating income tax payable. How can profits
be calculated if the book-keeping records are inadequate or incomplete?
42.2 Profit as an increase in capital
Recall that unless there has been an introduction of extra cash or resources
into the business, the only way that capital can be increased is by making
profits. Therefore, profits can be found by comparing capital at the end of the
last period with that at the end of the current period.
Let us look at a business where capital at the end of 2017 is $20,000.
During 2018, there have been no drawings, and no extra capital has been
brought in by the owner. At the end of 2018 the capital is $30,000. Then:
If, on the other hand, the drawings had been $7,000, the profits must have
been $17,000, calculated thus:
We can see that $17,000 profit was the figure needed to complete the
formula, filling in the missing figure by normal arithmetical deduction:
Exhibit 42.1 shows the calculation of profit where insufficient information is
available to draft a trading and profit and loss account (income statement),
only information of assets and liabilities being known.
H. Williams has not kept proper book-keeping records, but he has kept
notes in diary form of the transactions of his business. He is able to give you
details of his assets and liabilities as at 31 December 2017 and at 31
December 2018 as follows:
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Exhibit 42.1
First, a statement of affairs is drawn up as at 31 December 2017. This is
the name given to what would have been called a statement of financial
position if it had been drawn up from a set of records. The capital is the
difference between the assets and liabilities.
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A statement of affairs is now drawn up as at the end of 2018. The formula of
opening capital + profit – drawings = closing capital is then used to deduce
the figure of profit.
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Deduction of net profit: Opening capital + net profit – drawings = closing
capital.
Find the missing figures (A), (B) and (C) by deduction:
(A) is the figure needed to make the statement of financial position totals
equal, that is, $34,640
(B) is therefore $34,640 + $9,000 = $43,640
(C) is therefore $43,640 – $32,200 = $11,440
To check:
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Obviously, this method of calculating profit is very unsatisfactory as it is
much more informative when a trading and profit and loss account (income
statement) can be drawn up. Therefore, whenever possible, the ‘comparison
of capital’ method of ascertaining profit should be avoided and financial
statements drawn up from the available records.
It is important to realise that a business would have exactly the same
trading and profit and loss account and statement of financial position
whether the managers kept their books by single entry or double entry. As
shown previously, the double entry system uses the trial balance in preparing
the final accounts, whereas the single entry system will have to arrive at the
same answer by different means.
Helpful Hint!
Question:
How is a statement of affairs different from a statement of financial
position?
42.3 Drawing up the financial
statements
The following example shows the various stages for drawing up the financial
statements from a single entry set of records.
The accountant for J. Frank’s retail store has been given the following
information for the year ended 31 December 2017:
1 The sales are mostly on a credit basis. No record of sales has been made,
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2
3
4
5
but $100,000 has been received $95,000 by cheque and $5,000 by cash,
from persons to whom goods have been sold.
Amount paid by cheque to suppliers during the year = $72,000.
Expenses paid during the year: by cheque, rent $2,000, general expenses
$1,800; by cash, rent $500.
J. Frank took $100 cash per week (for 52 weeks) as drawings.
Other information available:
6 The only non-current asset consists of fixtures which were valued at 31
December 2016 at $8,000. These are to be depreciated at 10% per annum.
The following steps now need to be worked through.
Step 1: First, draw up a statement of affairs, taking into account all the
opening figures, on the closing day of the last accounting period. This is
shown below:
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Step 2: Next, a cash and bank summary, showing the totals of each separate
item plus opening and closing balances, is drawn up:
Step 3: Calculate the figures for purchases and sales to be shown in the
trading account. Remember that the figures needed are the same as those
which would have been found if double entry records had been kept.
Purchases: In double entry, purchases means the goods that have been
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bought in the period, irrespective of whether or not they have been paid for
during the period. The figure of payments to suppliers must therefore be
adjusted to find the figure for purchases. In our example we have:
The same answer could have been obtained if the information had been
shown in the form of a total accounts payable account, the figure for
purchases being the amount required to make the account totals agree:
Sales: The sales figure will only equal receipts where all the sales are for
cash. Therefore, the receipts figures need adjusting to find sales. This can
only be done by constructing a total accounts receivable account, the sales
figure being the one needed to make the totals agree.
The above accounts are exactly the same as the accounts payable and
accounts receivable control accounts, described in Chapter 23.
Step 4: Expenses: Where there are no accruals or prepayments either at the
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beginning or end of the accounting period, then expenses paid will equal the
expenses used up during the period. These figures will be charged to the
trading and profit and loss account.
In contrast, where such prepayments or accruals exist, then an expense
account should be drawn up for that particular item. When all known items
have been entered, the missing figure will be the expenses to be charged for
the accounting period.
In our example, only the rent account needs to be drawn up:
Alternatively, the rent for the year can be found using the following
calculation:
Step 5: Check to see if any depreciation needs to be charged to the profit and
loss account. In our example, Section 42.3 (6), it states that the fixtures are
valued at $8,000 and should be depreciated at 10% per annum. Therefore,
depreciation charge for the year is 10% of $8,000 = $800; this amount should
be charged to the profit and loss account. In the statement of financial
position, remember to deduct the depreciation from the fixtures, that is,
$8,000 – $800 = $7,200 to give you the net book value of the asset.
Now prepare the financial statements using all the information given in the
details and the figures you have calculated.
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Note: A step-by-step guide to incomplete records is given in Section 42.8 at
the end of this chapter.
42.4 Incomplete records and missing
figures
In practice, part of the information relating to cash receipts or payments is
often missing. If the missing information is in respect of one type of payment,
then it is normal to assume that the missing figure is the amount required to
make both totals agree in the cash column of the cash and bank summary.
This does not happen with bank items since another copy of the bank
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statement can always be obtained from the bank.
Exhibit 42.2 shows an example when the drawings figure is unknown;
Exhibit 42.3 is an example where the receipts from accounts receivable had
not been recorded.
The following information on cash and bank receipts and payments is
available:
Exhibit 42.2
The amount needed to make the two sides of the cash columns agree is
$1,265. Therefore, this is taken as the figure of drawings.
Information of cash and bank transactions is available as follows:
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Exhibit 42.3
Receipts from accounts receivable is, therefore, the amount needed to make
each side of the cash column agree, namely $930.
It must be emphasised that balancing figures are acceptable only when all
the other figures have been verified. Should, for instance, a cash expense be
omitted when cash received from accounts receivable is being calculated,
then this would result in an understatement not only of expenses but also
ultimately of sales.
42.5 Where there are two missing
pieces of information
If both cash drawings and cash receipts from accounts receivable were not
known, it would not be possible to deduce both of these figures. The only
course available would be to estimate whichever figure was more capable of
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being accurately assessed, use this as a known figure, and deduce the other
figure. However, this is a most unsatisfactory position as both of the figures
are no more than pure estimates, the accuracy of one relying entirely upon the
accuracy of the other.
Note: Remember that in Chapter 14, the calculation of missing figures
using mark-up and margin was fully covered.
42.6 Cash sales and purchases for
cash
Where there are cash sales as well as sales on credit terms, then the cash sales
must be added to sales on credit to give the total sales for the year. This total
figure of sales will be the one shown in the trading account.
Similarly, purchases for cash will need adding to credit purchases to give
the figure of total purchases for the trading account.
42.7 Disadvantages of single entry
recording
Someone without a double entry set of books will not be able to ascertain the
following information easily.
• Accounts receivable – They will not know who owes them money, how
much they owe and how long the money has been outstanding.
• Accounts payable – They will not know to whom they owe money, how
much they owe and how long the debt has been outstanding.
• Cash and bank balances – The owner(s) of a business frequently need to
know their current cash/bank balance and not maintaining a cash book
makes it impossible for this figure to be easily ascertained.
• Non-current assets – Since there are no double entry records, details of
purchase and disposal of non-current assets will be difficult to ascertain.
• Loans – Insufficient information makes it difficult to monitor amounts
borrowed and repayments made when the business has borrowed money in
the form of a loan.
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Helpful Hint!
Discussion:
With your classmates, discuss the advantages of the use of the
single entry recording system by a micro-entrepreneur.
It will also make it easier for employees to defraud the business, for example,
by destroying sales invoices but obtaining money from the customer and
failing to record it in the books of account.
42.8 Step-by-step guide to incomplete
records
Note: You may find it useful to use this guide when studying the example in
Section 42.3 – the accounts of J. Frank.
Step 1: Prepare a statement of affairs on the closing day of the last
accounting period to ascertain the initial opening capital. Remember to
include the cash and bank balances. (In our example, the opening capital is
$43,000.)
Step 2: Either draw up and balance a cash and bank summary or, if a cash
and bank summary is shown, it may only be necessary to balance off the
account. Remember to include the final cash and bank balances in the final
statement of financial position. (In our example, the balances at 31 December
2017 are cash $100 and bank $30,500.)
Step 3: Calculate the figures for purchases and sales to be shown in the
trading account. Remember that there are two ways that this may be
achieved: either as a calculation or by using double entry ‘T’ accounts. (In
our example, the purchases are $74,500 and the sales $102,200.)
Step 4: Calculate the figures for expenses. If there are no accruals or
prepayments either at the beginning or end of the accounting period, the
expenses paid will equal the expenses used up during the period. If, however,
there are accruals and prepayments, then it will be necessary to make
adjustments; again, this may be carried out as a calculation or by using ‘T’
accounts. (In our example, there is an ‘accrual for rent’ therefore it is
necessary to calculate the rent for the year using either of the aforementioned
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methods, the figure for the year is $3,000.) Remember that ‘accounting for
prepaid expenses’ has been shown in Chapter 28, Section 28.4.
Step 5: Check to see if you need to take account of any depreciation before
preparing the financial statements. The amount of depreciation may be given
or, alternatively, you may have to compare the value of each asset at the
beginning of the period with that at the end of the period – the difference
being depreciation. (In our example, item 6 in Section 42.3, we are told the
value of the non-current asset of ‘fixtures’ is $8,000 and they are to be
depreciated at 10% per annum. Thus 10% of $8,000 = $800 depreciation
which has been charged to the profit and loss account and shown as a
deduction from the fixtures in the statement of financial position.
Remember to check to see if there are any additions to assets and, if so,
ensure that you include them on the statement of financial position and
depreciate them as indicated above.
Finally, prepare the financial statements:
• trading and profit and loss account (income statement), and
• statement of financial position.
Helpful Hint!
Examination Tips:
Be able to clearly distinguish between opening and closing figures for
assets and liabilities when preparing the Statement of Affair.
Remember to include the final cash and bank balances in the final
Statement of financial position.
Summary
• In many small businesses it may not be practical to use a full
double entry accounting system; instead, single entry is used.
• Where there are no proper accounts kept, possibly the only way to
ascertain the amount of profit is to compare the capital account at
the beginning and end of an accounting period. Provided no
additional funds have been invested in the business or drawings
taken out then the difference must be either profit or loss.
• A statement of affairs is often prepared to ascertain the capital of
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the proprietor. This statement shows the value of the assets and
liabilities at a specific date; by using the accounting equation, the
capital can be found.
• Using the step-by-step method, the financial statements can be
prepared from records not kept by the double entry system of bookkeeping (refer to Section 42.8).
• Where there are missing figures, it is possible to deduce the figure
by careful analysis of data available and process of elimination.
• The disadvantage of single entry recording is that insufficient
financial information is available to the owner(s) of the business.
Chapter 42 Exercises
42.1 On 1 August 2016, S. Phillips started his business with $10,000
in his bank account. After the end of his first year of trading, he
realised that, because of his lack of book-keeping knowledge, he
was unable to prepare a statement of financial position. He was,
however, able to produce the following data for the year ended
31 July 2017.
You are required to:
(a) ascertain his profit or loss for the year ended 31 July 2017
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(b) prepare his statement of financial position as at 31 July
2017, showing clearly all the totals and subtotals normally
found in a statement of financial position.
42.2 The following figures have been extracted from the records of K
Rogers, who does not keep a full record of his transactions on
the double entry system:
All goods were sold on credit and all purchases were made on
credit. During the year ended 31 October 2017, cash received
from accounts receivable amounted to $14,610, whereas cash
paid to accounts payable amounted to $9,390.
Required:
(a) Calculate the amount of sales and purchases for the year
ended 31 October 2017.
(b) Draw up the trading account for the year ended 31 October
2017.
42.3X The following figures for a business are available:
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All goods were bought or sold on credit.
Required: Draw up the trading account for the year 31 May 2018,
deducing any figures that might be needed.
42.4 J. Marcano is a dealer who has not kept proper books of
account. At 31 August 2018 her state of affairs was as follows:
During the year to 31 August 2019, her drawings amounted to
$7,560. Winnings from a football pool $12,800 were put into the
business. Extra fixtures were bought for $2,000.
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At 31 August 2019, J. Marcano’s assets and liabilities were:
cash, $84; bank overdraft, $165; inventory, $24,891; accounts
payable for goods, $6,002; accounts payable for expenses,
$236; fixtures to be depreciated, $300; motor van to be valued at
$2,800; accounts receivable, $15,821; prepaid expenses, $72.
You are required to draw up a statement showing the profit or
loss made by Marcano for the year ended 31 August 2019.
42.5X Below is shown the statement of financial position of G. Brown
as at 31 May 2017:
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The following transactions took place on 1 June 2017.
Reconstruct the statement of financial position as it would
appear at close of business on 1 June 2017. You should neatly
set out all your calculations.
42.6X On 1 July 2017, D. Lewis commenced business with $60,000
in his bank account. After trading for a full year, he ascertained
that his position on 30 June 2018 was as follows:
You are required to:
(a) calculate D. Lewis’ capital at 30 June 2018
(b) prepare D. Lewis’ statement of financial position at 30 June
2018 (assuming a profit of $18,550), set out in such a
manner as to show clearly the totals normally shown in a
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statement of financial position.
42.7 A. Hernandez is a sole trader who, although keeping very good
records, does not operate a full double entry system. The
following figures have been taken from her records.
Accounts receivable on 31 March 2018 amounted to $2,980 and
sales for the year ended 31 March 2019 amounted to $11,520.
During the year ended 31 March 2019, cash received from
accounts receivable amounted to $10,820.
Accounts payable on 31 March 2018 amounted to $1,880 and
purchases for the year ended 31 March 2019 amounted to
$8,120. During the year ended 31 March 2019, cash paid to
accounts payable amounted to $7,780.
During the year to 31 March 2019, no bad debts were incurred.
Also, during the same period there was neither discount allowed
nor discount received.
Required:
(a) Calculate accounts receivable and accounts payable as at
31 March 2019.
(b) Calculate Hernandez’ capital as at 31 March 2018 and 31
March 2019.
(c) Calculate her net profit for the year ended 31 March 2019,
allowing for the fact that during that year her drawings
amounted to $2,540.
Note: Calculations must be shown.
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42.8X John Prince is a sole trader who does not keep his books on
the double entry system. From his records, however, the
following information is available.
During the year ending 31 March 2017, Prince used his private
banking account to purchase additional office furniture costing
$720, and this was brought into his business. Also, during the
same period Prince made drawings of $2,560 in cash and $120
in goods (cost price).
Required:
(a) Calculate the amount of Prince’s capital as at 31 March
2016 and 31 March 2017.
(b) Calculate his net profit for the year ending 31 March 2017.
(c) Draw up his capital account for the year ending 31 March
2017 as it would appear under the double entry system.
Note: Calculations must be shown.
42.9 J. Evans kept records of her business transactions in a single
entry form. Her bank account for the year 2017 is as follows:
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Records of cash paid were: sundry expenses $122, accounts
payable $642. Cash sales amounted to $698; cash drawings
were $5,289.
The following information is also available:
You are to prepare:
(a) calculation of capital as at 1 January 2016
(b) a cash and bank summary for the year
(c) a trading and profit and loss account (income statement) for
the year ended 31 December 2017.
42.10X S. Agnew has lost his records of sales, and you will have to
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deduce the sales figure. The summary of his bank account for
the year ended 31 December 2018 is as follows:
A cash loan of $500 was received on 1 July 2018. Interest is to
be paid on this at the rate of 16% per annum. Cash payments
were as follows:
Cash received from accounts receivable was $6,630.
The motor van owned by the business cost $8,000 in January
2016, and depreciation should be written off at 25% using the
reducing balance method. Fixtures costing $2,000 were bought
in January 2015, depreciation is being written off at the rate of
10%, using the straight line method.
The following information is also given:
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You are required to:
(a) draw up total accounts receivable and total accounts
payable accounts
(b) draw up the cash account summary for the year
(c) calculate opening capital as on 1 January 2018
(d) prepare the trading and profit and loss account (income
statement) for the year ended 31 December 2018.
(CSEC style)
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43 The business plan and cash
flow projections
Specific objectives
After you have studied this chapter you should be able to:
• define a budget and understand its purpose
• distinguish between a budget and a forecast
• appreciate the difference between fixed, flexible and functional
budgets
• understand why budget preparation is important in all businesses
• name the main types of budgets used in business planning
• understand ‘cash inflows’ (receipts) and ‘cash outflows’ (payments)
• prepare a cash flow projection
• prepare a production budget
• appreciate the contents of a business plan.
43.1 Definition of a budget
A budget is a cost plan, expressed mainly in financial terms, which covers all
the activities of a business enterprise. It is usually for a specific period of
time, that is:
• monthly budget
• yearly budget
• three- or five-year budget
The budget is usually prepared and approved of prior to the budget year and
shows the policy to be taken to achieve the business objectives.
43.2 Budgetary control
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Budgetary control assigns responsibility for various sections of the overall
budget to individual managers. Periodically, the actual results are compared
with the budgeted figures to ensure that targets are being achieved.
43.3 Purposes of budgeting
Budgets have several different purposes, as shown below:
• Planning – enables the owner(s) of a business to look ahead, set targets,
anticipate problems and provide objectives.
• Communicate – ideas and plans to both management and employees.
• Co-ordinate – the activities of different parts of the organisation so that all
sections work towards the same goal.
• Responsibility – for managers to manage their own budgets and obtain
authorisation for expenditure.
43.4 Forecasts and budgets
It is important to distinguish between a forecast and a budget:
(i) Budget – a planned result that a business aims to achieve.
(ii) Forecast – a prediction (rather like the weather forecast!) of what will
happen as a result of a given set of circumstances.
43.5 Fixed, flexible and functional
budgets
(i) Fixed budget – where the budget is based upon the assumption of a
certain level of activity, for example, producing 5,000 units of a product.
(ii) Flexible budget – where it is difficult to estimate the future level of
activity then a flexible budget is often prepared for a range of possible
levels of output/sales, such as for businesses affected by weather
conditions (for example ice cream sales) or businesses affected by the
relationship between the economic climate and consumption of luxury
goods.
(iii) Functional budgets – a budget for a particular aspect of business
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operations. For example, in a manufacturing company, these would
include:
• production budget for the number of units to produce
• production budget for materials and labour
• sales budget for forecast sales.
There are many other budgeting approaches that are in use today but these are
outside the scope of this book.
43.6 Preparation of the budget
The preparation of a budget usually consists of five stages:
1 Initial forecast – to ascertain preliminary forecasts relative to the external
environment, economic climate, changes in the market and technology.
2 Development of policy – considering the above and making decisions on
what products or services to offer.
3 Operations planning – ascertaining operational requirements for quantities
of raw materials, the labour force and plant and equipment required.
4 Formalisation of budgets – ensuring there is a co-ordinated plan for smooth
operation and which reflects the aims and policies of the management.
5 Approval – usually authorised by senior management/directors, after which
they become formal documents. Specific responsibility is then given to the
individual managers.
43.7 Types of budgets
An organisation may be involved in the preparation of various types of
budgets depending upon their specific requirements, for example:
(i) cash budget (cash flow projection)
(ii) production budget
(iii) sales budget
(iv) marketing budget
(v) income and expenditure budget.
43.8 Cash flow projections
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One of the most important documents to prepare is a cash flow projection
(also called a cash flow forecast) which details the expected cash/bank
receipts (inflows) and payments (outflows) on a month-by-month basis, for
the next three, six or twelve months. It shows the times when cash is coming
into the business (cash inflows) and when cash is going out of the business
(cash outflows). This will then show the estimated bank balance at the end of
each month throughout the period.
The managers use the cash flow projection to decide what action to take
when there is either a surplus of cash available, or as is more likely, when a
bank overdraft may be needed.
The cash flow projection, therefore, shows when money enters and leaves
a business whereas profit is the difference between income and expenditure.
43.9 Preparing a cash flow projection
A cash flow forecast has three sections:
1 Cash inflows – money received by the business from sales, investments
and other sources
2 Cash outflows – money paid out by the business on wages, raw materials
and other items
3 Balances – the opening and closing balance on a monthly basis
Step-by-step guide to preparing a cash flow
projection using a worked example:
Step 1: Ascertain the opening bank balance and note this for inclusion on the
cash flow projection form at point (5).
Step 2: Enter all the cash inflows in the appropriate month when the receipt
is expected, for example these may be one or more of the following:
• Cash sales
• Receipts from customers
• Tax refunds
• Loans
• Injections of capital into the business’s for example, new investor, new
partner
• Any other sources of income, for example, interest
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• Sale of assets
Step 3: Enter all the cash outflows and list them in detail, including when
they are expected to be paid; these may include the following:
• Expenses
• Paying suppliers for goods or services
• Purchase of assets
• Payment of taxes
• Repayment of loans
• Investing surplus cash
Step 4: Add up each monthly column of both the cash inflows and cash
outflows.
Step 5: At the foot of the cash flow projection (refer to Exhibit 43.1)
complete the balancing summary.
(i) Start with the opening bank balance (in the example below this figure is
$5,000)
(ii) Enter the total cash inflow (receipts) for the first month, January $2,000
(iii) Add these two figures together, $7,000
(iv) Enter the cash outflows (payments) for the first month, for January
$2,600
(v) Deduct the cash outflow figure, $2,600, from the balance and receipts
figure of $7,000 to ascertain the closing bank balance figure at the end of
the month ($7,000–$2,600 = $4,400)
(vi) The figure remaining is the bank balance at the end of the month
($4,400); this figure is then carried forward to the beginning of the next
month (February)
Step 6: Repeat the above procedure for each of the remaining five months.
Draw up a cash flow projection for the six-month period from 1 January to 30
June 2019 for Joseph Moxon from the following information:
(i) Opening bank balance 1 January 2019 was $5,000
(ii) Sales all cash and banked in the month of sale:
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(iii) Raw materials paid for in the month of delivery:
(iv) Labour costs are: $1,000 per month
• Variable expenses: $500 per month
• Fixed costs: $200 per month
• Joseph is to buy a new machine in March for $4,000
• In June, a loan of $6,000 was obtained from the bank
The worked cash flow projection is now shown in Exhibit 43.1:
Exhibit 43.1 Cash flow projection
From this cash flow projection, it can be seen that in March and April the
bank balance is only showing $300 and $600 respectively, therefore, Joseph
decides he needs further funds and applies to the bank for a loan. This is
received in June restoring the bank balance to $8,700 at the end of June.
Cash flow projections:
• Enable advance planning
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•
•
•
•
Anticipate cash surpluses or shortages
Loans/overdrafts can be applied for in advance
Loans may be short- or long-term
Loans can be provided by banks, debentures or shareholders
Helpful Hint!
Question:
What are the main differences between inflows and outflows? List
four types of each.
43.10 Production budget
Manufacturing organisations prepare production budgets to calculate the
number of units that the factory can produce in a specific period to meet
expected sales. An example of a production budget is shown below:
What will be the production per month if the following information is
known?
Exhibit 43.2 Production budget
Answer:
Workings, by arithmetical means:
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The table can now be completed:
43.11 The business plan
A business plan is a document which states the details of your business, the
products or services you sell or supply, who you are targeting as customers,
your goals and how you plan to achieve those goals.
43.12 Reasons for preparing a business
plan
A business plan is prepared for a number of reasons:
• to assess the viability of starting a business
• to obtain a loan from the bank, local credit union, other financial
institutions
• to apply for grant funding if applicable
• to encourage others to join you in the business as partners, or investors
• if already running a business to make plans for expansion
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• for decision-making processes.
43.13 The content of a business plan
The sections below are those typically included in a business plan:
• Executive summary
• Overview of the business
• Marketing plan
• Marketing analysis
• Operational plan
• Management plan
• Financial plan
Executive summary – summarises the contents of a business plan which
form part of a longer report or document. It is produced for business purposes
to enable the reader to have an overview of the report/document prior to
reading the whole document. The summary appears first in the business plan
yet it is prepared last after the body of the report has been written.
Overview of the business – this section gives details of the business and
would include the following:
• Aims/objectives – of the business
• Description – of the products/services
• Features – special features which are attractive to the customer
• Market – potential market for the products/services
• Location – of the business
Marketing plan – it is essential to assess the market in order to sell the
goods or services provided by the business. Consideration should be given to:
• Target market – for potential customers
• Market need – is there a niche market for the products/services?
• Market research – carrying out market research to identify competitors,
market changes etc
Competitive strategy – to attract customers to the business’s
products/services and away from those of the competitors, various strategies
can be used, for example cheaper prices, better products and services.
Marketing and promotions – effective methods to inform customers about
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the business’s products/services, for example, using sales and marketing
representatives, advertising (television and radio), social media such as,
Facebook, e-mail, flyers, business cards and newspapers.
Marketing analysis –
• Define and research the target market the business aims to trade within –
see above.
• Ensure that there is a continuing process of collecting information of
demand for the businesses products/services.
Operational plan – the process of operational planning is ascertaining in
advance the aims and objectives of the business and how this is to be
achieved in a specific timescale. Management would need to consider the
following areas when planning how to operate the business.
Premises – the office, factory and/or warehouse’s location should be in a safe
and accessible situation with room for expansion.
Machinery and equipment – details of machinery and equipment required
and its cost.
Materials – types of materials required and their sources.
Labour – the number of employees required, both full- and part-time, and
their skill levels.
Working hours – operational business hours to be decided and known to
employees and customers.
Manufacturing process – details of the manufacturing processes should be
comprehensive to ensure high standards of the goods to be produced.
Management plan – a management team needs to be established with
manager’s responsibilities and areas of work defined. Each member of the
team needs to be highly motivated, competent and be experienced.
Financial plan – the financial plan is an overview of the business’s financial
accounting requirements and consists of three main documents, namely:
• cash flow statements
• trading and profit and loss account (income statement)
• statement of financial position.
There are other financial documents that could also be included such as a
Sales forecast, Production forecast etc.
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Helpful Hint!
Examination Tip:
List five main sections of a business plan. Which section do you think
is the most important? Give a reason for your answer.
Summary
• A budget is a cost plan, mainly expressed in financial terms and
has many useful purposes.
• A budget is a planned result, compared to a forecast, which is a
prediction.
• Fixed, flexible and functional budgets are explained.
• The preparation of a budget comprises of five stages, that is, initial
forecast, development of policy, operations planning, formalisation
of budgets and approval.
• An organisation may use various budgets in their planning such as
cash flow projection, production, sales, marketing and income and
expenditure budgets.
• A cash flow projection is shown together with a step-by-step guide.
• A production budget is shown with full workings.
• The contents of a business plan comprise of the executive
summary, overview of the business, marketing plan, marketing
analysis, operational plan, management plan and financial plan.
Chapter 43 Exercises
43.1 What is the purpose of an Executive Summary in a business
plan? Why is it done after the business plan has been written?
43.2 Which of the following is not a cash inflow: salaries, capital,
bank loan and sales revenue? Give a reason for your answer.
43.3 Paul makes a healthy income by selling ready-to-eat fresh fruits
in pre-packed bags to passers-by on a busy main street in a
major Caribbean city. By 10.00 am on mornings, however, his
fruits start showing signs of deterioration and he makes fewer
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sales as the day goes by. Give three methods he can use to
increase his sales and reduce inventory losses.
43.4X Alex White, a sole trader, has decided he would like to
prepare a ‘cash flow forecast’ for the period January to April. He
has started the cash flow forecast but due to work pressure has
been unable to complete the projection.
You are asked to copy the cash flow forecast he has prepared
so far, add in columns and complete the cash flow forecast for
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March and April using the following information:
• Sales are expected to increase to $19,000 in March and April.
• The cost of materials increases to $5,000 in March but returns
to $4,000 in April.
• He purchases a new piece of equipment in March costing
$6,000.
All other items remain the same as in February.
43.5x (a) Draw up a cash flow projection for Laura Kerr showing the
balance at the end of each month, from the following information
for the six months ended 31 December.
(b) State the closing bank balance, if you would need to
arrange an overdraft and, if so, the amount.
(c) What other alternatives would be available to Laura to
provide additional funds?
(i)
(ii) Bank balance 1 July was $25,000.
(iii) Wages are $10,000 per month.
(iv) Tax $6,000 is payable in September.
(v) New equipment is to be bought in October $9,000.
(vi) Fixed costs are $600 per month.
(vii) Rent payable is $400 per month.
(viii) Laura takes drawings of $800 out of the business each
month.
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Multiple-choice questions – Set 6 (101 to 120)
Each multiple-choice question has four suggested answers: (A), (B),
(C) or (D). You should read each question and then decide which
choice is best: (A), (B), (C) or (D). Write down your answers on a
separate piece of paper. You will then be able to repeat the set of
questions later without the distraction of previously written attempts.
When you have completed a set of questions, check your answers
against those given in Appendix C.
101 Accounts used for regular banking and withdrawals by cheque
are known as:
(A) deposit accounts
(B) savings accounts
(C) current account
(D) revolving accounts.
102 A regular payment made by your bank, for which you have given
authority, is:
(A) a credit transfer
(B) a standing order
(C) an unpresented cheque
(D) a dishonoured cheque.
103 A statement of affairs is similar to:
(A) a bank statement
(B) an appropriation account
(C) a statement of financial position
(D) a statement of account.
104 Which of the following are errors of principle?
(i) Rent entered in buildings account
(ii) Purchases of $150 completely omitted from the books
(iii) Sale of machinery of $500 entered in sales account
(iv) Cheque payment to R. Kago entered only in the cash book
(A) (ii) and (iii)
(B) (iii) and (iv)
(C) (i) and (ii)
(D) (i) and (iii)
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105 Superannuation contributions and income tax should be:
(A) added to the gross pay to give net pay
(B) deducted from gross pay to give the amount payable to an
employee
(C) deducted from net pay
(D) added to net pay to give the amount payable to an
employee.
106 Pay for piece work is related to:
(A) the amount of work performed
(B) net pay
(C) the time taken
(D) holiday pay.
107 What is the number of units in inventory on 31 March?
(A) 57
(B) 35
(C) 30
(D) 180
108 At 1 June,
(A) LIFO has the lowest stock value and highest profits.
(B) FIFO has the highest stock value and highest profits.
(C) AVCO has the highest stock value and lowest profits.
(D) LIFO has the lowest stock value and lowest profits.
109 How much should the goods bought on April 1 be sold for, to
make a profit of $2,000?
(A) $2,000
(B) $6,000
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(C) $8,000
(D) $10,000
110 Working capital is not the same as:
(A) net current assets
(B) the difference between current assets and current liabilities
(C) the measure of the ability of a business to meet current
obligations
(D) cash in hand plus money in the bank.
111 The following information was extracted from the books of a
business at their year end 31 March.
The acid test ratio for the business at the year end is:
(A) 2.5 : 1
(B) 4.0 : 1
(C) 3.0 : 1
(D) 6.0 : 1
112 The book-keeping entries for the creation of a Provision for
doubtful debts is:
[A] debit Accounts receivable and credit Provision for doubtful
debts.
[B] debit Profit and loss account and credit Provision for
doubtful debts.
[C] debit Provision for doubtful debts and credit Profit and loss
account.
[D] debit Provision for doubtful debts and credit Bad debts
account.
113 The credit note below shows that:
(A) Hunters’ Ltd. overstated a sale by $18.
(B) Hunters’ Ltd. deducted a 2% discount from a previous sale.
(C) T. Work-Horse is returning goods valued $18.
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(D) T. Work-Horse got a cash discount of 2%.
114 In Joe’s cash book the balance in the bank account was $1,022,
while the balance shown on the bank statement was $1,210.
Cheques not yet presented were $165 and $78 but bank
charges of $55 had been included in the bank statement but not
entered in the cash book. The real balance in the cash book
should be:
(A) $1,453
(B) $967
(C) $1.077
(D) $1,508
115 Which statement is true?
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116
117
118
119
120
(A) Taxes and NIS contributions are voluntary deductions.
(B) Union dues and loan payments are statutory deductions.
(C) Taxes and NIS contributions are statutory deductions.
(D) Union and credit union dues are statutory deductions.
An employee’s take home pay is calculated from
(A) gross tax minus net pay
(B) net pay less total deductions
(C) overtime pay add net pay
(D) gross pay less total deductions.
Subscriptions received by a club in advance are:
(A) shown in the statement of financial position as an asset
(B) when preparing an income and expenditure account
included in the ‘subscriptions’
(C) shown in the statement of financial position as a liability
(D) not included in the receipts and payment account.
An expense account with a debit balance at the beginning of the
period indicates that:
(A) the amount is a prepayment
(B) the amount is owing by the business
(C) it is the expense for the current period
(D) it is a cash payment.
Debentures issued by a company are:
(A) the same as preference shares
(B) certificates showing loans made to a company
(C) shares issued which cannot be paid back to the
shareholders
(D) the same as ordinary shares.
Which of the following statements is true?
(A) Returns inwards is the same as purchases returns.
(B) Carriage inwards is the transportation of purchases.
(C) Returns outwards is the transportation of sales.
(D) Carriage outwards is the goods returned to suppliers.
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44 Computers and accounting
systems
Specific objectives
After you have studied this chapter you should be able to:
• appreciate the uses of computer technology in recording financial
information
• appreciate the different types of financial accounting packages
available for all types of organisations
• understand the functions and benefits of computer accounting
software
• appreciate the benefits of having online facilities within a computer
system to provide for the use of the internet
• realise the importance of backing up data when using a
computerised accounting package
• understand the importance of security when using an accounting
package and the benefits of using a password
• describe the advantages and disadvantages of using a
computerised accounting system.
44.1 Introduction
Today, computers are used widely to operate accounting systems.
Sophisticated technology is now available in computer hardware and
software at a reasonable cost. Large to medium-sized concerns have used
specially written packages for a number of years but smaller enterprises were
initially discouraged from setting up their own systems by the cost of such
packages.
However, small businesses can now afford to use a computerised system
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using off-the-shelf packages such as Sage or QuickBooks. These packages
carry out the same double entry functions of processing of data and recording
financial information as manual systems and also offer other features such as
information management.
The rapid development of the internet enables accounting information and
transactions to be carried out online, such as purchasing goods and making
payments.
44.2 Functions of computerised
accounting packages
A computerised accounting package offers all the functions that a manual
system provides but in addition it provides useful reports and management
information. Since the system is integrated, basic data is entered, processed
and automatically posted to supplier and customer accounts and the general
(nominal) ledger updated. At the same time, inventory records are updated
and in some instances automatic re-ordering systems are in place. The main
functions of a computerised accounting package are listed below.
Sales
• Preparation and printing of sales invoices, credit notes and month-end
statements. Data from the above documents is entered, processed and
recorded in:
(a) the customer accounts in the sales ledger
(b) automatic update of the inventory records.
Purchases
• Data from the purchase invoice and credit notes is entered, processed and
recorded in:
(a) the supplier accounts in the purchase ledger
(b) automatic update of the inventory records
(c) print out of remittance advices.
Bank account
• Recording data such as customer receipts, supplier payments, other
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payments and receipts.
• Many banks offer online banking facilities which have the added advantage
of the organisation’s bank account being completely up-to-date.
• All receipts and payments are linked to the personal accounts of the
accounts receivable and accounts payable and the system provides for such
transactions to automatically update these accounts.
General (nominal) ledger
• Automatic updating of the general (nominal) ledger.
Wages/salaries
• Organisations have the option of using a combined computerised
accounting and wages/salary package, alternatively, they may use a
separate ‘payroll package’. Such packages perform all the necessary
payroll functions.
Inventory control
As mentioned, the functions relating to ‘Sales and purchases’, are linked to
the inventory records. This means that inventory records are automatically
updated after each sales and purchases invoice is entered into the system, so
providing an accurate figure of inventory held at any particular point in time.
When an organisation decides to undertake an inventory check at the end
of the financial year, it is very easy to print up-to-date inventory lists to
facilitate this procedure. The lists are then used to physically check the items
and enable variances to be identified and amended.
The functions mentioned above are summarised in Exhibit 44.1.
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Exhibit 44.1 Integrated computerised accounting system
The diagram in Exhibit 44.1 can be compared to ‘The Accounting Cycle’
diagram in Chapter 3. The source documents and their entry in the books of
prime entry are clearly shown.
Management reports
One of the main features of a computerised accounting system is the facility
to provide the owners of the business and/or management with useful
financial data and reports. At the end of each month or specific accounting
period, certain ‘month end/year end’ functions are carried out to provide the
following information:
(a) Day books for customers and suppliers
(b) General (nominal) ledger and bank account transactions
(c) Activity reports on all ledger transactions
(d) An audit trail
(e) Analysis reports for aged accounts receivable and accounts payable
(f) Financial statements including the trial balance, trading and profit and
loss accounts (income statement) and statement of financial position
(g) Ratio analysis
Other useful functions
• Spreadsheets – The use of spreadsheets is another facility that a computer
offers. Spreadsheets can be used to provide financial budgets, or cash-flow
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budgets, a non-current asset register, calculation of loan interest payments
plus many other uses.
• Internet access – As mentioned above, internet access can provide such
things as online banking, payment of suppliers and other payments such as
wages/salaries.
An organisation having its own website can advertise its products and
services and online ordering systems linked to the site. In addition, the
internet is a useful source of information and data that an organisation may
from time to time need to access.
44.3 Data backup
It is important that data held on the computer is saved regularly. The
regularity has to be determined by the business relative to the type of
operation and could mean every few minutes, after a specified computer task
or after a longer timescale, say, every hour.
It is also vital to back up data held on the computer. Backup can be
achieved by copying data onto a CD/DVD or by transferring it to another
computer, either on the premises or at a remote location. Recent
developments for storing information are USB pen drives, memory sticks,
and external/portable hard drives, which are small but robust solid state
devices. The USB pen drives and memory sticks are easily carried in a pocket
as well as in a briefcase, which is ideal for carrying an external/portable hard
drive.
Some large organisations may deem it essential to keep their
external/portable hard drives, etc. containing stored information off-site in a
secure location. This is particularly the case where the loss of such data could
have catastrophic implications for the business.
Some businesses are moving towards cloud storage. Instead of storing
software and data on a computer in the organisation, these are stored on
computers in another location managed by a hosting company (usually in
another country). You access the programs via the internet. This means that
you have access no matter where you are in the world, once you have an
internet connection but there is usually an additional layer of security. The
hosting company undertakes the responsibility of backing up your data.
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44.4 Security
All organisations regard their financial information as sensitive and as such it
should remain confidential except where legislation demands certain
information be made available to external bodies.
Staff working on computerised accounting systems will be allocated
passwords which will restrict access to their area of work. Passwords should
be changed regularly to help to prevent the possibility of non-authorised
persons accessing the system.
When a system uses internet connections, there is the constant threat of
fraudulent access and corruption. Most computer systems have packages to
resist viruses and attack by hacking. These have to be constantly reviewed
and updated.
44.5 Computerised accounting systems
Advantages and disadvantages of using accounting packages are detailed
below.
Advantages
• Data is input and processed very rapidly, far faster than in a manual system.
• There is greater accuracy since data is only input once and transactions
carried out automatically whereas with a manual system data may have to
be entered twice or more.
• Documents such as invoices, credit notes, statements and remittance
advices can be produced automatically.
• Constant updating of the accounting records gives the accurate state of
customers’ accounts enabling remedial action to be taken as necessary.
• Management information can quickly be made available in report form,
that is, aged accounts receivable and accounts payable analysis reports.
• A system connected to the internet can make financial transactions
electronically.
• Resources are used more efficiently so an organisation may not need as
many accounting staff.
Disadvantages
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• Cost of installation can be considerable together with the ongoing costs of
maintenance and updates.
• The introduction of the system will affect most other areas of the business
leading to considerable disruption. Staff may also be resentful of any new
system.
• Staff will need to be trained to use the system and training costs have to be
considered.
• System downtime can be very disruptive.
• Data backup is essential at regular intervals.
• Fraudulent access can seriously affect the business operation and its
profitability.
• Security measures are vital, for example, passwords for staff and protection
against viruses and hacking.
• Health risks associated with operation of computer keyboards and screens,
which include eyestrain, back problems due to poor posture, and muscular
fatigue in the arm and wrist from keyboard use. Regular rest intervals away
from the work station are essential.
44.6 Computerised packages
Tax structures vary from country to country, and there are changes from year
to year.
As a result, payroll software is usually designed and configured locally.
However, there are payroll packages which are written for the Caribbean
where the supplier would maintain and update the different tax tables for each
country. Examples of such packages include HRp5 and HRplus.
There is no such thing as ‘one size fit all’ accounting software. The needs
of the company and their particular industry will usually determine the
package chosen. These are some of the accounting software packages
available on the market.
Helpful Hint!
Examination Tip:
List four types of computerised accounting software packages. Give
two advantages and two disadvantages of using computerised
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accounting packages.
For small companies:
(1) Sage 50 commonly known as Peachtree (used in the service and retail
industries)
(2) QuickBooks (used in the service and retail industries)
For medium-sized companies:
(1) Infor Sunsystems (used in the hotel, insurance and oil and gas industries)
(2) Microsoft Dynamics GP (used in the retail and manufacturing industries)
For large companies:
(1) SAP (different industries)
(2) PeopleSoft (different industries)
Summary
• Computers are used widely in organisations for operating
accounting systems.
• Most computerised accounting packages are integrated systems
linking together the sales ledger, purchase ledger, general
(nominal) ledger and the bank account.
• The computerised accounting package also produces various
documents such as invoices, credit notes, statements and
remittance advices.
• Other features include providing financial information for the
owners of the business and/or management. The use of the
internet enables online facilities and spreadsheets for such things
as preparing budgets, etc.
• It is essential that users of computerised accounting packages
regularly back up data using one of the various methods available.
• Security within any system is paramount for any organisation and
every effort must be made to ensure that data is safe and secure.
• Organisations must consider the benefits of operating a computer
accounting package such as the speed at which data is entered,
accuracy, cost effectiveness and the information output such as
management reports.
• The disadvantages include the cost of installing equipment, buying
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software and providing training together with security concerns.
There may also be some resentment from staff and lack of
motivation.
Chapter 44 Exercises
44.1 A flag manufacturer’s business has recently received a large
increase in orders from overseas to meet the requirements of
major sporting events. This demand for flags has had a
considerable effect on the present manual accounting system.
The Finance Director has decided that he would like to introduce
a fully integrated computer accounting system. He intends to put
his case forward at the next Directors’ meeting and asks you to
prepare some notes on his behalf.
Required:
Prepare notes for the Finance Director to present at the meeting
including the main advantages to be gained by making the
change. You must also anticipate the arguments that may be
used by a board member objecting to the proposed change.
44.2 The security of data is a very important consideration when
using a computerised accounting package. Explain the
measures that a medium-sized company could initiate to provide
protection for the company against security threats to their
financial data and records.
44.3X You work in the accounts department of an advertising
agency where a new member of staff has recently joined the
accounts team. You have been asked to help her settle in the
department and provide training on the computerised accounting
system. One of the areas that you feel is very important is
security and backup of data.
Required:
Draft a memo to the trainee outlining the importance of security
of financial data and the agency’s procedures for backing up
data.
44.4X (a) Outline the benefits that are available to a small business
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when it has internet facilities.
(b) If the firm decided to obtain the services of a web designer
to develop a website, what benefits would this provide to the
business?
(c) If the website was developed, what do you think are the
disadvantages to offering such a service?
44.5X A local garage that carries out servicing and repairs, mainly to
cars and small commercial vehicles, is run by the owner with two
other employees. The book-keeping and accounting is carried
out on a part-time basis by a lady who works one day per week.
She uses a manual accounting system to deal with customer
invoices and payments, paying suppliers for goods received,
banking monies received, petty cash and paying wages.
The owner is considering a computerised accounting system but
is unsure as to the benefits to be gained from a large initial
investment.
Required:
Put forward the benefits that might be gained but also consider
the adverse aspects of such an investment. State whether you
would advise him to proceed or not.
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45 School-based assessment
(SBA) – research project
Specific objectives
After you have studied this chapter you should be able to:
• appreciate the requirements of the school-based assessment in its
structure and layout
• identify a suitable topic, issue or problem for the school-based
assessment
• undertake the research project in a systematic and logical way.
45.1 Introduction
The Caribbean Examination Council (CXC) have made changes to the
Caribbean Secondary Education Certificate (CSEC) subject, Principles of
Accounts. The syllabus for this subject will be examined at General
Proficiency only.
The examinations will cover the entire syllabus and comprise:
• Paper 01 A multiple-choice test of 60 items.
• Paper 02 A problem-solving paper consisting of five compulsory questions.
• Paper 031 A school-based assessment component (SBA) comprising an
individual report on a research project. Students may work individually or
in groups to gather the data. Each candidate must be identified on the
project report.
• Paper 032 For private candidates an alternative to the school-based
assessment is required. This will consist of a case study on which the
candidates will be required to answer ten questions.
The effective start date for these examinations is May/June 2019.
School-based candidates will study for these examinations with the aid of
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their teachers, but private candidates will need to obtain the relevant syllabus
to ensure that they can prepare properly.
45.2 The school-based assessment
(SBA) – research project
The school-based assessment (SBA) is essentially a research project which is
carried out over a period of time with the support and guidance of your
teacher. Your project will be marked by your teacher using a structured
marking scheme which allocates marks for very specific aspects, so it is
important to take note of your teacher’s guidance.
The research project should involve the manipulation of accounting data in
real-life situations, including data collection, analysis and interpretation. The
activities selected must be legal and provide opportunities for the collection
of accounting data and the application of accounting principles. Students who
are doing Principles of Accounts and any of the other subjects in the Business
cognate group consisting of Principles of Accounts, Principles of Business
and Economics, can submit ONE school-based assessment (SBA) report
provided that this report is based on the Business subjects being studied.
The report should not exceed 1,000 words not including appendices. A
penalty will be applied if a candidate exceeds the maximum length for the
project by more than 10%. A reduction of 10% of the score that the candidate
achieves on the project will be imposed.
The CXC provided some suggestions in its syllabus for entities or
situations that might be suitable topics for the report. These are mainly based
on school activities and situations. It is, of course, important that students
decide on a familiar topic and have ready access to the necessary data.
It is anticipated that the SBA project would be completed before the
examination Papers 01 and 02 are taken in May/June.
45.3 The teacher’s role
Teachers have a crucial role to play in assisting candidates with their projects.
They will provide instructions for doing each project, help in the selection of
a suitable topic or subject and give guidance during the project.
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45.4 The sequence of activities for
those undertaking the research project
The following points show a suggested sequence for tackling the project.
Review, visit and explain
Review entities that could be possible sources for the project. These could
include sole traders with whom someone in your family is familiar or does
business with, that is, builder, garage, local shop, and who might allow you
access to their financial information.
As this is a sensitive area, there may be reluctance by these people to
permit investigation of their books. Alternatively, it may be possible to
investigate your family’s finances or use a simulated situation agreeable to
the teacher.
Having selected a possible business, arrange a visit and make sure you
have a letter of introduction to show on your initial approach to the business.
Explain the aims of the project to the owner, that is, ‘to compare the
accounting procedures learned in the classroom to those that are actually
practised in the business world’.
Agree a subject
Agree with your teacher that you have selected a suitable entity and chosen
an area for investigation within the business.
For example, if your initial visit is to a local locksmith, you may find that
there is little evidence of proper inventory records. From your school studies
you would know that inaccurate inventory records affect both the trading and
profit and loss account (income statement) and the statement of financial
position.
Define a topic for study
As stated previously, the research project must be carried out on an actual
entity. This section deals with the visits that may be made to business
enterprises.
When you visit a particular business, you should take care to explain
clearly that you wish to observe and report on the accounting procedures used
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by the business, and that you will then compare these to your school
accountancy studies.
Using the example of inventory records, mentioned in the step described
above, you might take this further and observe the methods of inventory
control and inventory valuation. You could then compare these methods to
those covered in your school studies where you would have learned about
accepted accounting methods for valuations.
You might also look at inventory levels and comment as to whether or not
these are too high or too low relative to the activity of the business.
Investigate
The investigation into the topic that has been chosen requires careful thought
and will be influenced by the availability of information within the business.
This information may be in the form of documents and records, but where
there is lack of documentation it could be necessary to gain the required
information from the owner or employees.
It is possible that some or all of the following methods may be needed to
collect data.
• Documents and records – Collect relevant documents and records and
review these to provide information and data, for example:
(i) company year books, manuals, reports etc – to provide information on
production, sales and marketing, financial, and so on
(ii) government departments, agencies – to provide statistical reports and
policy documents
(iii) library resources and computer-based information.
Make notes on the relevant information from the documents you have
sourced.
• Questionnaires – These are normally used when information and opinions
need to be collected from a number of people. They would not be used
unless there were more than six people as the time required to construct a
questionnaire would not be justified for fewer people than this. In
designing a questionnaire, two main points need consideration:
(i) posing the right questions to gain the relevant information
(ii) structuring the questions in such a way that provides for a choice of
answers, say four or five, and then allows easy analysis of these
answers.
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Example: In general, how good or poor would you say the standard of
inventory control is in the business?
The question in the example above gives a choice of answers, allows easy
analysis but also asks for additional information when the ‘Poor’, or ‘Very
poor’ responses have been chosen. Limit the number of questions to a
maximum of ten, making sure that those that give the opportunity for
opinions to be recorded do not exceed more than three or four of the
questions as otherwise analysis will be difficult. This is due to the variety of
opinions that could be offered, which can cause problems in how to present
these opinions in the findings.
• Interviews – These provide face-to-face contact with the person from
whom you wish to gain information and allow flexibility in the
questioning. However, each interview should be structured by preparing
the questions beforehand. This will ensure that the person being questioned
does not deviate from the theme of the interview. Interviews can be timeconsuming and so a time limit should be estimated before undertaking
these. Aim to ask about ten questions. Make notes of the interviewees’
answers for analysis later.
• Observations – These are a very valuable source of data, but it should be
clear before commencing the observation that it is going to provide
information relevant to the project. It is also essential to have some
knowledge of the activity to be observed. If you are unfamiliar with the
activities, it can be confusing to watch them. Again, observations can be
time-consuming, but there is the opportunity during the activity to ask
questions of the person being observed. Ensure good records are made of
the observation for later analysis.
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Analyse
Having collected the data, it will now be necessary to analyse the
information. In the case of questionnaires, this will involve looking at the
answers to see if any trends emerge with each question. Notes taken during
interviews need to be examined and the main points from the answers need to
be assessed and recorded.
When observations have been used, you should have good notes from the
observed activity – possibly more than will eventually be needed. Review
these notes and extract the relevant points for inclusion in your findings.
Report the findings
At this stage, it will be necessary to report your findings in a clear and factual
manner. You should present the information in the most appropriate way
relative to the method of investigation. For example, the results of a
questionnaire could be set out in a table, showing the various responses to
individual questions.
When an interview has been carried out, the answers to the questions asked
should be stated. You might have been given quite lengthy answers in some
instances and these should be edited so that only the relevant points are
stated.
Do not make any comments on the findings at this stage.
Conclusion
Here you should use your findings to come to some conclusion. Ask yourself
‘What did I set out to find, and how does what I really found compare to
that?’
Recommendations
This is where you make some proposal or suggestion to improve the situation
you found. Aim to discuss two ways to improve the accounting procedures
used. For example, in the case of the inventory control problem referred to
earlier, you might be able to compare previous trading and profit and loss
accounts (income statements) and statements of financial position with recent
financial statements where more realistic inventory figures were used. You
might also be able to recommend the importance of keeping to a consistent
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method of valuing inventory as required by the accounting concepts.
45.5 The completed research project
The sequence referred to above will have given a good indication as to how
the stages of the project should be dealt with. The CSEC syllabus states that
the report should be presented electronically and in the following specific
order:
Format for the Research Project Report
• Table of Contents
• Topic, Issue or Problem
• Objectives – These can be stated in the form of research questions
which are linked to Specific Syllabus Objectives. One to three
objectives are adequate. (Ensure that the objective(s) is/are related
to the specific project topic, issue or problem and NOT to your
reason for doing the subject or subject cognate.)
• Background to or overview of the topic, issue or problem
• Methodology – Data collection and instrumentation
• Presentation and Analysis of Data
• Conclusion
• Recommendations
• Bibliography
• Appendices
45.6 Preparing the research project
report – some points to consider
1 Format of the Research Project Report
Having gathered and analysed the data and drawn your conclusions, you
will be in a position to compile your report which, as stated above, must be
prepared electronically and presented in a folder.
2 Title Page
This page should include your name, registration number, name of the
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Business Cognate subjects, the title of the report, your school, the Form/Class
you are in and the date the report is submitted.
3 Acknowledgements
This is where you show gratitude and thank those who provided assistance
with the research.
4 Bibliography
Follow the styles that you see in the Bibliography of textbooks and on
reputable websites, for example:
Textbook: Wood, F; Robinson, S; Principles of Accounts for the
Caribbean, 6th Edition (UK: Hodder Education, 2018).
Newspaper: Education on the move, Jamaica News, pp 20–24, January 15,
2018.
Website: Modern Language Association – www.MLA.org
Personal interview: D. Rich, personal communication, January 10, 2018.
Note: Only include a person who has agreed to being cited.
45.7 Sample school-based research
project
This sample gives an indication of the kind of scenario that you may find and
an appropriate topic. It has been shown in a very brief form only – to comply
with the requirements of the CXC it would need to be presented much more
formally.
Example of a school-based research project
J. Lopez is a locksmith who has a shop selling high-security locks and safes.
As a friend of your father, he is aware of your need to undertake an
accounting project and has asked you to look at the issue of inventory
valuation and control. He hands you his draft trading account for the year to
31 December 2017.
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The figures that are of particular interest to you in terms of inventory
valuation are opening inventory of $4,500 and closing inventory of $9,000.
You decide to interview Mr Lopez and find that:
• he employed a book-keeper to carry out an inventory check at the end of
December 2016 who valued the inventory at cost
• he carried out the inventory check at the end of December 2017
• his records of the December 2017 inventory check were not fully detailed
• he used the list of selling prices to value his inventory
• he could not show you any formal inventory records
• he re-orders inventory when he runs out
• his profit margin is 33¹/₃%.
As a result of the interview, you decide to do a detailed inventory check with
Mr Lopez, valuing the inventory on the same basis as previously, that is, cost
price. On completion of the task, the closing inventory is now found to be
valued at $6,000 (cost price) and you then produce an amended trading
account.
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In concluding the project, you could state that:
• the inventory was not properly counted and was incorrectly valued at 31
December 2017
• as a result of this, the profit was overstated.
Your recommendations could now be presented:
• Proper inventory records should be maintained:
– to help with inventory checks
– to set minimum and maximum inventory levels
– to establish re-order levels to ensure inventory does not run out
– to monitor financial value of inventory
A consistent and proper basis of inventory valuation should be adhered to, as
required by the accounting concept – in this example, ‘consistency’ – so you
propose cost price as a proper basis.
This sample topic could be used as a basis in producing other financial
data, for example, the profit and loss account (income statement) and
statement of financial position. This would depend on obtaining further
financial data from the owner of the business. This could then lead to the
student being able to carry out an evaluation of the business using ratio
analysis.
45.8 Case studies
The Alternative to the SBA, Paper 032 requires that private candidates
answer ten questions based on a case study. For Case Studies practice, visit
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the website (www.hoddereducation.com/POAResources) where you will be
able to access case studies and suggested solutions.
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Appendix A: Glossary of
accounting terms
The chapter where the term first appears is shown in brackets at the end of
each definition.
Absorption costing A method of costing whereby overhead costs are shared
amongst all the cost units to which they relate. (36)
Account The place in a ledger where all the transactions relating to a
particular asset, liability or capital, expenses or revenue item are recorded.
Accounts are part of the double entry book-keeping system. They are
sometimes referred to as ‘T accounts’ or ledger accounts. (1)
Accounting A skill or practice of maintaining accounts and preparing reports
to aid the financial control and management of a business. (1)
Accounting concepts The rules which lay down how the activities of a
business are recorded. (4)
Accounting cycle The period in which a business operates its financial year.
It involves recording all trading activities from source documents to the
preparation of the financial statements. (3)
Accounting equation If a business starts trading it will require resources,
expressed as: resources supplied by the owner = resources in the business
or capital = assets – liabilities. (5)
Accounts payable A person to whom money is owed for goods or services,
originally known as a creditor. (3)
Accounts payable : purchases ratio A ratio assessing how long it takes a
business to pay its creditors. (40)
Accounts receivable A person who owes money to the organisation for
goods or services supplied, originally known as a debtor. (3)
Accounts receivable : Sales ratio A ratio assessing how long it takes
customers to pay a business. (40)
Accrual An accrued expense. An amount owing. (28)
Accrual concept Where net profit is the difference between revenues and
expenses incurred in generating that revenue. (4)
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Accrued expense An expense that has been incurred and the benefit
received but that has not been paid for at the end of the accounting
period. Also referred to as an accrual. (28)
Accumulated fund A form of capital account for a non-profit-making
organisation. (33)
Acid test ratio A ratio comparing current assets less inventory with current
liabilities. Also known as the ‘quick ratio’. (40)
Administrative expenses Costs incurred in the administrative section of a
business, i.e. wages and salaries of managers, secretarial staff etc.,
communication expenses. (36)
Advice note A note sent to a customer by the supplier prior to goods being
despatched, advising of the goods to be despatched and the estimated date
of delivery. (17)
Affiliation fees Membership fees paid to local, regional or international
cooperative societies. (39)
Amortisation A term used instead of depreciation when assets are used up
simply because of the time factor. (25)
Annual General Meeting (AGM) A meeting held every year which all
shareholders in a company are invited to attend. At the meeting, the latest
set of financial statements are considered, together with the appointment or
removal of directors and/or auditors. (38)
Appropriation account An addition to the Profit and Loss Account of
partnerships and companies. The appropriation account shows how profit
earned is divided. In a partnership it is divided in accordance with the
partnership deed or agreement. With a company it is apportioned to reserve
accounts, provision for taxation and distributed as a dividend to the
shareholders. (39)
Assets Resources owned by the business. (6)
Authorised share capital The total amount of share capital or number of
shares which a company can have in issue at any given time. (38)
AVCO A method by which the goods used are priced out at average cost.
(30)
Bad debt A debt owing to a business which is unlikely to be paid. (22)
Bad debt recovered A debt, previously written off, that is subsequently paid
by the customer. (27)
Balance sheet Now called a Statement of financial position; a statement
showing the assets, capital and liabilities of a business. (3)
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Balancing the account Finding and entering the difference between the two
sides of an account. (8)
Bank cash book The cash book for monies other than petty cash. (21)
Bank giro credit transfers Method used by businesses to pay suppliers,
wages and/or salaries. A bank giro credit list and slips containing
information about each person or organisation to be paid and the amounts
payable are sent to the bank, together with one cheque to cover all the
payments. The bank then automatically transfers the funds from the
business’s account to the account of each of the respective people or
organisations. (24)
Bank reconciliation statement A bank reconciliation statement is prepared
regularly by businesses to check that the balance shown in the cash book
(3) (bank column) agrees with the balance shown on the bank statement.
(24)
Bank statement Copy of a customer’s current account given to the customer
on a regular basis. (20)
Bankers’ Automated Clearing Service (BACS) Computerised payment
transfer system that is a very popular way of paying suppliers, wages and
salaries. (3)
Book-keeping The process of recording of accounting data in the books of
account. (1)
Books of original entry Books where the first entry of a transaction is
entered. Sometimes these are referred to as ‘prime books of entry’. (3)
Budgets The usual term for financial plans (1)
Business entity concept Concerning only transactions that affect the
business, and ignoring the owner’s private transactions. (4)
Called-up capital Where only part of the amounts payable on each share
have been asked for. The total amount requested on all the shares is known
as the ‘called-up capital’. (38)
Calls in arrears The amount for which payment has been requested (i.e.
called for), but has not yet been paid by shareholders. (38)
Capital The total of resources supplied to a business by its owner. (6)
Capital employed This term has many meanings, but basically it means the
amount of money that is being used up or ‘employed’ in the business. It is
the balance of the capital account plus any long-term loan or, alternatively,
the total net assets of the business. (28)
Capital expenditure When a firm spends money to buy or add value to a
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non-current asset. (15)
Capital invested The amount of money, or money’s worth, brought into a
business by its proprietor. (28)
Capital reserve Reserves which cannot be used for the payment of
dividends. The two most common types of capital reserve are the Share
Premium Account and Revaluation Reserve Account. (Capital reserves
are outside the scope of this book.)
Carriage inwards Cost of transport of goods into a business. (13)
Carriage outwards Cost of transport of goods to the customers of a
business. (13)
Carriage paid Another word for carriage is transport, therefore, carriage paid
indicates the cost of transport that has been included in the cost of the
goods. (17)
Cash book Book of original entry for cash and bank receipts and payments.
(3)
Cash discount An allowance given for quick payment of an account owing.
(17)
Cash float A sum of money held as a ‘float’ to provide the petty cashier with
funds with which to pay out petty cash claims. (21)
Casting Adding up figures. (31)
Cheque A cash-free method of transferring money using a form of standard
format. It is used to instruct one’s own bank to transfer money from one’s
own account to another person or business. (3)
COD Literally ‘Cash on delivery’. (17)
Coding of invoices A process used, particularly in computerised accounting,
to code the invoice to the supplier or purchaser, and also to the relevant
account in the general ledger. (18)
Commission A percentage, based on the amount of sales made by an
employee, that may be paid in addition to a basic salary or instead of a
salary. (41)
Compensating error Where two errors of equal amounts but on opposite
sides of the accounts, cancel out each other. (10)
Complete reversal of entries Where the correct amounts are entered in the
correct accounts, but each item is shown on the wrong side of the
account. (31)
Computerised accounting package A software accounting package used
to enter data in the financial records and providing additional financial
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information. (1)
Consistency Keeping to the same method of recording and processing
transactions. (4)
Contactless payments A recent feature of the debit/credit card that allows
purchases up to small limit (£30 in UK) by the cardholder holding the
contactless card against a reader in the retail outlet. (41)
Contra A contra is where both the debit and credit entries are shown in the
cash book. (20)
Control account An account which checks the arithmetical accuracy of a
ledger. (23)
Cooperative societies A business entity formed to further the economic
welfare of its members by providing them with goods and services. (39)
Corporations Limited liability companies. (38)
Cost of goods sold Calculated as follows: Opening inventory plus
purchases during the period less the value of the inventory at the end of
the period (closing stock). (11)
Costing Presents management with cost information to enable them to
manage the business more effectively. (36)
Cost centres Any part of the business to which costs can be charged. (36)
Cost-plus pricing A costing method of pricing to which a percentage, to
represent profit, is added to the total cost of production. (36)
Credit The right-hand side of the accounts in double entry. (6)
Credit card Issued by organisations such as Visa, Mastercard. The credit
card holder uses the card to buy goods or services. The credit card
company transfers money to the seller electronically and bills the credit
card holder for repayment. (19)
Credit note A document sent to a customer showing allowance given by
supplier in respect of unsatisfactory goods. (3)
Credit transfer An amount paid by someone direct into a bank account.
(24)
Creditor See Accounts payable. (3)
Current assets Assets consisting of cash, goods for resale, or items having a
shorter life. (5)
Current liabilities Liabilities to be paid for in the near future. (5)
Current ratio A ratio comparing current assets with current liabilities.
Also known as the ‘working capital’ ratio. (40)
Debenture Loan to a company, often secured on the non-current assets of
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the business. (38)
Debenture interest An agreed percentage of interest paid to a debenture
holder for lending money to a company. (38)
Debit The left-hand side of the accounts in double entry. (6)
Debit note A document sent to a supplier showing allowance given for
unsatisfactory goods. (3)
Debtor See Accounts receivable. (3)
Delivery note A note which accompanies goods being despatched, enabling
the customer to check what goods have been received. The carrier often
retains a copy and asks the customer to sign this to verify that the customer
has received the goods. (16)
Depletion The wasting away of an asset as it is used up (25)
Depreciation The part of the cost of the non-current asset consumed during
its period of use by a business. (4)
Direct costs Costs which can be traced to the item being manufactured. (37)
Direct debit A payment collected from a payer’s bank by the payee. The
payer signs a direct debit mandate authorising their bank to allow the payee
to collect previously notified amounts direct from the bank. (24)
Directors Officials appointed by shareholders to manage the company for
them. (38)
Directors’ remuneration Directors are legally employees of the company
and any pay they receive is called directors’ remuneration. (38)
Discounts allowed A reduction given to customers who pay their accounts
within the time allowed. (20)
Discounts received A reduction given to us by a supplier when we pay their
account before the time allowed has elapsed. (20)
Dishonoured cheque A worthless cheque that the bank refuses to honour
because there are insufficient funds in the account. (24)
Dividends The amount given to shareholders as their share of the profits of
the company. (23)
Donation A monetary gift donated to the club or society, monies received
should be shown as income in the year that they are received. (33)
Double entry book-keeping A system where each transaction is entered
twice, once on the debit side and once on the credit side. (3)
Doubtful debt A debt which is unlikely to get paid in the time requested.
(27)
Drawee The bank on which a cheque is drawn. (41)
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Drawer The person making out a cheque and using it for payment. (24)
Drawings Cash or goods taken out of a business by the owner for private use.
(8)
Dual aspect concept Dealing with both aspects of a transaction. (4)
E & OE This stands for ‘errors and omission excepted’ and appears on the
bottom of an invoice. It is a warning to the buyer that there may be an error
on the invoice and as such the recipient should check the invoice carefully.
(17)
Employee A person who is employed by an organisation in return for
payment. (1)
Employer A person or organisation that employs workers and pays them
wages or salaries in return for services rendered. (2)
Equity Another name for the capital of the owner. Also described as ‘net
worth’. (5)
Error of commission Where a correct amount is entered, but in the wrong
person’s account. (31)
Errors, complete reversal of entries See Complete reversal of entries.
Error of omission Where a transaction is completely omitted from the
books. (31)
Error of original entry Where an item is entered, but both debit and credit
entries are of the same incorrect amount. (31)
Error of principle Where an item is entered in the wrong type of account,
e.g. a non-current asset entered in an expense account. (31)
Ethics The moral principles of human conduct referred to as ‘a code of
behavior considered correct for a particular profession, association or
group. (2)
Ex works An indication that the price of certain goods does not include
delivery costs. (17)
Expenses Costs of operating the business. (8)
Expenses : Sales ratio A ratio which indicates whether costs are rising
against sales or whether sales are falling against expenses. (40)
Extended trial balance A trial balance with additional columns added to
enable adjustments to be made prior to the preparation of the financial
statements. The extended trial balance is often referred to as a ‘worksheet’.
(29)
Factoring A system used by a business to improve its cash flow. This
involves ‘selling’ its accounts receivable (3) (debtors) to a factoring
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company, which is then responsible for collecting debts as they become
due and which keeps a percentage of the money collected, usually around
10%. (17)
Factory overhead costs Refer to: Indirect manufacturing costs. (36)
FIFO A method by which the first goods to be received are said to be the
first to be sold. (30)
Final accounts At the end of the accounting period or year a business usually
prepares its final accounts, which includes the trading and profit and loss
account (income statement) and statement of financial position. This term
has been largely superseded by the term ‘financial statements’. (3)
Financial statements Formal documents produced by an organisation to
show the financial status of the business at a particular time. These include
the trading and profit and loss account (income statement) and the
statement of financial position. (3)
Fixed assets Now called non-current assets. Refer to non-current assets.
Fixed capital accounts Capital accounts which consist only of the original
capital invested in the business. (34)
Fixed costs Costs that remain the same irrespective of the levels of
production or business activity (36)
Fluctuating capital accounts Capital accounts whose balances change from
one period to the next. (34)
Folio columns Columns used for entering references to page numbers in
ledgers and day books. (20)
General ledger All accounts other than those for customers and suppliers.
(3)
Going concern concept Where a business is assumed to continue for a long
time. (4)
Goodwill The extra amount paid for an existing business above the value of
its other assets. (35)
Gross loss When the cost of goods sold exceeds sales, then the business has
incurred a gross loss. (11)
Gross pay The amount of wages or salary before deductions are made. (41)
Gross profit Where the sales income exceeds the cost of goods sold. (11)
Gross profit : sales ratio A ratio which states gross profit as a percentage
of sales; can indicate how well a business has controlled their cost of
goods. (40)
Historical cost concept Valuing the assets of a business based on their cost
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price. (4)
Honoraria Voluntary payment to members of committees that run
cooperatives as a form of thanks for their help. (39)
Impersonal accounts All accounts other than accounts receivable (debtors’)
and accounts payable (creditors’ accounts). (3)
Imprest system A system used for controlling expenditure of small cash
items which are recorded in the petty cash book. A cash ‘float’ of a fixed
amount is provided initially to the person responsible for operating the
petty cash system. Any cash paid out during a particular period, e.g. a
week, is reimbursed by the petty cashier so restoring the ‘float’ to its
original sum. (21)
Inadequacy When an asset is no longer used because of changes within an
organisation due to growth, competition or product range changes. (25)
Income and expenditure account An account for a non-profit-making
organisation to find the surplus or deficit made during a period. (1)
Incomplete records Where only some transactions are recorded in the books
of account, the missing information has to be obtained by other means. (14)
Income statement A financial report which quantifies an organisation’s
revenue and expenses for a specified time period and is based on the
trading and profit and loss account (11)
Indirect manufacturing costs Costs which occur in a factory or other
production facility but cannot be easily traced to the items being
manufactured. (37)
Intangible asset An asset that cannot be physically seen or touched such as
goodwill. (35)
Integrated computerised accounting system A software package
incorporating all the normal accounting functions. (44)
Interest on capital An amount, at an agreed rate of interest, that is credited
to a partner based on the amount of capital contributed by him/her. (34)
Interest on drawings An amount, at an agreed rate of interest, that is based
on the drawings taken out and is debited to the partners. (34)
Inventory Goods purchased by a business for resale. (5)
Inventory turnover ratio The cost of goods sold is compared to the average
inventory to show the number of times inventory is sold in an accounting
period. (14)
Invoice A document prepared by the seller and sent to the purchaser
whenever a business buys goods or services on credit. It gives details of the
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supplier and the customer, the goods purchased and their price. (6)
Issued share capital The amount of the authorised share capital of a
company that has been issued to shareholders. (38)
Journal A book of account used to record rare or exceptional transactions
that should not appear in the other books of original entry in use. (3)
Lease An agreement to rent property for a period of time. (4)
Liabilities Total of money owed for assets supplied to the business. (6)
Life membership Where members pay one amount for membership to last
them their lifetime. (33)
LIFO A method by which the goods sold are said to have come from the last
lot of goods to be received. (30)
Limited company An organisation owned by its shareholders, whose
liability is limited to their share capital. (1)
Limited liability The liability of shareholders, in a company, is limited to
any amount they have agreed to invest. (38)
Limited partner A partner whose liability is limited to the capital invested in
the partnership (34)
Liquidity The ability of a business to pay its debts as they fall due and to
meet unexpected expenses within a reasonable settlement period. (40)
Liquidity ratios Ratios that attempt to indicate the ability of a business to
meet its debts as they become due and include current ratio and acid test
ratio. (40)
Loan capital Money owing by a company for debentures and for loans
from banks and other sources that are not repayable in the near future. (8)
Long-term liabilities Liabilities not having to be paid for in the near future.
(12)
Loss Result of selling goods for less than they have cost the business. (8)
Manufacturing account An account in which production cost is calculated.
(37)
Margin Profit shown as a percentage or fraction of the selling price. (14)
Mark-up Profit shown as a percentage or fraction of the cost price. (14)
Matching concept This is the same as the accrual concept. (4)
Materiality To record something in a special way only if the amount is not a
small one. (4)
Memorandum account An account which is not part of the double entry
system. These may be the personal accounts of accounts receivable (3)
(debtors) or accounts payable (3) (creditors) where the control account is
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part of the double entry and the personal accounts are classified as
‘memorandum accounts’. Alternatively, the sales and purchases ledgers
may be part of the double entry and the control accounts classified as
‘memorandum accounts’. (23)
Money measurement concept Accounting is only concerned with the money
measurement of things and where most people will agree to the monetary
value of a transaction. (4)
Narrative A description and explanation of the transaction recorded in the
journal. (22)
Net book value The cost of a non-current asset with depreciation deducted,
also known as ‘book value’. (25)
Net current assets Value of current assets less that of current liabilities. Also
known as ‘working capital’ (12)
Net monthly This phrase frequently appears at the foot of an invoice and
means the full amount of the invoice is due for payment within a month.
(17)
Net pay The amount of wage or salary after deductions are made (the net
wage is often referred to as ‘take-home pay’). (41)
Net profit Gross profit less expenses. (3)
Net profit : sales ratio A ratio that states net profit as a percentage of sales
and brings expenses into the calculation. (40)
Net realisable value The value of goods calculated as the selling price less
expenses before sale. (30)
Net worth See Equity.
Nominal accounts Accounts in which expenses, revenue and capital are
recorded. (3)
Nominal ledger Ledger for impersonal accounts (3) (also called general
ledger). (3)
Non-current asset An asset bought for long-term use in the operations of the
business and originally known as a fixed asset (5)
Non-profit-making organisations Clubs, associations and societies
operated to provide a service or activity for members since their main
purpose is not trading or profit making. (1)
Non-statutory deductions Deductions made from pay at an employee’s
request. (41)
Non-trading organisations These include clubs, associations and other nonprofit-making organisations that are normally run for the benefit of their
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members to engage in a particular activity. (1)
Objectivity Using a method that suits everyone. (2)
Obsolescence Becoming out of date. (25)
Opening entry An entry needed to open a new set of books of account.
(22)
Ordinary shares Shares entitled to dividends after the preference
shareholders have been paid their dividends. (39)
Overcasting Incorrectly adding up a column of figures to give an answer
exceeding the correct total. (31)
Overdraft A facility offered by banks allowing customers to withdraw more
money out of their current account than they have deposited. The overdraft
is subject to interest charges on a daily basis. The bank may request
repayment of an overdraft at any time. (xx)
Paid-up capital The total of the amount of share capital that has been paid
for by shareholders. (38)
Partnership A business of two or more people working, as owners, with the
aim of making profit. (1)
Partnership agreement The contractual relationship, written or verbal,
between partners, covering how profits or losses should be shared and
the relevant responsibilities of the partners. (34)
Partnership deed See Partnership agreement.
Partnership salaries Agreed amounts payable to partners in respect of
duties undertaken by them. (34)
Payee The person to whom a cheque is paid. (23)
Paying-in slip Form used for paying money into a bank account. (3)
Payroll A list of employees employed by a business to whom a wage or
salary is paid. (1)
Pension fund/superannuation scheme Scheme set up by employers to
provide their employees with a pension. (41)
Personal accounts Accounts for both creditors and debtors. (3)
Personnel department An organisation’s department that deals with
interviewing and appointing staff, together with keeping of accurate
employee records. (41)
Petty cash book A cash book used for making small (petty) payments.
Payments are usually analysed and the totals of each column later posted to
the various accounts in the general ledger. The source document used for
entry into the petty cash book is a petty cash voucher. (3)
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Petty cash voucher The form used by anyone requesting payment for a small
item of expenditure incurred on behalf of the business. The form gives
details of the expense and should be signed and duly authorised. (3)
Piece rate Pay based on the number of units produced or operations
completed. (41)
Posting The act of using one book as a means of entering the transactions to
another account. (3)
Preference shares Shares that are entitled to an agreed rate of dividend
before the ordinary shareholders receive anything. (38)
Preliminary expenses All the costs that are incurred when a company is
formed. (38)
Prepaid expense An expense – usually a service – that has been paid for in
one accounting period, the benefit of which will not be received until a
subsequent period. It is a payment for an expense that has been paid for in
advance. (28)
Prepayment See Prepaid expense.
Prime cost Direct materials plus direct labour plus direct expenses. (37)
Private limited company A legal entity with at least two shareholders,
where their liability is limited to the amount of their investment. The public
cannot subscribe for its shares. (1)
Production cost Prime cost plus indirect manufacturing costs. (37)
Profit The result when goods are sold for more than they cost. If they are
sold for less than they cost, then a loss is incurred. (1)
Profit and loss account Account in which net profit is calculated. (3)
Profitability Effective operation of a business to make ongoing profits to
ensure its long-term viability. (40)
Profitability ratios Ratios that attempt to indicate the trend in a business’s
ability to make profit. These include gross profit and net profit to sales
and return on capital employed. (40)
Provision for depreciation account An account where depreciation is
accumulated and shown as a deduction from the cost price of the noncurrent asset to give the net book figure in the statement of financial
position (23)
Provision for doubtful debts An account showing the expected amounts of
accounts receivable (3) (debtors), who at the date of the statement of
financial position, may not be able to pay their outstanding accounts. (27)
Prudence or conservatism To ensure that neither profit nor the assets are
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shown at too high a value. (4)
Public limited company A legal entity with many shareholders since the
public can subscribe for its shares. Shareholder liability is limited to the
amount of their investment. The issued capital must be at least £50,000. (1)
Purchase invoice A document received by purchaser showing details of
goods bought and their prices. (3)
Purchase order This is a document prepared by the purchaser and it contains
details of the goods or services required by the purchaser. (16)
Purchases Goods bought by the business for the purpose of selling them
again. (7)
Purchases day book Book of original entry for credit purchases also
known as ‘purchase journal’. (3)
Purchases ledger A ledger for suppliers’ personal accounts. (3)
Purchases returns Goods returned by a business to its suppliers. See also
Returns outwards. (7)
Purchases returns day book Book of original entry for entering goods
returned to suppliers. (3)
Quick ratio Same as the ‘acid test ratio’. (40)
Real accounts Accounts in which property of all kinds is recorded. (3)
Realisation concept The point at which profit is treated as being earned. (4)
Receipt A form acknowledging receipt of money for goods or services
rendered. (3)
Receipts and payments account A summary of the cash book of a nonprofit-making organisation. (33)
Reducing balance method Method of depreciation whereby the asset is
depreciated by a fixed percentage of the net book value cost less
depreciation to date) each year. Thus the depreciation charge reduces each
year. (25)
Remittance advice A document which accompanies payments by cheque or
via BACS and gives details of the payment. (16)
Remuneration Reward for work carried out. (38)
Reserve accounts The transfer of apportioned profits to accounts for use in
future years. (38)
Residual value The amount received on disposal of an asset, also called
‘scrap value’. (26)
Retained profits Profits earned in a year but not paid out in dividends. (38)
Return on capital employed (ROCE) ratio A ratio that shows the net profit
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made for each $100 of capital employed. (40)
Returns inwards Goods returned to the business by its customers. (7)
Returns inwards day book Book of original entry for goods returned by
customers. (3)
Returns outwards Goods returned by the business to its suppliers. (7)
Returns outwards day book Book of original entry for goods returned to
suppliers. (3)
Revenue expenditure Expenses needed for the day-to-day running of the
business. (15)
Revenue reserve Reserves of a company which are available for
distribution as a dividend. (38)
Revenues Monetary value of goods and services supplied to the customers.
(4)
Salary Fixed payment, usually monthly, to an employee for professional or
office work. (34)
Sale or return Goods sent on approval by the seller to the purchaser. The
goods remain the property of the seller until the buyer agrees to their
purchase. (30)
Sales Goods sold in the normal course of business. (7)
Sales day book Book of original entry for credit sales also known as the
‘sales journal’. (3)
Sales invoice A document showing the details of goods sold and the prices of
those goods. (3)
Sales ledger A ledger for customers’ personal accounts. (3)
Sales returns Goods returned to the business by its customers. (7)
Selling and distribution expenses Expenses incurred in the selling and
distribution of goods or services such as marketing and advertising sales,
staff salaries and commission. (36)
Shareholder An owner of shares in a company. (36)
Shares The division of the capital of a limited company into parts. (38)
Share premium The excess in price of an issued share over its nominal
value. (38)
Single entry Where transactions are only recorded once in the books of
account. (xx)
Sole trader A business owned by one person only. (1)
Standing order Payment made out of payer’s bank, direct to payee’s bank,
on the payer’s instructions. (24)
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Statement of account This is normally sent to customers at the end of each
month and it states the amount owing to the supplier at the end of that
particular month. (16)
Statement of affairs A statement from which the capital of the owner is
deduced by estimating assets and liabilities. Then Capital = Assets less
Liabilities. (42)
Statement of financial position (balance sheet) A statement showing the
assets, capital and liabilities of a business. (1)
Statutory deductions Deductions that an employer has to make by law
from workers’ gross pay. (41)
Straight line method Method of calculating depreciation wherby an equal
amount is deducted each year. (23)
Subjectivity Using a method which other people may not agree to. (4)
Subscriptions Amounts paid by members of a club or society, usually on
an annual basis, to enable them to participate in the activities of the
organisation. (33)
Substance over form Where substance takes precedence over legal form.
(4)
Super profits Net profits less the opportunity costs of alternative earnings
and alternative returns on capital invested. (35)
Suspense account An account where any difference in the trial balance is
entered prior to looking for the error(s). (23)
‘T’ account Alternative name for an account in double entry. (6)
Time card Card issued to employees enabling them to ‘clock in’ and ‘clock
out’ at work. The card is then used to calculate the employees’ pay. (41)
Time sheet A form used to record the time spent on various jobs and the
overall weekly attendance from which the employees’ pay can be
ascertained. (41)
Total cost Production cost plus administration, selling and distribution
expenses. (36)
Trade discount A reduction given to a customer when calculating the selling
prices of goods. (17)
Trading account Account in which gross profit is calculated. (11)
Trading and profit and loss account Combined account in which both gross
and net profits are calculated. (11)
Transaction Events which change two items in the statement of financial
position. (6)
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Trial balance A list of all the balances in the books at a particular point in
time. The balances are shown in debit and credit columns. These columns
should balance provided no errors have occurred. (3)
Uncalled capital The amount that is to be received in future, but which has
not yet been requested. (38)
Undercasting Incorrectly adding up a column of figures to give an answer
less than the correct total. (31)
Unit cost The cost of producing one unit. (36)
Unpresented cheque A cheque which has been sent but has not yet gone
through the bank account of the payee. (24)
Variable costs Costs that vary depending on levels of production or activity.
(36)
Wage Payment made to a worker in return for services rendered and usually
paid weekly. (3)
Work in progress Items not completed at the end of a period. (37)
Working capital The amount by which the current assets exceed the current
liabilities. Also known as ‘net current assets’. (12)
Working capital ratio Same as the ‘current ratio’. (40)
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Appendix B: Downloadable
model layouts for financial
statements and worksheets
Many students have difficulty remembering the layout of the financial
statements of various businesses. In this appendix you will find suggested
model layouts of the financial statements, which include the trading and
profit and loss account (income statement) and statement of financial position
for the following organisations:
• sole trader
• partnership – including the appropriation account
• corporations – including the appropriation account
• a manufacturing account.
Also included are suggested working sheets for answering questions on petty
cash, ratio analysis and the extended trial balance. You may find it useful to
download the above documents from
www.hoddereducation.com/POAResources and put them in your file for
reference and to use when answering questions on these topics.
In this appendix you will find the following suggested model layouts for
financial statements and worksheets; these are shown with column lines for
ease of working:
Financial statements
1 Sole trader
2 Partnership
3 Corporations (Limited company)
• Trading and profit and loss account (income statement) suitable for both
UK and overseas examinations
• Statement of financial position based on UK legislation
• Statement of financial position for local overseas examinations
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4 Manufacturing account
Worksheets
5 Petty cash book
6 Worksheet for accounting ratios
7 Worksheet for extended trial balance
1 Sole trader – financial statements
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*Note: Alternatively, the Income can be added to Gross Profit before
deducting expenses.
Statement of financial position – Sole trader
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2 Partnership – financial statements
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*Note: The appropriation account is usually shown under the general heading
of trading and profit and loss account.
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3 Corporations – financial statements
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Note: The above trading and profit and loss account (income statement)
format is suitable for both UK and overseas examinations. For internal use,
not for publication.
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Notes: Based on UK legislation
(A) Notes to be given in appendix as to cost, acquisitions and sales in the
year and depreciation.
(B) ‘Reserves’ consist either of those unused profits remaining in the
appropriation account, or those transferred to a reserve account
appropriately titled (e.g. general reserve, fixed asset replacement reserve,
etc.).
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Note: For students sitting local overseas examinations.
4 Manufacturing account – financial
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statements
Note: The Production cost of goods completed will be entered in the trading
account, refer to Chapter 37.
5 Petty cash book
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6 Accounting ratios – Calculation sheet
7 Format for an extended worksheet
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Appendix C: Answers to
multiple-choice questions
Set No. 1 (pages 84 to 86)
1 (A)
2 (D)
3 (C)
4 (C)
5 (B)
6 (C)
7 (A)
8 (C)
9 (D)
10 (A)
11 (A)
12 (A)
13 (C)
14 (A)
15 (A)
16 (D)
17 (C)
18 (B)
19 (C)
20 (D)
Set No. 2 (pages 129 to 130)
21 (C)
22 (D)
23 (A)
24 (D)
25 (B)
26 (B)
27 (C)
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28
29
30
31
32
33
34
35
36
37
38
39
40
(D)
(B)
(C)
(A)
(D)
(D)
(B)
(B)
(B)
(B)
(A)
(C)
(D)
Set No. 3 (pages 225 to 226)
41 (A)
42 (A)
43 (D)
44 (A)
45 (B)
46 (B)
47 (C)
48 (A)
49 (D)
50 (B)
51 (C)
52 (C)
53 (C)
54 (A)
55 (D)
56 (C)
57 (D)
58 (C)
59 (A)
60 (A)
Set No. 4 (pages 315 to 316)
61 (C)
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62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
(A)
(D)
(D)
(A)
(C)
(C)
(D)
(B)
(A)
(D)
(B)
(D)
(A)
(D)
(B)
(D)
(A)
(B)
(B)
Set No. 5 (pages 411 to 412)
81 (D)
82 (B)
83 (C)
84 (D)
85 (C)
86 (D)
87 (C)
88 (D)
89 (A)
90 (D)
91 (C)
92 (A)
93 (C)
94 (A)
95 (D)
96 (B)
97 (D)
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98 (B)
99 (C)
100 (D)
Set No. 6 (pages 453 to 455)
101 (C)
102 (B)
103 (C)
104 (D)
105 (B)
106 (A)
107 (D)
108 (B)
109 (D)
110 (D)
111 (A)
112 (B)
113 (A)
114 (B)
115 (C)
116 (D)
117 (C)
118 (A)
119 (B)
120 (B)
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Appendix D: Answers to
exercises
In this Appendix are the answers to the exercises at the end of each chapter,
excluding those marked X in the exercise number.
Part 1 Introduction to principles of accounting:
Chapters 1 to 10
Chapter 1 Introduction to accounting principles
1.1 Refer to text – Section 1.2
1.2 Refer to text – Section 1.5
1.4 Refer to text – Section 1.4
Chapter 2 Professional ethics
2.1 Refer to text - Section 2.4
2.3 Items which are not fundamental ethical principles are:
Subjectivity
Professional standards
2.5 (a) There are a number of ethical issues that students will encounter in
both their studies and working in a financial environment.
Draw on your own experiences and the content of this chapter and
decide on six ethical principles you consider most important.
(b) Examples include:
Know right from wrong.
Behave with respect and courtesy.
Act responsibly and honestly.
Be trustworthy.
Ensure confidentiality.
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Chapter 3 The accounting system
3.1
3.2
3.3
3.5
3.6
Refer to text – Section 3.3
Refer to text – Section 3.4
Refer to text – Section 3.6
Refer to text – Section 3.9
Refer to text - Section 3.11
Chapter 4 Accounting concepts
4.1
(a) Materiality
Section 4.6
(b) Business Section 4.4
entity
(c) Prudence Section 4.5
(d) Historical Section 4.4
cost
Section 4.4
(e) Money
measurement
(f) Accrual Section 4.5
(g) RealisationSection 4.5
Section 4.5
(h) Going
concern
(i) ConsistencySection 4.5
(j) Materiality Section 4.6
4.4 The historical cost concept is an accounting concept whereby the assets
of a business are recorded in the accounts at cost price. (Refer to text,
Sections 4.2 and 4.4.)
Advantages of using the cost method of valuation are that the assets can
easily be verified since there will be an invoice available for checking the
purchase price; and, also, no valuations need be carried out on assets
whose value may be subjective. (Refer to text, Sections 4.2 and 4.4.)
4.5 (a) Prudence
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(b) Materiality
(c) Money management
(d) Business entity
4.6 Emily should not divulge any information about her parent’s friends,
Alice and George’s financial affairs since these are confidential.
Although confidentiality is not an accounting concept people working
within a financial area and haveing access to financial data should
recognize that the information is confidential.
Emily’s father should not have asked her about their friends’ affairs and
put her in this difficult position.
Chapter 5 The accounting equation and the statement of
financial position (balance sheet)
5.1 (a) 10,700
(b) 23,100
(c) 4,300
(d) 3,150
(e) 25,500
(f) 51,400
5.3 (a) Asset
(b) Liability
(c) Asset
(d) Asset
(e) Liability
(f) Asset
5.5 Wrong – Assets: Loan from C. Smith, Accounts payable; Liabilities:
Inventory of goods, Accounts receivable.
5.7 Assets: Motor vehicle 8,000, Premises 20,000, Inventory 4,000, Bank
2,800, Cash 400 = 35,200
Liabilities: Loan from D. Bevan 12,000, Accounts payable 1,600 =
13,600 Capital = Assets 35,200 – Liabilities 13,600 = 21,600
5.9
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5.11
5.13
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Chapter 6 The double entry system for assets, liabilities
and capital
6.1
Debited
Credited
(a) Motor Cash
van
(b) Office J. Grant & Son
machinery
(c) Cash Capital
(d) Bank J. Beach
Cash
(e) A.
Barrett
6.2
Debited
Credited
A. Jackson & Son
(a) Machinery
Machinery
(b) A.
Jackson & Son
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J. Brown
(d) Bank J. Smith (loan)
(e) Cash Office machinery
(c) Cash
6.4
Debited
(a) Motor
lorry
Credited
Cash
(b) T. Lee
Bank
(c) Loan
from P. Lopez
Cash
(d) Cash
(e) Office
machinery
Motor lorry
Ultra Ltd
(f) Cash
A. Hill
(g) Bank
J. Cross
(h) Bank
Capital
(i) Cash
Loan from L. Lowe
(j) D. Lord Cash
Note: To save time and space the months are omitted in the ledger
accounts which follow. The day of the month is shown in brackets.
6.5
6.6
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6.7
Chapter 7 The double entry system for the asset of
inventory
7.1 (a)
(b)
(c)
(d)
(e)
7.2 (a)
(b)
(c)
(d)
(e)
7.5
Dr. Purchases, Cr. Cash.
Dr. Purchases, Cr. E. Flynn.
Dr. C. Grant, Cr. Sales.
Dr. Cash, Cr. Motor van.
Dr. Cash, Cr. Sales.
Dr. H Fong, Cr. Returns outwards.
Dr. Purchases, Cr. P. Franklin.
Dr. S. Mullings, Cr. Sales.
Dr. Returns Inwards, Cr. M. Patterson.
Dr. Purchases, Cr. Bank.
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7.6
7.7
7.8
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Chapter 8 The double entry system for expenses and
revenues
8.1
Account to be debited Account to be credited:
(a) Rates Bank
(b) Wages Cash
(c) Bank Rent received
(d) Bank Insurance
(e) GeneralCash
expenses
8.2
Account to be debited Account to be credited:
Cash
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(a) Rent
Cash
(b) Purchases
(c) Bank Rates
(d) GeneralBank
expenses
(e) Cash Commissions received
(f) T.
Jones
(g) Cash
Returns outwards
Sales
(h) Office Bank
fixtures
(i) Wages Cash
Cash
(j) Drawings
8.5
8.6
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Chapter 9 Balancing off accounts
9.1
9.2
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9.3
Chapter 10 The trial balance
10.1
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10.2
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10.3
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10.6
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Part 2 Introduction to financial statements and
ratios
Chapter 11 Introduction to trading and profit and loss
accounts (income statements)
11.1
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11.2
11.5
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Chapter 12 Statements of financial position (balance
sheets)
12.1
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12.2
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12.5
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Chapter 13 Financial statements: further considerations
13.1
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13.3
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13.4
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Chapter 14 Introduction to accounting ratios
14.1 (a) (i) Markup = 25% (ii) Margin = 20%
(b) Margin = 25%
(c) Markup = 20%
14.3
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Mark-up is deduction, i.e. mark-up is 25%, therefore margin is 20%,
consequently gross profit is 20% × 30,000 = 6,000.
(A) (B) and (C) are then found, in that order, by normal arithmetical
deduction.
14.4
Cost of goods sold is then calculated as 14,000. Mark-up is 50%, so sales
= 14,000 + 50% = 21,000. If net profit on sales is not to be less than 10%
of sales = 2,100, this means that he can afford up to 4,900 expenses, i.e.
gross profit 7,000 – 4,900 expenses = 2,100 net profit.
Chapter 15 Capital and revenue expenditure
15.1 Capital: (a) (c) (d) (f) (j) (l). Revenue: (b) (e) (g) (h) (i) (k).
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15.3 Capital: (a) (b) (e).
Revenue: (c) (d).
Refer to text – Sections 15.2 and 15.3.
Part 3 Books of original entry
Chapter 16 Business documentation
16.1 (a) Refer to text - Section 16.1
(b) Refer to text - Section 16.1
(c) Refer to text - Section 16.1
(d) Refer to text - Section 16.1
16.3 (a) Purchase order
(b) Delivery note
(c) Debit note
(d) Invoice and Credit note
(e) Statement
(f) Remittance advice
Chapter 17 Accounting for sales, discounts and internal
controls
Note: To save space, the folio numbers in answers 17.1 to 17.6, 18.1 to 18.3,
and 19.1 to 19.4 have been omitted.
17.1
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17.3 (a) Workings for invoices.
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17.5 Refer to text – Section 17.14
17.6 Refer to text – Section 17.15
Chapter 18 Accounting for purchases
18.1 Working for purchases invoices.
18.3
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18.5
Chapter 19 Accounting for returns
19.1
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19.3
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19.4
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19.6 (a)
(b)
(c)
(d)
(e)
Sales invoice – Sales day book
Debit note – Returns outwards day book
Cash sale – Cash Book
Purchase invoice – Purchases day book
Credit note – Returns inwards day book
Chapter 20 Cash book and cash discount
20.1
20.5
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20.6
20.7
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Chapter 21 Petty cash and the imprest system
21.1
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21.2
Chapter 22 The general journal
22.1
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22.2
Chapter 23 Control accounts
23.1
23.2
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23.5
Chapter 24 Bank reconciliation statements
24.1 (a)
24.1 (b)
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Note for teachers:
Both in theory and in practice, you can start with the cash book balance
working to the bank statement balance, or you can reverse this method. Many
teachers have their preferences, but this is a personal matter only. Examiners
sometimes ask for them using one way, sometimes the other. Students should
therefore be able to tackle them both ways.
24.3 (a)
24.3 (b)
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24.5 (a) & (b) (i)
24.5 (b) (ii)
24.5 (b) (iii) Refer to text.
Part 4 Accounting adjustments
Chapter 25 The nature of depreciation and calculations
25.1
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25.2
25.3
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Chapter 26 Double entry records for depreciation and
the disposal of assets
26.1 (a)
26.1 (b)
26.1 (c)
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26.1 (d)
26.2
26.6 (a) Straight line depreciation method
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26.6 (b) (i) The purpose of depreciation provisions is to apportion the cost
of a non-current asset over the useful years of its life to the
organisation.
The matching concept concerns the matching of costs against the
revenues which those costs generate. If the benefit to be gained
is equal in each year, then the straight line method is to be
preferred. If the benefits are greatest in year 1 and then falling
year by year, then the reducing balance method would be
preferred. The impact of maintenance costs of the non-current
asset, if heavier in later years, may also give credence to the
reducing balance method.
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(ii) The net figure at the end of year 2 is the original cost of the asset
less depreciation to date. It is the value of the asset at the date of
the statement of financial position (balance sheet), i.e. year 2 in
this case.
Chapter 27 Bad debts and provision for doubtful debts
27.1
27.2 (a)
27.2 (b)
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27.2 (c)
Chapter 28 Accruals, prepayments and other
adjustments for financial statements
28.1 (a)
28.1 (b)
28.1 (c)
28.1 (d)
28.1 (e)
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28.3 (a)
28.3 (b)
28.3 (c)
28.3 (d)
28.5
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28.8
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28.9
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28.10
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Chapter 29 The extended trial balance
29.1
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29.2
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29.4
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Chapter 30 Inventory valuation
30.1
30.2
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30.4 (a)
(i) FIFO: 20 × $14 = $280 inventory valuation at 31 December 2016.
(ii) LIFO
The closing inventory at 31 December 2016 is, therefore valued
at $240 by the LIFO method.
(iii) AVCO
The closing inventory at 31 December 2016 is therefore valued
at $260 by the AVCO method.
30.4 (b)
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30.5 (a) (i)
30.5 (a) (ii)
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30.5 (a) (iii)
30.5 (b)
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Chapter 31 Errors and their effect on accounting records
31.1
31.3
Chapter 32 Suspense accounts and errors
32.1
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32.2 (a)
(b) 1:3:4
(c) 3
(d) (i) Principle 1; (ii) Commission 5; (iii) Original entry 3.
(e)
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32.4
32.6 (a)
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32.6 (b)
Note: Discounts allowed 305 + (ii) 100 = 405 Accounts payable
5,045 + (iv) 166 – (v) 490 = 4,721
Part 5 Financial statements of other
organisations
Chapter 33 Receipts and payments accounts and income
and expenditure accounts
33.1
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33.2 (a)
33.2 (b)
33.2 (c)
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33.2 (d)
Chapter 34 Partnership accounts: an introduction
34.1
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34.2
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34.5
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34.7 (a)
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34.7 (b)
34.7 (c)
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Chapter 35 New partners: entries on admission, goodwill
and premiums
35.1 Average sales = (240,000 + 280,000 + 275,000 = 795,000) ÷ 3 =
265,000. Goodwill = 4 × 265,000 = 1,060,000.
35.3 Average fees = (163,500 + 181,000 + 178,500 + 201,000 = 724,000) ÷
4 = 181,000. Goodwill = 5 × 181,000 = 905,000.
35.5
35.7
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Chapter 36 Costing principles
36.1 Refer to text - Section 36.2
36.2 (a) Refer to text - Section 36 3
(b) Refer to text - Section 36.4
36.4 (a) Direct
(b) Direct
(c) Direct
(d) Indirect
(e) Direct
(f) Direct
(g) Direct
(h) Indirect
Chapter 37 Manufacturing accounts
37.1
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37.4
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37.5 (a)
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(b)
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(c) We can manufacture each unit more cheaply than we could buy it
elsewhere. Therefore we should carry on production ourselves.
Chapter 38 Accounting for limited liability companies
38.1
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38.3
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38.5
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38.7 (i) (a)
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38.7 (ii) (b)
Chapter 39 Accounting for cooperatives
39.1
39.2
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Chapter 40 Analysis and interpretation of accounting
statements
40 (a)
(b) Business B is the most profitable, both in terms of actual net profits
($15,000 compared to $10,000) and in terms of capital employed,
where B has managed to achieve a return of $37.50 for every $100
invested, i.e. 37.5%, and A has managed a lower return of 25%.
Reasons (suppositions only. More needs to be known about the
business to give a definite answer):
(i) Possibly managed to sell far more merchandise because of lower
prices, i.e. took only 20% margin as compared with A’s 25%
margin.
(ii) Maybe more efficient use of mechanized means in the business.
Note B has more equipment, and perhaps as a consequence kept
other expenses down to $6,000 as compared with A’s $9,000.
(iii) Did not have as much inventory lying idle: turned over
inventory 4.8 times in the year as compared with 3 for A.
(iv) A’s current ratio of 9 far greater than normally needed. B kept it
down to 4. A therefore had too much money lying idle and not
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doing anything.
(v) Following on from (iv), the acid test ratio for A is also higher
than necessary.
(vi) Part of the reasons for (iv) and (v) is that A waited (on average)
3.75 months to be paid by his customers, where B managed to
collect them on a 2-month average Money represented by debts
is money lying idle.
(vii) A also paid his suppliers quicker than did B, but not by much.
Put all these factors together, and it is obvious that B is running
his business far more efficiently, and is more profitable as a
consequence.
Part 6 Accounting for the entrepreneur
Chapter 41 The banking system and payroll accounting
41.1 Refer to text – Chapter 41 Section 41.3
41.2 Refer to text – Chapter 41
41.5
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41.6 (a)
41.6 (b)
41.6 (c)
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41.9
41.10
Chapter 42 Single entry and incomplete records
42.1
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Workings:
(A), (B) and (C) found in that order by filling in figures needed to
balance the statement of financial position (balance sheet) figures.
(A) equals the total of the statement of financial position (balance sheet),
see *
(B) is 22,500 + 30,000 = 52,500
(C) is 52,500 – 10,000 = 42,500 Net profit
42.2 (a)
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42.2 (b)
42.4
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Workings:
(A) Found as figure to make statement of financial position (balance
sheet) totals agree 42,465.
(B) Less 7,560 = (A) 42,465, therefore (B) is 50,025.
(C) Missing figure to total 50,025 = 9,223.
42.7 (a)
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(b)
(c)
42.9 (a)
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42.9 (b)
42.9 (c)
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Chapter 43 The business plan and cash flow projections
43.1 Refer to text 43.13
43.2 Salaries is not a cash inflow since it is a payment and, therefore, a cash
outflow. Refer to Section 43.9.
43.3 Paul can prepare a budget plan whereby he plans his stock intake
carefully and uses cold storage he can gain access to throughout the
day. Thereby, only topping up his fruit and vegetables as they are
sold.
He could also diversify and sell non-perishable food.
He could rent premises and have refrigerators and chill cabinets. In
this case Paul would need to budget carefully to ensure he could
afford to make the change from street stall to shop premises.
Chapter 44 Computers and accounting systems
44.1 Refer to text 44.5
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44.2 Refer to text 44.4
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Index
A
absorption costing 354, 472
accounting cycle 12–18, 472
accounting, definition 3–4, 472
accounting equation 28–9, 32–3
accounting ratios 117–23, 398–404, 406, 486
accounting rules/concepts 20–6, 472
accounts payable 16–17, 30, 31, 71–2, 472
accounts payable to purchases ratio 403–4
accounts receivable 16–17, 30–1, 52, 68–71, 154, 155, 472 see also bad and
doubtful debts
accounts receivable to sales ratio 403, 472
accrual concept 24, 472
accruals 253–5, 257–8, 260–1, 264–6, 267, 277, 472
accumulated funds 319, 472
acid test ratio 402–3, 472
adjustments, examples and guide 264–8, 276–8 see also specific adjustment
advice notes 153, 472
appropriation accounts 378–9, 395, 472
assets 28–34, 101–2, 238–40, 472 see also depreciation; goodwill; inventory;
investments
AVCO (average cost method) 288, 472
B
BACS (Bankers’ Automated Clearing Service) 14, 220, 418, 472
bad and doubtful debts 198, 210, 243–51, 268, 277, 282–3, 472, 474
balance sheets see statements of financial position
balancing off accounts 68–74
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bank accounts 174–84
bank giro transfer 220, 417–18, 472
bank lodgements 217, 220
bank reconciliation statements 205, 215–21, 472
banking system 220–1, 414–19
bonds 385–6
book-keeping 3, 15–17, 38–46, 472 see also double entry; single entry
books of original entry 15–17, 143–5, 472
books, types used 148
budgets 446–50, 472
business plans 451–2
C
capital 28–9, 262, 472
in limited companies 374, 375–7
in partnerships 330–1, 341–7, 404
profit or loss and 61, 431–4
in statements of financial position 29–34
working capital 102, 262, 405, 477
see also depreciation
capital accounts 92, 95, 102–3, 113, 334–6
capital employed 404–5, 472
capital expenditure 125–7, 228, 473
carriage 105–6, 155, 473
cash books 15, 174–84, 192, 215–19, 473 see also petty cash
cash discounts 153, 178–83, 473
cash flow projections 448–50
cash transactions 51, 52, 55–6, 145, 148, 176, 415
cheques 14, 217, 219–20, 221, 415–16, 473
coding (invoices) 161, 473
Companies Acts 22–4, 373, 374–5
computers 72–3, 458–62, 473
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contactless payments 414, 419, 473
control accounts 205–13, 473
cooperative societies 5, 19, 390–6, 473
corporations see limited liability companies
cost accounting 349–58
cost centres 352, 473
cost of goods sold 108–9, 473
cost-plus pricing 353, 473
costing 349–58, 473
credit cards 171, 417, 473
credit notes 14, 132, 133, 140, 143, 164–6, 473
credit transactions 51, 52, 55–6, 148–51, 159–60
current assets 34, 102, 473
current liabilities 34, 102, 473
current ratio 402, 473
D
debentures 378, 384–5, 473
debit notes 14, 132, 133, 139, 166–8, 473
debtors see accounts receivable; bad and doubtful debts
delivery notes 132, 133, 134, 137, 153, 473
depreciation 23, 228–33, 235–41, 267–8, 277, 281–2, 473
direct costs 350, 360–1, 473
direct debits 220, 418, 473
directors 375, 377, 473
discounts 152–3, 178–83, 263, 267, 473, 477
dishonoured cheques 219–20, 221, 473
dividends 376–7, 473
double entry system 15–17, 38–46, 473
control accounts and 210–11
depreciation and 235–41
for expenses and revenues 60–5
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for inventory 50–6, 108
doubtful debts 244–50, 268, 277, 282, 474
drawings 64, 92, 331, 474
E
equity see capital
errors 293–301, 303–12, 474
control accounts and 207, 212
in expenditure allocation 127
trial balances and 80–1, 293–4, 303–12
see also incomplete records
errors and omissions excepted (E&OE) 155, 474
expenses
accrued and prepaid 253–6, 257–8, 260–1, 264–7, 472
apportionment of 366
depreciation as 228–9
in double entry system 61–3
in trading account 110
expenses to sales ratio 400, 474
F
factoring 155, 474
FIFO (first in, first out) method 287, 288, 474
financial accounting 349, 350
financial statements
definition and role of 3, 17, 20–1, 110, 474
layout of 478–87
preparation of 113–14
in single entry systems 434–8
see also statements of financial position; trading and profit and loss
accounts
fixed capital accounts 334–5, 336, 474
fixed costs 351, 474
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fluctuating capital accounts 334, 335–6, 474
folio columns 177–8, 474
G
general journals 195–203, 295–300, 304–6, 308–11
general ledgers 16, 18, 161, 474
control accounts in 210–11
error correction recording in 309–10
opening entries 201
returns and 165–6, 168–9
glossary 472–7
goods for own use 261
goodwill 341–7, 474
gross profit to sales ratio 121–2, 399, 474
H
historical cost concept 21, 22, 25, 474
horizontal formats 89, 95
I
IESBA Code 8
IN and OUT approach 40–1, 150, 159, 165
income and expenditure accounts 5, 319, 321–5, 394–5, 474
income statements see trading and profit and loss accounts
incomplete records 117–21, 438–41, 474
indirect costs 351, 360–1
interest 127, 220, 331–2, 378, 386, 474, 475
inventory
adjustments for 107–10, 277
computerised systems for 459–60
double entry system for 50–6, 108
rate of turnover 122–3, 401, 475
in statements of financial position 30–4, 289–90
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unsold 92–4
valuation of 286–91
investments 385–6
invoices 132, 133, 134, 154–5, 475
entering into books 143–4, 149–50
preparation of 138, 148–9
trade discounts and 152–3
J
journals 15, 475 see also general journals
L
ledgers 16 see also specific ledger
liabilities 28–9, 30–5, 51, 53, 102, 475
life memberships 324, 475
LIFO (last in, first out) method 287, 288, 475
limited liability companies (limited companies) 5, 18, 45, 373–86, 405, 475,
482–4
limited partners 329, 475
liquidity ratios 399, 402–4, 475
losses 112–13, 475 see also profit and loss
M
manufacturing accounts 360–9, 475, 485
margin 117–21, 475
mark-up 117–21, 475
matching concept 24
memorandum accounts 211, 475
monetary measure stability 25
N
net book value 231, 235–6, 475
net current assets (working capital) 102, 262, 405, 475, 477
net profit 24, 89, 91, 475
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net profit to sales ratio 122, 399–400, 475
non-current assets 34, 101–2, 238–40, 475 see also depreciation
non-profit organisations 5, 19, 318–25, 475
opening entries 200–2, 475
ordinary shares 376–7, 475
original entry, books of 15–17, 143–5, 472
overdrafts 184, 218–19, 220, 475
overheads 354–7, 361
P
partnerships 5, 18, 328–37, 341–7, 373, 404, 475, 481
payment methods 414–19
payroll accounting 420–7
petty cash 15, 188–93, 476, 486
posting 150–1, 159–60, 476
prepaid expenses 255–6, 257, 258–9, 260, 264–7, 277, 476
pricing 117–18, 352–3
private limited companies 5, 18, 373–85, 476
production budgets 450
production costs 360–1, 476
profit and loss 60–2, 475, 476
gross profit 88–9, 90–1, 474
in limited companies 376–9
net profit 24, 88, 91, 475
in partnerships 330, 332–3, 343–4
in single entry systems 431–4
profit and loss accounts
accruals and prepayments in 254, 259
bad and doubtful debts in 246, 247, 248, 250
manufacturing accounts and 363
in service sector 262–3
see also trading and profit and loss accounts
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profitability ratios 121–2, 399–401, 476
public limited companies 5, 18, 373–85, 476
purchase invoices 14, 154–5, 158–61, 476
purchase orders 132, 133, 136, 476
purchase requisitions 132, 133, 134–5
purchases
accounting for 158–61
documentation for 132–3, 134, 136, 139, 142
of inventory 51–2, 53, 55–6
in journals 197–8
returns 15, 53, 111–12, 139, 144, 164, 166–71, 476
purchases day books/journals 15, 144, 158–60, 476
purchases ledgers 16, 18, 476
control accounts and 207–11
discounts and 182–3
posting into 144, 159–61
returns and 168–9
Q
quick ratio 402–3
R
realisation 24, 476
receipts 14, 127, 132, 145, 476
receipts and payments accounts 318, 476
reducing balance method 228, 231, 476
remittance advice 132, 133, 142, 476
retained profits 378–9, 476
return on capital employed ratio (ROCE) 400–1, 476
returns
accounting for 164–71
credit notes 14, 132, 133, 140, 143, 164–6, 473
debit notes 14, 132, 133, 139, 166–8, 473
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inwards (sales returns) 15, 52–3, 110–12, 140, 143, 164–6, 169–71, 476
outward (purchases returns) 15, 53, 111–12, 139, 144, 164, 166–71, 476
revenue expenditure 125–7, 476
revenues 64–5, 256–7, 258–9, 476
S
sales
accounting for 147–55, 171
documentation for 132–42, 170 (see also invoices)
of inventory 52–3, 55–6
in journals 197–8
returns 15, 52–3, 110–12, 140, 143, 164–6, 169–71, 476
sales day books/journals 15, 143, 149–51, 476
sales ledgers 16, 18, 476
control accounts and 206–11
discounts and 182
posting into 143, 150–1, 161
returns and 165–6
school-based assessment (SBA) 464–70
services sector 262–3
shares 374, 375–7, 382–4, 477
single entry bookkeeping 431–41, 477
sole traders 5, 18, 477, 479–80
source documents 13–15, 18, 132–45, 149–52
standing orders 221, 418, 477
statements of account 132, 133, 141, 170, 477
statements of affairs 432–4, 435, 477
statements of financial position (balance sheets) 99, 477
accruals and prepayments in 257, 259
adjustments in, example of 266
assets in 29–34, 101–2
bad debts in 245, 247, 248, 250
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bank balance in 218
for cooperatives 396
depreciation and 236, 237, 238, 282
errors and 304, 307
inventory in 30–4, 289–90
for limited companies 380–2, 483–4
for manufacturers 368–9
for non-profits 321, 322, 323
for partnerships 336–7, 481
preparation of 99–104
for second year of trading 109
in single entry systems 438
for sole traders 480
suspense accounts and 304
stock see inventory
stockturn (inventory turnover) 122–3, 401, 475
straight line method 231, 281, 477
subscriptions 322–3, 477
substance over form 24, 477
super profits 343–4, 477
suspense accounts 205, 303–10, 477
T
T accounts 41, 477
taxes 424–5
time cards/sheets 423, 477
trade discounts 152–3, 477
trading accounts 118–22, 320, 362, 365, 477
trading and profit and loss accounts 88–96
adjustments in, example of 265
bad debts in 245
errors and 306–7
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extended trial balances and 280
for limited companies 377–8, 482
losses in 112–13
for manufacturers 367–8
for partnerships 333, 481
for second year of trading 107, 109
in single entry systems 437
for sole traders 479
see also profit and loss accounts
treasury bills 385–6
trial balances 477
errors and 80–1, 293–4, 303–12
extended 274–83
for manufacturers 366–7
for non-profits 320
preparation of 76–9
role of 12, 13, 17, 18, 76, 80, 274, 477
for second year of trading 106–7
for sole traders 264–6
statements of financial position and 99–100
trading and profit and loss accounts and 89, 92–3, 96
U
unit costs 352, 353, 477
V
variable costs 352, 477
vertical formats 33, 89, 95
W
work in progress 364–5, 477
working capital (net current assets) 102, 262, 405, 477
working capital ratio 402, 473
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worksheets (extended trial balances) 274–83, 487
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